Consumer price and asset price inflation: Looking the wrong way

Recent readings of the harmonized index of consumer prices (HICP) suggest a nontrivial risk of dipping into deflation in the euro area. While ECB's Draghi sticks to his "subdued price pressures" line, the IMF's Madame Lagarde has already called central bankers to arms to fight the "ogre" of deflation.  This post argues that asset price inflation--in particular housing--is driving an overlooked wedge between the HICP and the cost of living, which ECB and commentators should take into account.

As shown below, asset prices have risen markably throughout Europe and Germany, much more than harmonized consumer prices. Stock and bond prices have advanced since 2011, albeit from depressed levels in some cases. Real estate prices are rising in Germany, among other euro area countries.

The HICP is largely aloof of asset price inflation. One perennially controversial item is the cost of housing. Currently, Eurostat's HIPC assigns small weight to housing--about 10 percent--as it excludes the implied cost of owner occupied housing given these are seen as capital expenditures. Eurostat is set to include owner-occupied housing cost in the HICP in a few years. This will significantly lift the weight of housing cost in the HICP, and lead to an increase in HICP measured inflation. Deflation no more.

House prices could and should also affect inflation expectation as the method for housing cost reflect average rather than marginal house prices. An example: Expectations of housing cost inflation of a young (and economics-literate) couple are less likely based on the constant rent they are currently paying for their current small student flat. Rather, the couple's expectations should be driven by run-away prices for family-size apartments in job-rich cities, such as Munich or Hamburg.

But there are more reasons for the ECB to take into account asset prices. Asset price inflation can stoke risks to financial stability. Juergen Stark once warned that "doing too much for too long" inhibits healthy balance sheet adjustments and leads to distortions. While financial stability is not at the core of ECB's mandate, ECB will increasingly become responsible for prudential and supervisory policies as well.

It is not deflation, it is the incapacitated transmission channels that ECB needs to fix. To achieve that, unconventional (and un-German) measures may be needed to avoid fueling unhealthy asset price inflation.

Read More

Policy responses to debt overhang: Asset price support

The role of sectoral balance sheets, and their linkages, is used oftentimes to explain the euro area crisis and the sluggish recovery. Richard Koo's holy grail narrative of balance sheet recessions experiences a post-academic renaissance. A recent Vox piece by Jorda, Schularick, and Taylor adds to the empirical analysis in this field. (Let me forgive them to cite the infamous 90 percent public debt-to-GDP threshold.)

Their research shows that in advanced economies, balance sheets of the household and financial sectors empirically play a pivotal role in explaining the outbreak of crises and the speed of recovery. Strong government balance sheets, i.e. low public debt and a healthy structural balance (also coined "fiscal space"), help to mitigate a shock.

These are all useful empirical insights, but what are the mechanics which need to be understood to develolp effective policy responses? This is yet less clear. This blog argues for the importance to prevent asset price undershooting, using the example of the recent household debt crises in Ireland, Spain, and--to a lesser degree--the UK and US.

In these countries, households thrive to deleverage, i.e., shrink and repair their balance sheets from a debt load which exceeded 100 percent of GDP. Agents save instead of spend, in turn depressing incomes and output. For instance, household savings rates since 2007 jumped by 4-5 percentage points in Ireland and the UK. House price declines of 50 percent in Ireland, 30 percent in Spain, and 20 percent in the US have spread negative equity which in turn induced mortgage default, crippling the banking system.

The usual policy response of bank stress tests, bank recapitalization and the like has ensured banks are mostly sound and well capitalized. Also, interest rates, the core monetary policy tool, has in part helped households' debt burden to become more affordable and reduce defaults. But many banks couldn't benefit from lower rates, owing to impaired monetary transmission channels.

So... what other policies are needed?

Direct debt relief would help but in many cases is unaffordable. While household debt relief following the Great Depression or in the fairly small mortgage sector in Iceland worked, the public purse is too small for such a policy response in places like Spain, Ireland, and the Netherlands where household debt is higher and public debt not low. If markets see such a policy as undermining public debt sustainability and demand higher risk premia, banks' funding conditions usually worsen as well, offsetting the benefit of such policy.

What looks more promising is a financial policy that buffers asset prices which, given the size of balance sheets, could have a very wideranging effect. Generally, market prices often get depressed amid thin trading in the aftermath of popped price bubbles, and it takes little to avoid asset prices to undershoot their fundamental levels. This will prevent damage from balance sheets of all agents holding that asset. Thus, in countries with a high degree of home ownership, a policy that carefully avoids excessive house price slumps can bring broad benefits to households' balance sheets.

In general, this line of argument supports asset purchases. Yet, not all assets can in any practical way be purchased by central banks (think houses). Thus, there is also a role for regulatory policy to be used to support asset prices. Procyclical tightening of prudential and tax rules, such as in the Netherlands, is not what I mean. 

Read More

Foreign Invasion in German's Housing Market: A Blessing?

The recent house price jolt in some German cities reportedly coincides with strong buying interest by foreigners (see FT weekend edition from August 3). This trend is not so different from other global cities, such as London where three quarters of buyers are reportedly from abroad (dito). Are wealthy foreign buyers causing German cities to become unaffordable to German dwellers? Here is a view that could liven up your Stammtisch debate.

First, compared to other countries, home ownership in Germany is exceptionally low and tenant regulations strong, limiting the impact of house price inflation on many German dwellers. Recent research has shown that low ownership rates are associated with lower unemployment, possibly as tenants are more mobile than home owners. This suggests that rental demand could be elastic enough to contain rent-to-income ratios, limiting the pass through of housing inflation to rents. On the flipside, buy-to-let investors will have to put up with below-cost rental yields as house prices rise. Second, if there is a bubble (and excessively low rental yields are one of its indicators), the investors affected by an eventual house price crash would largely be foreign. As foreign buyers oftentimes pay cash without the leverage of a mortgage, the repercussions of a crash on German households and banks would be less daunting than in, say, Ireland or Spain. Third, foreign buyers are more used to off plan purchases of new developments, which helps developers and could do good to German’s dated housing stock. As sad as it sounds, architectural advances are often sighted in cities with property bubbles. Foreign investors may thus bring some architectural joy to the dull look of many German cities.

With this in mind, what are appropriate policy responses to deal with the flipside of the property bubble? First, tighten prudential policies for mortgage origination. Global liquidity conditions—including an ECB policy rate that is too low for Germany—have set off a search for yield that tempts many Germans to participate in the house price rally. That is a bad idea, and debt-to-income and loan-to-value limits could ensure that those who accept this gamble maintain sufficient buffers. Second, regulation of rent increases—if designed well—could protect the large cohort of tenants who else lose amid house price inflation. While price controls are distorting and become ineffective over time, a temporary ceiling on rent increases—as often in place elsewhere—could buffer the effect of house price swings on rents. Third, a real estate transaction tax—akin to the financial transaction tax—could slow the transaction flow and discourage flipping, while revenues could be put aside as reserve or be used to help those suffering most from house price inflation, such as families with increasing housing needs.

Read More