An overheated housing market proved to be a catalyst for the recent economic meltdown. It spurred unsustainable borrowing and inflated consumption as people perceived themselves to be richer. However the higher house prices have not been underpinned by higher future income prospects. Overcooked house prices still pose difficulties to the economy. This phenomenon sparks a number of questions. Why aren’t asset prices, such as house prices, accounted for in monetary policy directly? How can asset prices be controlled? And what is being done to ensure that disruptive house price booms do not occur again?
The events of recent years have knocked the credibility of macroeconomic policy and highlighted inadequacies in current economic practice. The measure to control asset price misalignments, and notably housing, is one of these inadequacies. It is widely acknowledged that asset price imbalances create volatility in a number of economic variables, including inflation and output.
Due to the disruptions over-inflated asset prices can provoke, policymakers are forced to consider the effects of misalignments. However, there is no weapon in the arsenal of central bankers that can directly affect asset prices.
Adjusting the OCR is the main instrument available to central banks but this has not proved to be effective in taking the steam out of consumer spending and over investment in housing in a timely way. Part of the problem has been that lending rates are determined on international markets, which until the crisis hit were flooded with funds from China and other countries with balance of payment surpluses. In New Zealand, raising interest rates in an attempt to take air out of the bubble caused further strain on the exchange rate and exporters.
Some economists argue that there is insufficient information for a central bank to identify a bubble with any certainty. Others argue that leaning against a bubble is simply impractical, due to interest rate lags. However, the same argument could be made for controlling inflation in the conventional way.
A number of alternative potentially workable options have been investigated in New Zealand. The Treasury and Reserve Bank found that a Mortgage Interest Levy (MIL) was deserving of further investigation as a possible alternative to controlling house prices. The MIL was envisaged as an additional demand management instrument to supplement the OCR. In periods of particular pressure in the housing market and when the interest rate cycle is out of step with that internationally, a levy could be imposed on mortgage interest rates to ease the stress. This would reduce the adverse impact on exporters that monetary policy measures can create. However the previous Government put the idea on ice, and the current Government has not so far revived the idea.
There is a tax exemption for owner-occupied property held for less than two years. Removing this has also been suggested as a way to cope with wildly swinging house prices. Currently, only gains on non owner-occupied properties purchased with the intention of resale are liable for income tax. With increased publicity and enforcement, some effects on house price cycles could be possible. Such a policy would also help address the structural bias housing has over other forms of investment in the country.
Another option is counter-cyclical capital requirements on banks. This raises bank capital requirements in good times and lowers them in bad, which helps to nullify the tendency for bank lending to become looser when the house market starts ballooning. Similarly it may ease up lending on the downside of a cycle.
These propositions do have complications and trade offs that need to be considered. As we have seen, finance markets find ways to get around restrictions to serve their own ends. Trying to reduce a bubble in the house market may also cause pressures in other areas.
The fact that the housing market in New Zealand has not experienced nearly as much of a collapse as the US, together with the fact that the worst of it is now behind us, may lead to the inclination to let the issue of asset prices slip under the radar. The crisis offers us a rare opportunity to implement reforms to the operations of monetary policy. Therefore it is in this time that research into improving the current policy mix is crucial. Controlling house prices is an area that is in need of further research because rest assured, there will come a time in the future where a disruptive housing bubble does reappear. We need to be prepared for how to deal with this and cannot afford to chuck it in the 'too hard’ basket.