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Asset Prices: What can or
should Monetary Policy do?
Hernando Vargas
Banco de la República
Colombia
October 2007
Contents
I.
Answer
II.
Policy Reaction: A General Discussion
III. Asset Prices in Colombia: Current
Situation
I. Answer
• 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)
50
5
0
0
-50
1970
1975
1980
1985
Precio de los activos
Source: Tenjo et al. (2007)
1990
1995
2000
PIB (der)
<<
2005
-5
(%)
(%)
Colombia: Asset Prices and GDP cycles
Answer
• … 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
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
120
ITES
115
ITES FILTERED
110
105
100
Sep-07
Jun-07
Mar-07
Dic-06
Sep-06
Jun-06
Mar-06
Dic-05
Sep-05
Jun-05
Mar-05
Dic-04
Sep-04
Jun-04
Mar-04
Dic-03
Sep-03
Jun-03
Mar-03
Dic-02
Sep-02
Jun-02
Mar-02
90
Dic-01
95
Source: Corfinsura. 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.
90
Source: BVC
Sep-07
Jun-07
Mar-07
Dic-06
Sep-06
Jun-06
Mar-06
Dic-05
Sep-05
Jun-05
Mar-05
Dic-04
Sep-04
Jun-04
Mar-04
Dic-03
Sep-03
Jun-03
Mar-03
10090
Dic-02
Sep-02
Jun-02
Mar-02
Dic-01
IGBC
14090
12090
IGBC
IGBC FILTERED
8090
6090
4090
2090
Source: Banco de la República
Sep-07
Jun-07
Mar-07
Dic-06
Sep-06
Jun-06
Mar-06
Dic-05
Sep-05
Jun-05
Mar-05
Dic-04
Sep-04
Jun-04
Mar-04
Dic-03
Sep-03
Jun-03
Mar-03
Dic-02
Sep-02
Jun-02
Mar-02
Dic-01
%
Output Gap
3,00
2,00
1,00
0,00
-1,00
-2,00
-3,00
Source: Banco de la República, DANE
Dic-06
Sep-06
Jun-06
Mar-06
Dic-05
Sep-05
Jun-05
Mar-05
Dic-04
Sep-04
Jun-04
Mar-04
Dic-03
Sep-03
Jun-03
Mar-03
Dic-02
Sep-02
Jun-02
Mar-02
Dic-01
Loans/DGP
0,31
0,30
0,29
Loans/DGP
0,28
Filtered
0,27
0,26
0,25
0,24
0,23
0,22
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
Asset prices
Credit
Investment
* Significant al 10%
Independent Variable
Credit
Investment
Asset prices
Investment
Asset prices
Credit
Statistic
21.06
2.83
6.12
16.78
0.06
13.52
p-value
0.00
0.09*
0.01
0.00
0.81
0.00
Evidence of the Financial Accelerator in Colombia
• Tenjo et al. (2007): 1980-2006
Granger Cuasality Tests – Home Building Investment
1980-2006
Dependent Variable
Asset prices
Credit
Investment
Independent Variable
Credit
Investment
Asset prices
Investment
Asset prices
Credit
Statistic
20.88
4.95
16.09
5.47
0.03
12.84
p-value
0.00
0.03
0.00
0.02
0.87
0.00
Evidence of the Financial Accelerator in Colombia
• Tenjo et al. (2007): 1980-2006
Granger Cuasality Tests – Open Economy
1980-2006
Dependent Variable
Asset prices
Credit
Investment
Real Exchange Rate
Independent Variable
Credit
Investment
Real Exchange Rate
Asset prices
Investment
Real Exchange Rate
Asset prices
Credit
Real Exchange Rate
Asset prices
Credit
Investment
Statistic
6.09
0.81
2.30
5.85
41.15
46.25
0.30
13.58
0.00
10.33
0.03
0.05
p-value
0.01
0.37
0.13
0.02
0.00
0.00
0.86
0.00
0.97
0.00
0.86
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)
Percentage of outsanding loans with
payments past due three or six months
(Average for each year)
1997
1998
1999
2000
2001
2002
2003
3 Months
6 Months
7,2%
8,9%
15,3%
18,2%
22,1%
22,6%
23,0%
1,9%
3,6%
7,2%
9,9%
13,9%
15,8%
16,6%
Source: Calculations based on Table 1 of
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”
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
40
20
40
20
10
20
0
0
0
-20
-10
-20
-40
-20
-40
-60
1970 1975
1980
P. Activos
1985 1990
1995
-30
2000 2005
5
0
-60
1970 1975
Términos de Intercambio (der)
1980
1985 1990
20
40
10
0
-20
-10
-40
-60
1970 1975
1980
P. Activos
Source: Tenjo et al. (2007)
1985 1990
1995
-20
2000 2005
Tasa de Cambio Real (der)
(%)
20
0
-5
2000 2005
Flujos de Capital (der)
P. Activos
60
1995
(%)
60
(%)
30
(%)
(%)
60
Policy Reaction
• Monetary policy has been pro-cyclical in past
episodes of capital inflows and improving TOT
Gap of
Asset Prices
GDP
Investment/GDP
Real interest rate
Monetary Base/ GDP
1970-2006
Variation between
Peak year and 2 years 2 years after peak year
before
and peak year
43.2
-9.9
5.2
-6.2
4.1
-17.5
-1.2
3.6
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
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 passthrough 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)
130
120
110
100
90
80
Jun95
Jun96
Jun97
Jun98
Jun99
Source: DNP and Banco de la República.
Jun00
Jun01
Jun02
Jun03
Jun04
Jun05
Jun06
Jun07
House Prices and Mortgage Credit in Colombia:
No signs of alarm yet
Ratio of used home prices to rents
(Average 1988-2006 = 100)
120
110
100
90
80
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
%
12,0
10,0
8,0
6,0
4,0
2,0
0,0
Jun95
Jun96
Jun97
Jun98
Jun99
Jun00
Jun01
Jun02
Jun03
Jun04
Source: Financial Superintendency and ICAV. Calculations by Banco de la República.
Jun05
Jun06
Jun07
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.