The International Monetary Fund recommends in a housing study released on Thursday that central banks in countries with more developed mortgage markets such as the US, should take home prices into account when crafting monetary policy. However, monetary policy shouldn’t directly target housing prices, it said. The IMF study also says that in Ireland, the UK, the Netherlands, andFrance, house prices to 2007 in these countries were about 30 percent higher than justified by fundamentals in 2007.
“Given the uncertainty surrounding both the shocks hitting the economy and the effects of interest rates on asset-price bubbles, house prices should be one of the many elements to be considered in assessing the balance of risks to the outlook, within a risk-management approach to monetary policy,” said authors Roberto Cardarelli, Deniz Igan and Alessandro Rebucci.
Ireland, the UK, the Netherlands, and France appear the most vulnerable to a further correction in home prices, the IMF said.
"Countries that look particularly vulnerable to a further correction in house prices are Ireland, the United Kingdom, the Netherlands, and France. In these economies, it is difficult to account for the magnitude of the run-up in house prices on the basis of those countries’ fundamentals. Furthermore, a weakening housing market can also present a direct drag on growth from reductions in residential investment.
|The IMF says that in eFor each country, house price growth is modeled as a function of an affordability ratio (the lagged ratio of house prices to disposable incomes), growth in disposable income per capita, short-term interest rates, long-term interest rates, credit growth, and changes in equity prices and working-age population. The unexplained increase in house prices (defined as the “house price gap”) might reflect variables omitted from the model—for instance, macroeconomic volatility, household formation, and inward immigration—but could also be interpreted as a measure of overvaluation and, therefore, used to identify which countries may be particularly prone to a correction in house prices.|
The chart shows the percent increase in house prices during the period 1997 to 2007 that is not accounted for by the fundamental drivers of house prices. The countries that experienced the largest unexplained increases in house prices were Ireland, the Netherlands, and the United Kingdom—by the end of the decade, house prices in these countries were about 30 percent higher than justified by fundamentals. A group of other countries, including France, Australia, and Spain, have house price gaps of about 20 percent. Based on this measure, the United States is among the middle-ranked countries in terms of vulnerability to a housing correction, partly reflecting the fact that U.S. house prices have already declined (as measured by the U.S.
Countries that witnessed the largest runup in house prices also appear more vulnerable to this effect—in particular, Denmark, Spain, and France," the IMF study said.
The housing study found that housing prices are more sensitive to monetary policy in countries with the most developed mortgage markets, such as the US, Denmark, Australia, Sweden and the Netherlands. Financing innovations have made access to credit easier in those countries, where secondary markets are a bigger source of funding. Out of the 17 developed countries in the study, France, Italy and Germany rank at the bottom, suggesting tougher access to credit and less sensitivity to monetary policy measures.
The study also found that the housing sector has a bigger economic impact in countries with more developed mortgage markets, since the use of homes as collateral “strengthens the feedback effect of rising house prices on consumption via increased household borrowing.”
On the role of central banks, the IMF said that In the US, where the subprime mortgage crisis has seriously impacted the economy and global credit markets, “easy monetary policy at the beginning of the current decade seems to have contributed to the run up of housing prices and residential investment,” the authors said. Loose lending standards and “excessive risk-taking” by lenders also likely contributed to the bubble, they added.
The IMF made the projections in the analytical chapters of its semi-annual World Economic Outlook. Thee chapters were released in advance of the report’s publication next Wednesday.
|The ratio of residential investment to total output is a measure of the direct exposure of the economy to a weakening housing market. Residential investment, however, does not normally account for a very large share of the economy. Some notable exceptions are Ireland and Spain, where at the end of 2007 residential investment accounted for 12 and 9 percent of GDP, respectively, against an average for advanced economies of about 6½ percent. The relatively low GDP share of housing construction helps explain why the average contribution of residential investment to economic growth for the advanced economies over the past three decades has been rather low, at about 5 percent.|
Still, very large corrections in housing construction may have a nonnegligible impact on economic growth. In the United States, for example, the 1½ percentage points of GDP decline in real residential investment since late 2005 lowered GDP growth by ¾ percent in both 2006 and 2007. Furthermore, as discussed in this chapter, residential investment appears to lead the business cycle in many advanced economies, and a softening of housing construction may be an important factor leading to a cyclical downturn.