Houses in the Grund district of Luxembourg City, Luxembourg, one of the countries experiencing a housing boom (photo: The Travel Library/REX/Newscom)
Monetary Policy in Boom-Bust Cycles
IMF Survey: Many central banks around the world need to keep interest rates low to support an ailing economy but want to avoid triggering a boom in the housing market. What’s your advice on how this can be done?
Svensson: First, one must identify what problems one needs to solve while keeping in mind the available policies and policy tools, the objectives of these policies, and what the policies can achieve.
Let me start with monetary policy. With flexible inflation targeting, the objective of monetary policy is to stabilize inflation around an inflation target, and resource utilization (measured for instance as the unemployment rate) around its long-run sustainable rate. The main policy instruments are the central bank’s policy rate (such as the federal funds rate in the United States) and its communication, including forward guidance by the central bank on how the rate is likely to change in the future. When the policy rate is constrained by its lower bound (which, as I explained in a speech in 2009, is not zero but negative, and not hard but soft), unconventional monetary policies such as large-scale asset purchases (known as quantitative easing) and exchange rate policies (foreign exchange interventions and currency floors) can also be used.
It is important to remember the limitations of monetary policy. Monetary policy cannot achieve financial stability. For that, you need financial stability policy, that is, macro- and microprudential policy and corresponding supervision and regulation. Nor can monetary policy solve structural problems. For that, you need the appropriate structural policy or policies.
If the central bank’s forecast for inflation in an economy is below the inflation target, and the forecast for the unemployment rate in the economy is above its long-run sustainable rate, expansionary monetary policy is called for. That means that the policy rate must be below the so-called neutral interest rate—the interest rate that is consistent with unemployment reaching its long-run sustainable rate in a year or so. If that is prevented by the lower bound for the policy rate, the unconventional policies mentioned above are warranted.
IMF Survey: But what if the economy is also experiencing a housing boom, in the form of rising housing prices. Does that then call for additional policy action?
Svensson: That depends on whether the boom is a problem or not. Rising housing prices need not be a problem. If the general level of interest rates falls because the neutral interest rate falls, equilibrium housing prices will rise, everything else equal, because equilibrium housing prices reflect the present value of future housing services. With lower interest rates, the present value of future housing services is higher. It is important to remember that the neutral inflation-adjusted interest rate is determined not by monetary policy but by underlying structural factors such as a “saving glut,” demographics, and the economy’s potential growth rate. Monetary policy can make the actual inflation-adjusted policy rate deviate above or below the neutral inflation-adjusted rate for a few years, but it does not determine the neutral real rate.
Thus, whether rising housing prices are a problem or not requires thorough analysis:
â— Are the rising prices the natural response to rising disposable income, falling equilibrium mortgage rates, and/or reduced effective housing taxes?
â— Are they the consequence of urbanization from rural regions with low and stagnant housing prices to congested urban regions where prices are increasing due to high demand and limited space for new housing?
Is construction limited because of regulation and zoning restrictions? Or are the rising prices the consequence of falling mortgage lending standards or increasing loan-to-value ratios? Are the rising prices due to more people buying housing to live in, so-called buy-to-live, or because more people are buying them as investments—buy-to-rent? Are the housing costs for owner-occupied housing, including mortgage debt service, rapidly rising above rents, and are they becoming unsustainably high relative to disposable incomes?
â— Are the rising housing prices due to unrealistic expectations of future housing prices or mortgage rates? Are the new higher housing prices sustainable or not? Are the rising housing prices resulting in mortgage equity withdrawals that finance excessive consumption, revealed by unsustainably low or even negative household saving?
â— How are household balance sheets evolving? Are loan-to-value and net-wealth-to-total-assets ratios reasonable? Are borrowers’ repayment capacity and resilience to shocks such as increasing mortgage rates, falling housing prices, and income losses due to unemployment satisfactory?
Only after analyzing a country’s situation and answering questions such as those above can it be determined whether the rising housing prices are a problem and, if so, the nature of the problem. And only after the nature of the problem has been clarified can the appropriate policy to handle the problem be determined. The appropriate policy may be housing, macroprudential, or fiscal policy, or a combination of those.
IMF Survey: Can’t monetary policy also be one of the tools used to manage a housing boom?
Svensson: It has been suggested that monetary policy should be leaning against the wind of rising housing prices and household debt. Here, “leaning against the wind” means tighter policy than justified by stabilizing inflation around the inflation target and the unemployment rate around its long-run rate. It means aiming for average inflation somewhat below target.
If the inflation target is credible so that inflation expectations are anchored at the target, average inflation will fall below inflation expectations. Then there will be costs in the form of higher unemployment that exceeds its long-run sustainable rate. Inflation below households’ inflation expectations also means that the households’ real debt burden increases.
If inflation expectations instead adjust downward, meaning that the inflation target is no longer credible, there may be smaller costs in the form of higher unemployment and increased debt burden, but that loss in credibility may make it more difficult to achieve the inflation target in the future. Furthermore, the combination of low inflation and low inflation expectations makes the economy more vulnerable to negative shocks and increases the risk that the economy gets stuck in a liquidity trap with a binding lower bound for the policy rate.
Thus, leaning against the wind has a substantial cost in terms of a worse macro outcome during the next few years and an increased risk of being trapped with a binding lower bound for the policy rate. What are the potential benefits? One possible benefit is that somewhat higher policy rates and thereby mortgage rates may dampen the growth of housing prices and thereby that of household debt. Furthermore, less household debt might reduce the probability of a future crisis and/or the depth of a crisis in case it would occur, resulting in a better average future macroeconomic outcome. If the benefit exceeds the cost, leaning against the wind is arguably justified. But this requires a quantitative assessment of the cost and benefit. A gut feeling is not enough.
IMF Survey: How can one carry out such a quantitative assessment?
Svensson: In assessing the policy rate impact on household debt, one has to take into account that nominal household debt displays considerable inertia; the average length of mortgages is several years, so only a fraction of mortgages turn over each year. Furthermore, tighter monetary policy dampens the growth of both the price level and nominal disposable income. Thus, tighter policy slows down both the numerator and the denominator of both real debt and the debt-to-income ratio. Thus, the net effect of higher policy rates on real debt and debt-to-income is likely to be quite small.
According to existing estimates the effect is indeed quite small and often not statistically significant. Higher policy rates may even increase real debt and/or the debt-to-income ratio, as some research has found. Using also estimates of how the probability of a crisis depends on real debt and how the depth of crisis depends on initial household debt, it is then possible to estimate the benefit of leaning against the wind. Given existing estimates of the impact of the policy rate on unemployment, it is possible to estimate the cost in terms of unemployment of leaning against the wind. For cases I have examined, the benefit is much less than the cost, in many cases even less than 1 percent of the cost. That is, the cost in those cases is more than 100 times the benefit. According to these calculations, leaning against the wind is clearly not justified.
The conclusion is that monetary policy is not suitable for handling problems of rising housing prices and household debt. Leaning against the wind indeed seems inherently flawed as a policy to manage such problems. So, as I see it, there is no choice but to use other policies, such as macroprudential policy, housing policy, or fiscal policy.
IMF Survey: How can policymakers assess whether household debt poses a problem?
Svensson: For assessments of whether household debt is a problem or not, the annual Mortgage Market Report of Finansinspektionen, the Swedish Financial Supervisory Authority, provides a good model. In this annual report, Finansinspektionen uses individual data on new borrowers collected from the banks to assess the banks’ lending standards and the borrowers’ repayment capacity. Furthermore, stress tests on the individual data are used to assess the borrowers’ resilience to shocks in the form of increases in mortgage rates, drops in housing prices, and reductions in income due to unemployment. After detailed and thorough analysis, the assessment of Finansinspektionen in its reports over the past few years is that the banks’ lending standards are high and that new borrowers’ repayment capacity and resilience to the shocks mentioned are good. Such detailed analysis provides essential information about any risks associated with the housing and mortgage market.
IMF Survey: When household debt is judged to be problem, how can it be handled?
Svensson: As I said, it is important to first clarify and analyze the potential problem; the appropriate policies depend on the precise problem found. For instance, a loan-to-value cap for new mortgages can ensure that new borrowers have a sufficient down payment and equity in their housing as a buffer against any fall in housing prices. Risk weights on mortgages and the capital requirements for systemically important banks can be increased, in order to make banks more resilient to credit losses. Monitoring of banks’ lending standards and borrowers’ repayment capacity and resilience to shocks can be improved. Zoning restrictions and red tape can be eased to allow more construction. Each country’s macroprudential and other policy actions need to be tailored to the particular problems and issues in that country. The situation varies a lot from country to country. There is no one size that fits all.
