Bank policy could stop
house price bubbles
Ahmed Olayinka Sule, CFA, believes that the EXECUTIVE SUMMARY
current house-price crash and attendant
• The impact of the credit crisis is
fi nancial crisis could have been avoided if central
spreading to all sectors
banks had leant against the wind and taken a
• It can be traced back to the Fed’s
accommodative monetary policy
proactive approach to monetary policy
• A proactive approach may well have
stopped the bubble in its tracks
BY: AHMED OLAYIKA SULE,CFA
s the credit crisis bites deeper, shareholders, banks and Considering the importance housing
A
bondholders continue to lose billons of dollars. Since the plays in any economy, as well as the
start of the crisis in August 2007, fi nancial institutions have detrimental eff ects of burst housing
suff ered estimated write-downs and losses in excess of $600 bubbles, should monetary regulators
billion. Th e impact of the credit crisis is now spreading. Furthermore, contain housing credit bubbles?
consumer confi dence is at a long-time low, and activities in the Th ere are currently two camps: the
manufacturing and services sectors are rapidly declining. fi rst argues that monetary policy is an
Where did it all begin? Th e crisis has it root in the US housing ineff ective tool for preventing the
bubble, which started to infl ate in 2000 and 2001, by the build-up of asset bubbles; hence, they
accommodative monetary policy of the Federal Reserve Bank. advocate that central banks should
Th is introduced excess liquidity into the fi nancial system, resulting instead react after such bubbles have
in reduced risk premiums and credit spreads. It also increased investors’ burst. Th is is the approach adopted by
risk appetite. Th e accommodative policy encouraged lax credit most central banks. Th e second camp,
standards, which enabled less creditworthy borrowers and investors to which prefers a more proactive
speculate in real estate. As a result, a housing bubble ensued, resulting approach, suggests that monetary
in unsustainable valuations. Between 2000 and 2006, housing prices in regulators should ‘lean against the wind’
the US, according to the S&P/Case-Shiller Home Price Index, by using monetary policy tools to
increased by 73.6%, compared with a 14.8% increase in US median contain the future growth of potentially
income, and a 22.6% increase in rent across US cities over the same detrimental asset price bubbles.
period, as shown in table 1. Leaning against the wind is the use
of monetary policy to defl ate a
ROLE OF CENTRAL BANKS IN ASSET PRICE DEVELOPMENTS: potentially harmful bubble. It involves
Relative to other types of bubbles, housing credit bubbles should central banks increasing interest rates
concern monetary regulators more, for three reasons: housing assets above that normally required to achieve
constitute a greater proportion of household wealth, especially for a stable infl ation level. It is a proactive
low-income households; housing generates wealth for its owners, and approach to tackling asset bubbles
these have a direct eff ect on their consumption pattern; and housing when they are identifi ed, rather than
bubbles have a greater probability of defl ating, and they often result waiting to clear up the mess after they
in higher output losses. have burst.
38 WINTER 2008/09
38-4138-41 house bubble.indd 38house bubble.indd 38 27/11/0827/11/08 16:44:3516:44:35
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