Asset Prices: What can or should Monetary Policy do? Hernando Vargas Banco de la República Colombia October 2007

Contents I.Answer II.Policy Reaction: A General Discussion III.Asset Prices in Colombia: Current Situation

Assumption: CB pursues price stability and cares about financial stability So, CB should at least monitor asset prices: –Information on future income flows –Information on current / future expenditure and financial position of households and firms (especially relevant in EMES  Financial accelerator) I. Answer

Colombia: Asset Prices and GDP cycles Source: Tenjo et al. (2007) <<

… and CB should react when asset price behavior and the behavior of other variables entail risks on price or financial stability How to react?  Tricky Answer

II. Policy Reaction: A General Discussion 1.Monetary policy should not necessarily respond to all episodes of volatility or “bubbles” in asset markets Example: Stock and public bond prices in Colombia in 2005: –No excessive leverage –Financial system capital adequate to cope with market risk –No other indication of financial/spending excess

Policy Reaction 2.Asset price movements that signal inflation or financial stability risks are not isolated… … They are generally part of a broader set of indicators of financial fragility and unsustainable expenditure growth  Financial accelerator

Evidence of the Financial Accelerator in Colombia Tenjo et al. (2007):

Evidence of the Financial Accelerator in Colombia Tenjo et al. (2007):

Evidence of the Financial Accelerator in Colombia Tenjo et al. (2007):

The relationship between asset prices and other financial and macro variables may be even more complex  Asset prices influence not only access to credit, but also the incentives to pay back loans: House prices and mortgage loan default (Carranza and Estrada, 2007) “Income variation had a very small effect on the default probabilities, compared with the effect of housing prices and mortgage balances…, which is consistent with a model of rational default behavior”

Policy Reaction 3.Asset price behavior in EMEs is related to external variables (TOT, capital flows) So, the response of monetary policy has to do with the issue of how to handle periods of plenty and capital inflows

Source: Tenjo et al. (2007)

Policy Reaction Monetary policy has been pro-cyclical in past episodes of capital inflows and improving TOT Source: Tenjo et al. (2007) This was partly due to fixed or quasi-fixed exchange rate regimes  Rapid monetary expansion, low interest rates, fast credit growth

Policy Reaction So, one thing EMEs could do is to float as much as possible Problem # 1: Adverse effects on tradable sectors –Another instrument is required: Countercyclical Fiscal Policy?  Too inflexible in some countries? –Capital controls?  Effective? Distorting?

Policy Reaction Problem # 2: Even under floating exchange rates and Inflation Targeting, it is possible that: –The nominal appreciation allows the inflation target to be met with low interest rates –Money demand and financial system liabilities grow too fast, since there is preference for domestic currency-denominated assets and CB accommodates demand for money at the policy interest rate  Rapid credit growth, asset price increases  Financial instability So, there may be a conflict between the price and financial stability concerns of the CB

Policy Reaction Alternative: Allow inflation to deviate from target (concentrate on “non-tradable” inflation?)  May be accommodated within a range target for inflation, but it may prove insufficient if the extent of the appreciation is large and the pass- through is high Beyond Monetary Policy: –Strengthen prudential regulation of the financial system (countercyclical features)  May induce foreign indebtedness of some residents anyway –Countercyclical fiscal policy again

III. Asset Prices in Colombia: Current situation Stock and public bond prices experienced a correction after April 2006 … … Since then, they have not deviated significantly from trend Exposure of Banks to market risk was reduced in 2006

House Prices and Mortgage Credit in Colombia: No signs of alarm yet

Asset Prices in Colombia: Current situation Monetary policy has been tightened since 2006 Q2 to reach declining inflation targets amidst strong aggregate demand growth Transmission mechanism was weakened by shifts in Banks´ asset portfolios  Sharp increases in business and consumer loans Provisioning standards have been raised and CB imposed marginal reserve requirements Price and financial stability objectives have been consistent so far

References Carranza, J.E. and Estrada, Dairo. An empirical characterization of mortgage default in Colombia between 1997 and Borradores de Economía No Banco de la República, Tenjo, F., Charry, L., López, M., Ramírez, J.M. Acelerador Financiero y Ciclos Económicos en Colombia: Un Ejercicio Exploratorio. Borradores de Economía No Banco de la República, 2007.