FYI | Sep 28 2009
By Chris Shaw
The housing and stock price bust that resulted from the global financial crisis has been the most synchronised of its type in the past 40 years according to Commonwealth Bank economst James McIntyre, one significant enough to lead to increased debate on how best to conduct monetary policy to deal with asset price fluctuations.
McIntyre notes the International Monetary Fund (IMF) has done some studies on this, finding, not surprisingly, that asset busts such as that experienced over the past 12-18 months are costly events. Looking at the 82 stock and house price busts between 1985-2000 it estimates the average decline in GDP relative to trend from such a happening is 1.3% for stock price busts and 3.3% for house price busts.
The issue in the IMF’s view is the traditional focus of monetary policy, where the emphasis is on indicators such as output and inflation, can miss the early warning signs of an impending asset price bust. To try to assist, the IMF has come up with some early warning indicators of such a bust, these including lax lending standards, an excessive expansion in credit, too much investment and a worsening in a country’s external imbalances.
The problem remains that these indicators don’t always work as the IMF’s studies show they failed to give warning signs in about half of all busts since 1985, meaning there remains the need for policymakers to remain alert to what is happening in their economies given different rules are needed in different circumstances.
As McIntyre notes this leaves it open for a choice between a monetary policy style that tries to assist by preventing finacial vulnerabilities and one that tries to help the economy recover once a bust has occured. One option according to the IMF is to use an asset price targeting mechanism as then households and investors know interest rates will be used against them if asset prices are bid up, so factoring the threat of reaction into their decision making process.
Such an approach may result in less extreme asset price movements, but as McIntyre points out, the key according to the IMF’s studies remains for economies to retain some flexibility so they can adopt to whatever shocks the economic environment throws at them while still being able to respond to stimulus measures. As McIntyre notes, Australia is very lucky to have such flexibility in its economy at present, as evidenced by its solid economic performance compared to other nations during the current financial crisis.
