Asset Prices: What can or should Monetary Policy do?

Hernando VargasBanco de la República

ColombiaOctober 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

1970 1975 1980 1985 1990 1995 2000 2005-50

0

50(%

)

1970 1975 1980 1985 1990 1995 2000 2005-5

0

5

(%)

Precio de los activos PIB (der)

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

ITES

90

95

100

105

110

115

120D

ic-0

1

Mar

-02

Jun-

02

Sep

-02

Dic

-02

Mar

-03

Jun-

03

Sep

-03

Dic

-03

Mar

-04

Jun-

04

Sep

-04

Dic

-04

Mar

-05

Jun-

05

Sep

-05

Dic

-05

Mar

-06

Jun-

06

Sep

-06

Dic

-06

Mar

-07

Jun-

07

Sep

-07

ITES

ITES FILTERED

Source: Corf insura. Authors' calculations.Note: This is an index of the price variability w eighted by the liquidity of some fixed income Colombian Government securities representing more than 95% of the daily trading.

IGBC

90

2090

4090

6090

8090

10090

12090

14090

Dic

-01

Mar

-02

Jun-

02

Sep

-02

Dic

-02

Mar

-03

Jun-

03

Sep

-03

Dic

-03

Mar

-04

Jun-

04

Sep

-04

Dic

-04

Mar

-05

Jun-

05

Sep

-05

Dic

-05

Mar

-06

Jun-

06

Sep

-06

Dic

-06

Mar

-07

Jun-

07

Sep

-07

IGBC

IGBC FILTERED

Source: BVC

Output Gap

-3,00

-2,00

-1,00

0,00

1,00

2,00

3,00

Dic

-01

Mar

-02

Jun-

02

Sep

-02

Dic

-02

Mar

-03

Jun-

03

Sep

-03

Dic

-03

Mar

-04

Jun-

04

Sep

-04

Dic

-04

Mar

-05

Jun-

05

Sep

-05

Dic

-05

Mar

-06

Jun-

06

Sep

-06

Dic

-06

Mar

-07

Jun-

07

Sep

-07

%

Source: Banco de la República

Loans/DGP

0,22

0,23

0,24

0,25

0,26

0,27

0,28

0,29

0,30

0,31D

ic-0

1

Mar

-02

Jun-

02

Sep

-02

Dic

-02

Mar

-03

Jun-

03

Sep

-03

Dic

-03

Mar

-04

Jun-

04

Sep

-04

Dic

-04

Mar

-05

Jun-

05

Sep

-05

Dic

-05

Mar

-06

Jun-

06

Sep

-06

Dic

-06

Loans/DGP

Filtered

Source: Banco de la República, DANE

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): 1980-2006

Granger Cuasality Tests –Total Investment 1980-2006

Dependent Variable Independent Variable Statistic p-value Asset prices Credit 21.06 0.00 Investment 2.83 0.09* Credit Asset prices 6.12 0.01 Investment 16.78 0.00 Investment Asset prices 0.06 0.81 Credit 13.52 0.00 * Significant al 10%

Evidence of the Financial Accelerator in Colombia

• Tenjo et al. (2007): 1980-2006

Granger Cuasality Tests – Home Building Investment 1980-2006

Dependent Variable Independent Variable Statistic p-value Asset prices Credit 20.88 0.00 Investment 4.95 0.03 Credit Asset prices 16.09 0.00 Investment 5.47 0.02 Investment Asset prices 0.03 0.87 Credit 12.84 0.00

Evidence of the Financial Accelerator in Colombia

• Tenjo et al. (2007): 1980-2006

Granger Cuasality Tests – Open Economy 1980-2006

Dependent Variable Independent Variable Statistic p-value Asset prices Credit 6.09 0.01 Investment 0.81 0.37 Real Exchange Rate 2.30 0.13 Credit Asset prices 5.85 0.02 Investment 41.15 0.00 Real Exchange Rate 46.25 0.00 Investment Asset prices 0.30 0.86 Credit 13.58 0.00 Real Exchange Rate 0.00 0.97 Real Exchange Rate Asset prices 10.33 0.00 Credit 0.03 0.86 Investment 0.05 0.82

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 1997-2003 (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”

3 Months 6 Months

1997 7,2% 1,9%1998 8,9% 3,6%1999 15,3% 7,2%2000 18,2% 9,9%2001 22,1% 13,9%2002 22,6% 15,8%2003 23,0% 16,6%

Source: Calculations based on Table 1 of Carranza and Estrada (2007)

payments past due three or six monthsPercentage of outsanding loans with

(Average for each year)

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

1970 1975 1980 1985 1990 1995 2000 2005-60

-40

-20

0

20

40

60

(%)

1970 1975 1980 1985 1990 1995 2000 2005-30

-20

-10

0

10

20

30

(%)

1970 1975 1980 1985 1990 1995 2000 2005-60

-40

-20

0

20

40

60

1970 1975 1980 1985 1990 1995 2000 2005-5

0

5

(%)

1970 1975 1980 1985 1990 1995 2000 2005-60

-40

-20

0

20

40

60

(%)

1970 1975 1980 1985 1990 1995 2000 2005-20

-10

0

10

20

(%)

Flujos de Capital (der)P. Activos Términos de Intercambio (der)

Tasa de Cambio Real (der)

P. Activos

P. Activos

Source: Tenjo et al. (2007)

Policy Reaction• Monetary policy has been pro-cyclical in past

episodes of capital inflows and improving TOT

Variation between Gap of Peak year and 2 years

before 2 years after peak year

and peak year Asset Prices 43.2 -9.9 GDP 5.2 -6.2 Investment/GDP 4.1 -17.5 Real interest rate -1.2 3.6 Monetary Base/ GDP 11.0 -6.1 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

1970-2006

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

Ratio of new home prices to rents(average 1994-2007 = 100)

80

90

100

110

120

130

Jun-95

Jun-96

Jun-97

Jun-98

Jun-99

Jun-00

Jun-01

Jun-02

Jun-03

Jun-04

Jun-05

Jun-06

Jun-07

Source: DNP and Banco de la República.

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

Ratio of used home prices to rents(Average 1988-2006 = 100)

80

90

100

110

120

Dic-94 Dic-95 Dic-96 Dic-97 Dic-98 Dic-99 Dic-00 Dic-01 Dic-02 Dic-03 Dic-04 Dic-05 Dic-06

Source: Banco de la República.

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

Mortgage Credit/GDP%

0,0

2,0

4,0

6,0

8,0

10,0

12,0

Jun-95

Jun-96

Jun-97

Jun-98

Jun-99

Jun-00

Jun-01

Jun-02

Jun-03

Jun-04

Jun-05

Jun-06

Jun-07

Source: Financial Superintendency and ICAV. Calculations by Banco de la República.

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 2004. Borradores de Economía No. 450. Banco de la República, 2007.

Tenjo, F. , Charry, L., López, M., Ramírez, J.M. Acelerador Financiero y Ciclos Económicos en Colombia: Un Ejercicio Exploratorio. Borradores de Economía No. 451. Banco de la República, 2007.