Should India's Monetary Policy respond to Asset Prices?

A nice timely paper by RBI economists Bhupal Singh and Sitikantha Pattanaik. The question they look at it age-old should monetary policy look at asset prices? They look at the issue from RBI perspective.

The study shows that while interest rate changes cause movements in stock prices, monetary policy does not respond to asset prices. This suggests the asset price channel of monetary policy transmission exists. Within assets, credit markets explain a significant part of asset price variations over medium to long-run.

Given this, authors maintain monetary policy should not be looking at asset prices and asset price bubbles could be better addressed through micro and macro-prudential measures. These measures are enhanced when implemented in a sound macroeconomic policy environment.

In India, despite the limited risks from asset price cycles to macro-financial conditions relative to the advanced economies, much greater reference to asset prices is being made in the context of monetary policy. The concern relating to surges in capital flows fuelling asset prices has also provided another dimension to the debate on the dynamics between capital flows, asset prices and monetary policy. The Reserve Bank has used in the past both micro and macroprudential measures to limit the risks to financial stability from asset price cycles. It, however, has justifiably refrained from using policy interest rates with the specific intention of influencing asset prices. This paper provides empirical evidence to explain the appropriateness of such an approach and highlights that the same approach may have to continue. Expected impact of asset price trends on inflation and output, however, needs to be assessed regularly so that the scope for indirect response of monetary policy to asset price shocks could be integrated to the monetary policy framework. The monetary policy itself, which already caters to multiple objectives, should not be assigned any explicit direct role in stabilising asset prices. In this context, any policy that aims at limiting the overall pace of credit growth may have to be driven by developments such as either economic overheating or persistent high inflation, but not the perception of an asset price bubble. Similarly, if an accommodative monetary policy stance has to be sustained for a prolonged period in response to an economic slowdown or a recession, the fear of such a stance leading to asset price inflation should not trigger hasty tightening of monetary policy. For the purpose of clarity, sector specific limits on the flow of credit to asset price sensitive sectors, or even caps on direct and indirect exposure of the banking system to asset price cycles should be seen purely as prudential measures, which are different from monetary policy measures.

The empirical analysis for India exhibits that while interest rate changes cause changes in stock prices, the reverse causality does not hold. This seems to suggest that monetary policy in India does not respond to asset prices, but the asset price channel of monetary policy transmission exits. Evidence of a significant bi-directional causal relationship between credit growth and asset price trends does not provide any unambiguous result about the role of credit in asset price bubbles. This is so because of the role of a common factor; i.e. strong GDP growth coinciding with high credit growth, and the former driving the asset prices up.

They analyse the impact on housing prices as well:

Regarding housing assets, given the absence of a reasonably long time series data on house prices, this paper used a number of proxy variables. The movement in stock prices and collection of “stamp duties and registration fees” relating to housing tend to follow a systematic relationship, indicating the possibility of a broad-based asset price cycle. The housing credit demand in India appears to be sensitive to interest rate movements, which though does not validate an explicit role for monetary policy in influencing housing prices. This is because the impulse response functions reveal that monetary policy tightening leads to a moderation in credit demand over the medium-term, given the usual lags in the impact of monetary policy, which in turn gives rise to lower real output. Thus, any asset price objective attempted to be achieved through monetary policy actions may involve sacrifice of growth.

Given the possibility of an adverse feedback loop, where falling asset prices and contraction in output could intensify in a spiral, direct use of monetary policy must be avoided. Moreover, asset price dynamics could be difficult to decipher for meaningful use in the conduct of monetary policy. For example, an increase in the flow of credit in the VAR model seems to lead to increase in both output and asset prices. It could be, however, particularly difficult to segregate the part of asset prices increase that might have been caused by improvement in fundamentals from the part led by speculative credit flows to asset markets. This ambiguity suggests why countercyclical regulatory policies to counter asset price bubbles could be more appropriate relative to direct use of monetary policy.

The paper has an excellent literature survey on the issues and divides it nicely as pre and post crisis debate.

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