Asset prices — a policy blind spot

It is no surprise that Governor Raghuram Rajan has not changed interest rates in the monetary policy review, given the Reserve Bank of India’s avowed stance of bringing down inflation to 4 per cent levels.

The RBI’s monetary policy is driven by the objective of price stability. While such price stability looks at prices of goods and services, what about asset price stability (both property and equity prices), its impact on output growth, and the response of monetary policy? More importantly, while most of the discourse centres around asset price bubbles, what about asset price deflation?

The pre-crisis view regarding asset price inflation was that central banks should not try to contain it. The reasons given were that they lacked the mandate on asset prices, monetary policy instruments may prove ineffective in preventing speculative bubbles, and that central banks would perhaps be unable to distinguish between asset price bubbles and genuine bull runs.

In the aftermath of the global financial crisis, however, the predominant concern of monetary policy has been to prevent the occurrence of asset bubbles. This could take the form of monetary policy measures such as preventing excess liquidity conditions in the market, or financial regulation measures adopted by central banks.

A study in 2010 found that asset prices in India did not affect the inflation path. It was thus suggested that monetary policy could continue with not responding directly to asset price cycles and stick to price stability.

A recent study in the BIS Quarterly Review (March 2015) points to the problems of overlooking changes in asset prices, and focusing on its impact on output growth. By looking at empirical evidence pertaining to 38 economies over 140 years (1870-2013), the authors find that deflation in the prices of goods and services is only weakly associated with slower output growth.

On the other hand, asset prices and output growth are significantly positively correlated. Moreover, the link between output slowdown and asset price declines is stronger than the link with increases. Thus, a fall in asset prices has a greater impact on lowering output growth than vice versa.

Asset price deflation, especially housing price declines, have a stronger impact on growth than overall price deflation.

The evidence with regard to asset price categories in India is mixed. Asset prices in India for the period 2003-2010 have exhibited an inverted u-shaped pattern.

Between January and December 2014, the RBI kept the repo rates fixed at 8 per cent. However, a perusal of CPI data over the period reveals that as opposed to a 7.52 per cent rise in the CPI, housing prices (house rent data) rose modestly, by 4.98 per cent. On the other hand, stock prices rose by about 38 per cent. The Housing Price Index, measured by the National Housing Bank Residex Index for Mumbai, showed a dip in the first half of 2014. Similar dips in housing prices were seen in RBI’s House Price Index for 2013-14, from their high levels attained in 2011-12.

Asset prices, in particular the realty sector prices, reflect the output and employment generation potential of the economy and its ability to sustain growth. With its link with more than 300 industries, its impact on manufacturing, its ability to generate employment for more than 35 million low- and medium-skilled labour, as also its potential to attract FDI, the realty sector has a huge impact on GDP and capital formation.

It is time monetary policy takes into account two crucial aspects with regard to asset prices.

First, the differential inflation rates across asset categories, in particular — significant inflation in equity prices neutralising the deflation in property prices — may provide a misleading impression of a not-too-significant movement in overall asset prices.

Second, the significant impact of asset price deflation on output growth as suggested by empirical data should be taken into account.

While the focus of current monetary policy statements has been price stability, asset price peaks as also troughs may require close monitoring to achieve the government’s stated output growth objective.

The writer teaches economics at the SP Jain Institute of Management and Research, Mumbai. The views are personal