October 16, 2007 A SSET P RICES I NCREASES IN LAC: W HAT C AN OR S HOULD M ONETARY P OLICY D O ?

2 Outline I. A SSET P RICES AND M ONETARY P OLICY II. M ACROECONOMIC D ISTORTIONS AND A SSET P RICES IN M EXICO ( E ARLY 90’S) III.M ACROECONOMIC S TABILITY AND F INANCIAL D EEPENING IN MEXICO (2000’S) IV.T HE R ELEVANCE OF A SSET P RICE C HANNELS FOR M EXICO V. C ONCLUSIONS

3 The role of asset prices in the transmission mechanism of monetary policy: Stock Market Effects on Investment: Tobin's q-theory (Tobin, 1969). Firms Balance-Sheet Effects: This mechanism is related to the “credit channel” (Bernanke and Gertler 1995). Households Wealth Effects: Consumption is determined by the lifetime resources of consumers (Ando and Modigliani 1963). I. Asset Prices and Monetary Policy

4 How should monetary policy respond to asset price movements? Two general monetary policy responses to fluctuations in asset prices have been proposed: Standard or Conventional Policy (Bernanke and Gertler 2001): Changes in asset prices should affect monetary policy only to the extent that they convey information about the future path of inflation and output. “Leaning against the bubble” or active policy (Ceccheti, Genberg, Lypsky y Wadhwani 2000): Monetary policy should be used to contain or reduce bubbles that push asset prices above the value implied by fundamentals, in order to alleviate their negative consequences on the economy. I. Asset Prices and Monetary Policy

5 Arguments in favor of activism: Bubbles in asset prices could have severe adverse macroeconomic consequences. The cost of ignoring bubbles can be high. Thus, reducing the bubble in advance is a preferred policy. The difficulties in identifying bubbles in asset prices do not justify ignoring them. I. Asset Prices and Monetary Policy

6 Arguments against activism: Identifying a bubble in progress is extremely difficult. A “leaning against the bubble” policy could destabilize the economy. It may require a significant policy rate hike, which may imply near-term deviations from central bank’s macroeconomic goals (with loss of credibility). It may affect considerably other sectors. Not all asset price booms result in burst. Alternative vehicles to avoid bubbles are financial regulation or supervision. I. Asset Prices and Monetary Policy

7 Risk-Management Approach of Monetary Policy A risk management approach to monetary policy involves describing the uncertainty and assessing the costs associated with each of the possible policies. This approach evaluates monetary policy under a wide range of scenarios, considering not only the scenario with the highest probability to occur. It may be worthwhile for Central Banks to take out some insurance against the formation of bubbles in asset markets and its potentially negative effects on the economy. I. Asset Prices and Monetary Policy

8 Outline I. A SSET P RICES AND M ONETARY P OLICY II. M ACROECONOMIC D ISTORTIONS AND A SSET P RICES IN M EXICO ( E ARLY 90’S) III.M ACROECONOMIC S TABILITY AND F INANCIAL D EEPENING IN MEXICO (2000’S) IV.T HE R ELEVANCE OF A SSET P RICE C HANNELS FOR M EXICO V. C ONCLUSIONS

9 Credit Expansions in Mexico Early 90s2000s Rigid exchange rate. Credit expansion based on capital inflows. Weak banking regulation and supervision. High contingent risk. Short maturity of government debt. Foreign currency denominated bonds. Inflation targeting, flexible ER. Credit expansion based in domestic savings. Strong banking regulation and supervision Macroeconomic stability. Issuance of financial contracts at longer term. Local currency denominated bonds. II. Macroeconomic Distortions and Asset Prices in Mexico (early 90’s)

10 Mexico: Real Housing Rent Index and Net Transfer of Resources* (Index 1980=100; % of GDP) *Current account balance less net interest payments Source: Banco de México and World Bank. II. Macroeconomic Distortions and Asset Prices in Mexico (early 90’s)

11 Financial Saving and Banks Foreign Liabilities (Stocks as of GDP) Source: Banco de México. II. Macroeconomic Distortions and Asset Prices in Mexico (early 90’s)

12 Outline I. A SSET P RICES AND M ONETARY P OLICY II. M ACROECONOMIC D ISTORTIONS AND A SSET P RICES IN M EXICO ( E ARLY 90’S) III.M ACROECONOMIC S TABILITY AND F INANCIAL D EEPENING IN MEXICO (2000’S) IV.T HE R ELEVANCE OF A SSET P RICE C HANNELS FOR M EXICO V. C ONCLUSIONS

13 Financial savings (M4) and inflation (% Rate; Percentage of GDP) Average maturity of Government securities and inflation (Days; Percentage) Source: Banco de México III. Macroeconomic Stability and Financial Deepening in Mexico (2000’s)

14 The recent rapid growth in housing finance through private mortgages appears grounded on more solid primary and secondary markets than in the past. Mortgage credit is issued at long maturities and the most common mortgage instrument used by private financial intermediaries is a fixed rate loan. Financial sector reforms have facilitated the standardization of mortgages issuances and the progressive securitization of mortgages contracts. The expansion in mortgages credit has been preceded by several years of stagnation and is not a response to a relaxation in lending standards. The current expansion of credit is based in domestic financial savings. III. Macroeconomic Stability and Financial Deepening in Mexico (2000’s)

15 Mortgage Credit (% of GDP) Source: Banco de México III. Macroeconomic Stability and Financial Deepening in Mexico (2000’s)

16 Households Balance (% of GDP) Source: Banco de México III. Macroeconomic Stability and Financial Deepening in Mexico (2000’s)

17 Net Financial Position of Households (% of GDP) Source: Banco de México. III. Macroeconomic Stability and Financial Deepening in Mexico (2000’s)

18 Outline I. A SSET P RICES AND M ONETARY P OLICY II. M ACROECONOMIC D ISTORTIONS AND A SSET P RICES IN M EXICO ( E ARLY 90’S) III.M ACROECONOMIC S TABILITY AND F INANCIAL D EEPENING IN MEXICO (2000’S) IV.T HE R ELEVANCE OF A SSET P RICE C HANNELS FOR M EXICO V. C ONCLUSIONS

19 Given the relative size of the stock market, an increase in stock prices, whether driven by fundamentals or by a bubble, is not expected to have a significant impact on consumption expenditures. Common stocks are not the most important component of households wealth. Nevertheless, they have been gaining importance in the last few years. Housing is a more important component of households wealth than common stocks. However, mortgage credit as a fraction of GDP still has a small value compared to a decade ago. High transaction costs and the lack of mechanisms for withdrawing housing equity, reduce the effect of real state price increases on consumption expenditures. IV. The Relevance of Asset Price Channels for Mexico

20 Market Capitalization (% of GDP) Source: World Bank. Capitalization Value of BMV (% of GDP) Source: World Bank. IV. The Relevance of Asset Price Channels for Mexico

21 Outline I. A SSET P RICES AND M ONETARY P OLICY II. M ACROECONOMIC D ISTORTIONS AND A SSET P RICES IN M EXICO ( E ARLY 90’S) III.M ACROECONOMIC S TABILITY AND F INANCIAL D EEPENING IN MEXICO (2000’S) IV.T HE R ELEVANCE OF A SSET P RICE C HANNELS FOR M EXICO V. C ONCLUSIONS

22 Macroeconomic stability and a strong financial regulation and supervision are factors that help to avoid the formation of bubbles in asset prices. Nowadays, domestic financial markets have strengthened and deepened. Nevertheless, in Mexico financial intermediation is still low, both compared to international levels and to the size of the Mexican economy. However, to the extent that asset markets become deeper, the role of asset price channels may possibly gain more importance in the transmission mechanism of the monetary policy in Mexico. Conclusions