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ASSET PRICES INCREASES IN LAC: WHAT CAN OR SHOULD MONETARY POLICY DO? October 16, 2007 Outline I . ASSET PRICES AND MONETARY POLICY II. MACROECONOMIC DISTORTIONS AND ASSET PRICES IN MEXICO (EARLY 90’S) III. MACROECONOMIC STABILITY AND FINANCIAL DEEPENING IN MEXICO (2000’S) IV. THE RELEVANCE OF ASSET PRICE CHANNELS FOR MEXICO V. CONCLUSIONS 2 I. Asset Prices and Monetary Policy The role of asset prices in the transmission mechanism of monetary policy: Stock Market Effects on Investment: Tobin's q-theory (Tobin, 1969). Firms Balance-Sheet Effects: This mechanism is related to the “credit channel” (Bernanke and Gertler 1995). Households Wealth Effects: Consumption is determined by the lifetime resources of consumers (Ando and Modigliani 1963). 3 I. Asset Prices and Monetary Policy How should monetary policy respond to asset price movements? Two general monetary policy responses to fluctuations in asset prices have been proposed: Standard or Conventional Policy (Bernanke and Gertler 2001): Changes in asset prices should affect monetary policy only to the extent that they convey information about the future path of inflation and output. “Leaning against the bubble” or active policy (Ceccheti, Genberg, Lypsky y Wadhwani 2000): Monetary policy should be used to contain or reduce bubbles that push asset prices above the value implied by fundamentals, in order to alleviate their negative consequences on the economy. 4 I. Asset Prices and Monetary Policy Arguments in favor of activism: Bubbles in asset prices could macroeconomic consequences. The cost of ignoring bubbles can be high. Thus, reducing the bubble in advance is a preferred policy. The difficulties in identifying bubbles in asset prices do not justify ignoring them. have severe adverse 5 I. Asset Prices and Monetary Policy Arguments against activism: Identifying a bubble in progress is extremely difficult. A “leaning against the bubble” policy could destabilize the economy. It may require a significant policy rate hike, which may imply near-term deviations from central bank’s macroeconomic goals (with loss of credibility). It may affect considerably other sectors. Not all asset price booms result in burst. Alternative vehicles to avoid bubbles are financial regulation or supervision. 6 I. Asset Prices and Monetary Policy Risk-Management Approach of Monetary Policy A risk management approach to monetary policy involves describing the uncertainty and assessing the costs associated with each of the possible policies. This approach evaluates monetary policy under a wide range of scenarios, considering not only the scenario with the highest probability to occur. It may be worthwhile for Central Banks to take out some insurance against the formation of bubbles in asset markets and its potentially negative effects on the economy. 7 Outline I . ASSET PRICES AND MONETARY POLICY II. MACROECONOMIC DISTORTIONS AND ASSET PRICES IN MEXICO (EARLY 90’S) III. MACROECONOMIC STABILITY AND FINANCIAL DEEPENING IN MEXICO (2000’S) IV. THE RELEVANCE OF ASSET PRICE CHANNELS FOR MEXICO V. CONCLUSIONS 8 II. Macroeconomic Distortions and Asset Prices in Mexico (early 90’s) Credit Expansions in Mexico Early 90s 2000s • Rigid exchange rate. • Inflation targeting, flexible ER. • Credit expansion based on capital inflows. • Credit expansion domestic savings. • Weak banking supervision. • Strong banking regulation and supervision • High contingent risk. • Macroeconomic stability. regulation and Short maturity of government debt. Foreign bonds. currency denominated based in Issuance of financial contracts at longer term. Local bonds. currency denominated 9 II. Macroeconomic Distortions and Asset Prices in Mexico (early 90’s) Mexico: Real Housing Rent Index and Net Transfer of Resources* (Index 1980=100; % of GDP) 140 6 120 4 100 2 80 0 60 -2 Real Rent Housing Index 40 -4 Net Transfer of Resources (right axis) *Current account balance less net interest payments Source: Banco de México and World Bank. 2006 2004 2002 2000 1998 1996 1994 1992 1990 1988 1986 1984 1982 -6 1980 20 10 II. Macroeconomic Distortions and Asset Prices in Mexico (early 90’s) Financial Saving and Banks Foreign Liabilities (Stocks as of GDP) 80 External financing to commercial banks Financial savings from non-residents Financial savings from residents 70 60 Dic 89 Dic 94 50 40 30 20 10 Source: Banco de México. Dec-05 Dec-03 Dec-01 Dec-99 Dec-97 Dec-95 Dec-93 Dec-91 Dec-89 Dec-87 Dec-85 - 11 Outline I . ASSET PRICES AND MONETARY POLICY II. MACROECONOMIC DISTORTIONS AND ASSET PRICES IN MEXICO (EARLY 90’S) III. MACROECONOMIC STABILITY AND FINANCIAL DEEPENING IN MEXICO (2000’S) IV. THE RELEVANCE OF ASSET PRICE CHANNELS FOR MEXICO V. CONCLUSIONS 12 III. Macroeconomic Stability and Financial Deepening in Mexico (2000’s) Financial savings (M4) and inflation Average maturity of Government securities and inflation (% Rate; Percentage of GDP) (Days; Percentage) 180 55 160 Inflation 140 M2/GDP (right axis) 2000 70 1800 Average Manurity of Government Securities 1600 Inflation (right axis) 50 45 120 50 1400 1200 100 40 80 35 40 1000 30 800 600 60 30 40 25 20 20 400 10 200 Source: Banco de México Source: Banco de México Jan-06 Jan-04 Jan-02 Jan-00 Jan-98 Jan-96 Jan-94 Jan-92 2006 2002 1998 1994 1990 1986 1982 1978 1974 1970 20 0 Jan-90 0 0 60 13 III. Macroeconomic Stability and Financial Deepening in Mexico (2000’s) The recent rapid growth in housing finance through private mortgages appears grounded on more solid primary and secondary markets than in the past. Mortgage credit is issued at long maturities and the most common mortgage instrument used by private financial intermediaries is a fixed rate loan. Financial sector reforms have facilitated the standardization of mortgages issuances and the progressive securitization of mortgages contracts. The expansion in mortgages credit has been preceded by several years of stagnation and is not a response to a relaxation in lending standards. The current expansion of credit is based in domestic financial savings. 14 III. Macroeconomic Stability and Financial Deepening in Mexico (2000’s) Mortgage Credit (% of GDP) 14 12 Total Banks Sofoles Infonavit 10 8 6 4 2 Source: Banco de México Dec-06 Apr-06 Aug-05 Dec-04 Apr-04 Aug-03 Dec-02 Apr-02 Aug-01 Dec-00 Apr-00 Aug-99 Dec-98 Apr-98 Aug-97 Dec-96 Apr-96 Aug-95 Dec-94 0 15 III. Macroeconomic Stability and Financial Deepening in Mexico (2000’s) Households Balance (% of GDP) Total Total Real Assets Housing Durable goods Financial Assets Financial savings Equities 1/ Financial Liabilities Consumption Housing Memoranda items Total Net Financial Position Total Public Pension Funds Net Financial Position excluding Equities and Public Pension Funds Source: Banco de México 2000 146.9 95.7 73.7 22.0 51.2 30.1 21.1 9.7 1.4 8.2 2001 151.8 99.1 76.1 23.1 52.7 33.1 19.5 10.1 1.8 8.3 2002 153.2 101.6 77.7 23.9 51.6 34.7 16.9 10.9 2.3 8.6 2003 158.3 103.2 78.9 24.3 55.1 35.3 19.8 11.1 2.5 8.5 2004 161.2 102.3 78.1 24.1 59.0 34.3 24.7 11.9 3.3 8.6 2005 170.9 103.2 78.7 24.5 67.7 37.4 30.3 13.0 4.3 8.7 2006 182.8 102.9 78.3 24.5 80.0 38.9 41.1 14.4 5.2 9.2 41.5 7.0 42.6 8.8 40.8 9.8 44.0 10.7 47.1 11.0 54.6 12.0 65.6 12.3 13.4 14.3 14.1 13.5 11.4 12.3 12.2 16 III. Macroeconomic Stability and Financial Deepening in Mexico (2000’s) Net Financial Position of Households (% of GDP) 30 25 20 15 10 Total position 5 Position excluding pension funds Source: Banco de México. Jun-07 Dec-06 Jun-06 Dec-05 Jun-05 Dec-04 Jun-04 Dec-03 Jun-03 Dec-02 Jun-02 Dec-01 Jun-01 Dec-00 0 17 Outline I . ASSET PRICES AND MONETARY POLICY II. MACROECONOMIC DISTORTIONS AND ASSET PRICES IN MEXICO (EARLY 90’S) III. MACROECONOMIC STABILITY AND FINANCIAL DEEPENING IN MEXICO (2000’S) IV. THE RELEVANCE OF ASSET PRICE CHANNELS FOR MEXICO V. CONCLUSIONS 18 IV. The Relevance of Asset Price Channels for Mexico Given the relative size of the stock market, an increase in stock prices, whether driven by fundamentals or by a bubble, is not expected to have a significant impact on consumption expenditures. Common stocks are not the most important component of households wealth. Nevertheless, they have been gaining importance in the last few years. Housing is a more important component of households wealth than common stocks. However, mortgage credit as a fraction of GDP still has a small value compared to a decade ago. High transaction costs and the lack of mechanisms for withdrawing housing equity, reduce the effect of real state price increases on consumption expenditures. 19 IV. The Relevance of Asset Price Channels for Mexico Capitalization Value of BMV Market Capitalization (% of GDP) (% of GDP) 45 41.5 38.2 40 300 250 35 30.8 32.0 31.2 200 30 25.2 25 21.5 20.3 150 19.2 20 100 15.9 15 50 10.1 10 5 Source: World Bank. 2006 2005 2004 2003 2002 2001 2000 1999 1994 1992 1989 0 Venezuela Argentina New Zealand Portugal Turkey Colombia Mexico Germany Italy Philippines Brazil Thailand France Spain India Korea Israel Australia Chile Canada United States United Singapore South Africa 0 Source: World Bank. 20 Outline I . ASSET PRICES AND MONETARY POLICY II. MACROECONOMIC DISTORTIONS AND ASSET PRICES IN MEXICO (EARLY 90’S) III. MACROECONOMIC STABILITY AND FINANCIAL DEEPENING IN MEXICO (2000’S) IV. THE RELEVANCE OF ASSET PRICE CHANNELS FOR MEXICO V. CONCLUSIONS 21 Conclusions Macroeconomic stability and a strong financial regulation and supervision are factors that help to avoid the formation of bubbles in asset prices. Nowadays, domestic financial markets have strengthened and deepened. Nevertheless, in Mexico financial intermediation is still low, both compared to international levels and to the size of the Mexican economy. However, to the extent that asset markets become deeper, the role of asset price channels may possibly gain more importance in the transmission mechanism of the monetary policy in Mexico. 22