Why do central banks ignore asset prices?

Via FTAlphaville’s Claire Jones:

Comments on our articles about central banks’ attempts to fix the global economy through printing trillions in whatever currency tend to be a bloodbath. The prime swipe being that policymakers are wrong to carry on unleashing more and more stimulus on the grounds that they are falling short of their inflation targets because, actually, there is loads of inflation if you look at asset prices.

The voice of our dear readers mirrors the broader public debate, not least because rampant inflation in asset prices has a knock-on effect on a lot of people’s housing costs, even if they are not buying a property. We’d recommend this article, from Bloomberg, for a sense of the debate:

In the trendy Malasaña neighborhood of Madrid, Ramon G. del Pomar’s rent tripled to 3,500 euros ($3,900) per month when his contract came up for renewal. It was the kind of bumper increase that’s become a scourge of up-and-coming areas across Spain in recent years — all while official inflation averages about 1%.

“When I hear 1%, I laugh,” the 69-year-old Del Pomar said in an interview. “The figure must be false, because many, many people now pay more than half their income just for an apartment.”

We have included this in our Someone Is Wrong on the Internet series, but we think the commenters might be right. At the very least the criticism touches on an important point. It needs better explaining why central bankers don’t target a measure that includes movements in asset prices — chief among them changes in the cost of housing.

Madrid isn’t the only city where people have seen a big disconnect between surging property prices and wage growth. In Amsterdam, which is Europe’s most extreme example, house prices rose 64 per cent in the five years to September 2018, but real disposable household income grew just 4.4 per cent in that time, despite ultra-low unemployment. Without a bigger pick-up in wages, it is unsurprising that inflation for everyday goods and services is still so low.

Still most central banks target a measure of inflation that is made up of a basket of prices for goods we consume. The Bank of England targets CPI and the European Central Bank HICP, to name two examples.

A common reason for not including housing is that methodological disputes between statisticians (which we want to return to later) means that there is no consensus on what would be the right measure of housing costs to use. Another is that buying a house represents something you invest in, rather than something you consume.

We think, however, that you can make a strong case to see housing as something that people both invest in and, at least until the mortgage is gone, pay for as they consume it. It also makes up a massive chunk of most people’s spending, meaning that we would expect big changes in their economic behaviour — including how they consume other goods — should the price of housing shift.

Indeed if we take the US experience, we can also see that a closer examination of property prices in the run-up to 2007 might have suggested that interest rates were way too low. So why are central bankers still choosing to target measures of inflation that do not include house prices post-crisis?

For a better grasp of the statistical problems, we need to go back in time to 1983.

Up until then the most commonly used measure of US inflation included changes in house prices, but at that point it was replaced by a measure of what was dubbed as “non market rents”. In 1998, any measure of house prices was dropped altogether (though some measures still calculate changes in rents). European officials have also squabbled over how to include housing costs in their inflation measures. (To get a sense of some of the issues, the FT’s economics editor Chris Giles recommends this.)

When central banks were beginning to enter a new era of independence and inflation targeting in the early 1990s, this neglect of asset prices also owed more than a little to two economic theories that at that time were the flavour of the day.

The first was the belief that Robert Lucas had effectively solved the problem of how to deal with shortfalls in aggregate demand. If you can always stoke more aggregate demand, then why care about what happens to housing or other asset prices? If they fall and that leads to a general fall in consumption, then we know how to cure the problem.

The second was that the prevalence of the efficient markets hypothesis, which meant that there was a common view that asset prices largely reflected economic fundamentals. That housing costs could become unmoored from underlying conditions was not something that the pre-crisis generation of central bankers believed could happen. Former Federal Reserve Chair Alan Greenspan, for instance, described the crisis as showing a “flaw” in a worldview that emphasised deregulation that had served him well for 40 years. It therefore didn’t matter whether changes in asset prices were included in inflation baskets as the changes would broadly, over time, be reflected over time in consumption goods.

After the crisis in 2008, ignoring asset prices in a belief that markets are self-stabilising no longer looked wise. But rather than change their inflation targets, policymakers have preferred to look at things like changes in housing costs with a different hat on.

As far as most central bankers are concerned, controlling consumer prices should remain the focus of monetary policy. Controlling asset prices, meanwhile, should be done through the prism of safeguarding financial stability. This, they argue, should be done through what is known as macroprudential measures.

Macroprudential policies are often implemented by finance ministries and central banks together and differ from monetary policy in another respect: they tend to target specific market segments, limiting the supply of, say, riskier mortgages as opposed to influencing economic conditions through controlling the price of credit. This, they argue is a better way of dealing with problems that are often quite localised. Some countries, including the UK, have already started experimenting with them.

Which is all very neat and tidy but some central bankers are privately suspicious that these new tools actually work, with the more determined banker and borrower able to find a way around them. Seeing what’s happening in cities like Madrid and Amsterdam, one can appreciate why.

David Llewellyn-Smith
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