The debate may seem academic, but actually it has far reaching implications. When central banks set the rate of interest, should they then take into account asset prices?
Alan Greenspan might be known as the maestro, but he says that central bankers have no way of knowing if asset prices have risen too high. In effect he is saying you can’t expect the likes of Ben Bernanke and Mervyn King to be able to second guess the markets.
That’s why Mr Greenspan did something of a turnaround in the run up to the dotcom crash. Originally he talked about irrational exuberance, but then softened his tone. These days the maestro has started using the phrase ‘leaning against the wind’ when talking about taking asset prices into account when setting rates, and suggests that it can’t be done.
In the UK, Paul Tucker, a director at the Bank of England and a member of its rate-setting Monetary Policy Committee, recently gave a speech in which he said: “For too long, the debate has got sidetracked. Into whether we can rely on monetary policy ‘mopping up’ after bubbles burst. Or into whether monetary policy could be used to control asset prices…But let me make this absolutely clear: there are formidable obstacles to finding a solution.”
But yesterday, in its latest report, the IMF seemed to disagree. “Financial developments,” it said, “have fueled the continuing debate about the degree to which central banks should take asset prices into account in setting monetary policy…Recent experience seems to support giving greater weight to house price movements in monetary policy decisions, especially in economies with more developed mortgage markets where ‘financial accelerator’ effects have become more pronounced. This could be achieved within a risk-management framework for monetary policy by ‘leaning against the wind’ when house prices move rapidly or when prices have moved out of normal valuation ranges, although it would not be feasible or desirable for monetary policy to adopt specific house price objectives.”
It has been suggested that the solution to all this is simple enough. All you need to do is change the time frame over which central banks have to keep inflation in check. If the Bank of England was allowed to take into account the longer-term forces that determine inflation – and focus on keeping it under control over the long-term, it would in any case look more closely at asset prices.
The trouble is this. Low interest rates can help encourage investment into business. This can result in higher productivity, which in turn can reduce inflationary pressures. So in some respects lower interest rates could lead to lower inflation in the long-term – at least, that’s our view – although it is not a conventional opinion.
But this positive force is contradicted by another force – lower rates encourage higher consumer borrowing, and lead to higher house prices which in turn encourage consumer booms which could be both inflationary and unsustainable. The key, surely, is to find a way that ensures lower interest rates do not automatically lead to escalating asset prices.
This can be achieved through encouraging mortgage providers to insist on lower income-to-loan multiples, through encouraging more mortgage deals that offer fixed rates over the long term, and perhaps through tinkering with the way buy-to-let investors can offset interest payments on their mortgages against revenue.
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