October 16, 2007

ASSET PRICES INCREASES IN LAC: WHAT CAN OR SHOULD

MONETARY POLICY DO?

2

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

3

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).

I. Asset Prices and Monetary Policy

4

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.

I. Asset Prices and Monetary Policy

5

Arguments in favor of activism:

Bubbles in asset prices could have severe adverse 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.

I. Asset Prices and Monetary Policy

6

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.

I. Asset Prices and Monetary Policy

7

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.

I. Asset Prices and Monetary Policy

8

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

9

Credit Expansions in Mexico

Early 90s 2000s

• Rigid exchange rate.

• Credit expansion based on capital inflows.

• Weak banking regulation and supervision.

• High contingent risk.

Short maturity of government debt.

Foreign currency denominated bonds.

• Inflation targeting, flexible ER.

• Credit expansion based in domestic savings.

• Strong banking regulation and supervision

• Macroeconomic stability.

Issuance of financial contracts at longer term.

Local currency denominated bonds.

II. Macroeconomic Distortions and Asset Prices in Mexico (early 90’s)

10

Mexico: Real Housing Rent Index and Net Transfer of Resources*

(Index 1980=100; % of GDP)

20

40

60

80

100

120

140

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

-6

-4

-2

0

2

4

6

Real Rent Housing Index

Net Transfer of Resources (right axis)

*Current account balance less net interest paymentsSource: Banco de México and World Bank.

II. Macroeconomic Distortions and Asset Prices in Mexico (early 90’s)

11

-

10

20

30

40

50

60

70

80

Dec

-85

Dec

-87

Dec

-89

Dec

-91

Dec

-93

Dec

-95

Dec

-97

Dec

-99

Dec

-01

Dec

-03

Dec

-05

External financing to commercial banksFinancial savings from non-residentsFinancial savings from residents

Dic 89 Dic 94

Financial Saving and Banks Foreign Liabilities (Stocks as of GDP)

Source: Banco de México.

II. Macroeconomic Distortions and Asset Prices in Mexico (early 90’s)

12

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

13

Financial savings (M4) and inflation

(% Rate; Percentage of GDP)

Average maturity of Government securities and inflation

(Days; Percentage)

0

20

40

60

80

100

120

140

160

180

1970

1974

1978

1982

1986

1990

1994

1998

2002

2006

20

25

30

35

40

45

50

55

Inflation

M2/GDP(right axis)

0

200

400

600

800

1000

1200

1400

1600

1800

2000

Jan-

90

Jan-

92

Jan-

94

Jan-

96

Jan-

98

Jan-

00

Jan-

02

Jan-

04

Jan-

06

0

10

20

30

40

50

60

70Average Manurity of GovernmentSecurities

Inflation (right axis)

Source: Banco de México Source: Banco de México

III. Macroeconomic Stability and Financial Deepening in Mexico (2000’s)

14

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.

III. Macroeconomic Stability and Financial Deepening in Mexico (2000’s)

15

Mortgage Credit (% of GDP)

Source: Banco de México

0

2

4

6

8

10

12

14

Dec

-94

Aug

-95

Apr

-96

Dec

-96

Aug

-97

Apr

-98

Dec

-98

Aug

-99

Apr

-00

Dec

-00

Aug

-01

Apr

-02

Dec

-02

Aug

-03

Apr

-04

Dec

-04

Aug

-05

Apr

-06

Dec

-06

Total Banks

Sofoles Infonavit

III. Macroeconomic Stability and Financial Deepening in Mexico (2000’s)

16

Households Balance (% of GDP)

Source: Banco de México

2000 2001 2002 2003 2004 2005 2006Total 146.9 151.8 153.2 158.3 161.2 170.9 182.8

Total Real Assets 95.7 99.1 101.6 103.2 102.3 103.2 102.9

Housing 73.7 76.1 77.7 78.9 78.1 78.7 78.3Durable goods 22.0 23.1 23.9 24.3 24.1 24.5 24.5

Financial Assets 51.2 52.7 51.6 55.1 59.0 67.7 80.0Financial savings 30.1 33.1 34.7 35.3 34.3 37.4 38.9Equities 1/ 21.1 19.5 16.9 19.8 24.7 30.3 41.1

Financial Liabilities 9.7 10.1 10.9 11.1 11.9 13.0 14.4Consumption 1.4 1.8 2.3 2.5 3.3 4.3 5.2Housing 8.2 8.3 8.6 8.5 8.6 8.7 9.2

Memoranda itemsTotal Net Financial Position 41.5 42.6 40.8 44.0 47.1 54.6 65.6Total Public Pension Funds 7.0 8.8 9.8 10.7 11.0 12.0 12.3

13.4 14.3 14.1 13.5 11.4 12.3 12.2Net Financial Position excluding Equities and Public Pension Funds

III. Macroeconomic Stability and Financial Deepening in Mexico (2000’s)

17

0

5

10

15

20

25

30

Dec

-00

Jun-

01

Dec

-01

Jun-

02

Dec

-02

Jun-

03

Dec

-03

Jun-

04

Dec

-04

Jun-

05

Dec

-05

Jun-

06

Dec

-06

Jun-

07

Total position

Position excluding pension funds

Net Financial Position of Households (% of GDP)

Source: Banco de México.

III. Macroeconomic Stability and Financial Deepening in Mexico (2000’s)

18

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

19

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.

IV. The Relevance of Asset Price Channels for Mexico

20

0

50

100

150

200

250

300

Ven

ezue

laA

rgen

tina

New

Zea

land

Por

tuga

lT

urke

yC

olom

bia

Mex

ico

Ger

man

yIt

aly

Phi

lippi

nes

Bra

zil

Tha

iland

Fra

nce

Spa

inIn

dia

Kor

eaIs

rael

Aus

tral

iaC

hile

Can

ada

Uni

ted

Sta

tes

Uni

ted

Sin

gapo

reS

outh

Afr

ica

Market Capitalization (% of GDP)

Source: World Bank.

Capitalization Value of BMV(% of GDP)

38.2

30.832.0

21.520.3

15.9

19.2

25.2

31.2

10.1

41.5

0

5

10

15

20

25

30

35

40

45

1989

1992

1994

1999

2000

2001

2002

2003

2004

2005

2006

Source: World Bank.

IV. The Relevance of Asset Price Channels for Mexico

21

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

22

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.

Conclusions