An overheated housing market proved to be a catalyst for therecent economic meltdown. It spurred unsustainable borrowing and inflatedconsumption as people perceived themselves to be richer. However the higherhouse prices have not been underpinned by higher future income prospects.Overcooked house prices still pose difficulties to the economy. This phenomenonsparks 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 occuragain?
The events of recent years have knocked the credibility ofmacroeconomic policy and highlighted inadequacies in current economic practice.The measure to control asset price misalignments, and notably housing, is oneof these inadequacies. It is widely acknowledged that asset price imbalancescreate volatility in a number of economic variables, including inflation andoutput.
Due to the disruptions over-inflated asset prices canprovoke, policymakers are forced to consider the effects of misalignments. However,there is no weapon in the arsenal of central bankers that can directly affectasset prices.
Adjusting the OCR is the main instrument available tocentral banks but this has not proved to be effective in taking the steam outof consumer spending and over investment in housing in a timely way. Part ofthe problem has been that lending rates are determined on international markets,which until the crisis hit were flooded with funds from China and othercountries with balance of payment surpluses. In New Zealand, raising interestrates in an attempt to take air out of the bubble caused further strain on theexchange rate and exporters.
Some economists argue that there is insufficient informationfor a central bank to identify a bubble with any certainty. Others argue thatleaning against a bubble is simply impractical, due to interest rate lags.However, the same argument could be made for controlling inflation in theconventional way.
A number of alternative potentially workable options havebeen investigated in New Zealand. The Treasury and Reserve Bank found that aMortgage Interest Levy (MIL) was deserving of further investigation as apossible alternative to controlling house prices. The MIL was envisaged as anadditional demand management instrument to supplement the OCR. In periods ofparticular pressure in the housing market and when the interest rate cycle isout of step with that internationally, a levy could be imposed on mortgage interestrates to ease the stress. This would reduce the adverse impact on exportersthat monetary policy measures can create. However the previous Government putthe idea on ice, and the current Government has not so far revived the idea.
There is a tax exemption for owner-occupied property heldfor less than two years. Removing this has also been suggested as a way to copewith wildly swinging house prices. Currently, only gains on non owner-occupiedproperties purchased with the intention of resale are liable for income tax.With increased publicity and enforcement, some effects on house price cyclescould be possible. Such a policy would also help address the structural biashousing 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 thehouse market starts ballooning. Similarly it may ease up lending on thedownside of a cycle.
These propositions do have complications and tradeoffs thatneed to be considered. As we have seen, finance markets find ways to get aroundrestrictions to serve their own ends. Trying to reduce a bubble in the housemarket may also cause pressures in other areas.
The fact that the housing market in New Zealand has not experiencednearly as much of a collapse as the US, together with the fact that the worstof it is now behind us, may lead to the inclination to let the issue of assetprices slip under the radar. The crisis offers us a rare opportunity toimplement reforms to the operations of monetary policy. Therefore it is in thistime that research into improving the current policy mix is crucial. Controllinghouse prices is an area that is in need of further research because restassured, there will come a time in the future where a disruptive housing bubbledoes reappear. We need to be prepared for how to deal with this and cannotafford to chuck it in the â€˜too hard’ basket.
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