CENTRAL BANKS TO PAY GREATER ATTENTION TO ASSET PRICES?

29.03.2021 The New Zealand central bank will, following a change of its mandate, have to not only target inflation but also aim to achieve more sustainable house prices. Does this foreshadow a move to try to rein in increasingly volatile asset prices around the world?

In 1990 New Zealand was the first country in the world to introduce an explicit medium-term inflation target. This approach was subsequently adopted by most advanced economies around the globe.  The primary rationale for doing this was that volatile and unexpected inflation imposed significant costs on an economy. One of the main costs identified was that volatile inflation tended to misallocate resources across the economy, via mistaken investment decisions, as businessmen tended to confuse rising inflation with rising profits.

However, the success that central banks around the world had in delivering stable inflation and low interest rates coincided with increasing speculative activity in housing and equity markets. For example in America the low interest rates that followed the .dotcom bubble are seen as having sown the seeds of the 2000’s real estate boom. This in turn precipitated the Credit Crunch of 2008/09.  Following the enormous cost associated with cleaning up the financial system, after the Global Financial Crisis, macroprudential regulatory frameworks were put in place. These aimed to ensure that financial systems, as a whole, would be in a stronger position to withstand economic shocks and asset price bubbles. For example, the authorities could require certain banks to hold additional capital if their lending was deemed increasingly risky. Alternatively, a limit could be placed on the amount house-buyers could borrow compared with the cost of a house or their income.

Whilst the financial systems of the UK and the US are undoubtedly much more robust, macroprudential regulation has not banished speculative activity from asset markets. Indeed, in a low interest rate environment it is inherent within a modern financial system. This is because human nature tends to look for ways round regulations and human ingenuity has always found new assets and new markets to speculate on. In America much has been made of the impact that the army of retail investors has had on the US stock markets. While the impetus for including house prices in the Reserve Bank of New Zealand’s mandate was unaffordable housing and galloping house price inflation.

If part of the rationale for moving to inflation targeting regimes was that volatile and unexpected inflation misallocated resources then asset prices are also important variables. This is because volatile house prices and stock markets, that are prone to speculation, misallocate resources as well. At certain points in time slightly lower inflation and higher interest rates may well be a better outcome than the economic and financial damage that bursting asset price bubbles cause.

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This post was written by Robin