Global Housing Price Boom and its Aftermath, The

Housing Finance International, Dec 2007 by Renaud, Bertrand, Kim, Kyung-Hwan

The second major change is the transformation of central banking and of the monetary regime. The lesson of the Great Inflation of the 1970s is that there is no long run trade-off between price stability and achieving full employment and growth. It now defines a widely shared monetary policy consensus managed by independent central banks. (Goodfriend 2007). The past two decades have been a golden era of central banking that has produced steady economic growth at low inflation (Mishkin, 2007b; The Economist, 2007). A recent analysis of a sample of 21 industrialized and emerging economies compared to a control group of 13 industrialized economies shows that explicit inflation targeting by central banks improves economic performance. Explicit targeters reduced their inflation rates from an average of 12.6% to 4.4%. Emerging economies that suffered from higher inflation saw the biggest drop - to 6% after they began targeting inflation. Developed economies with inflation targeting did better, dropping to an average of 2.2 percent. Interestingly, developed economies that were only informal targeters not bound by a pre-announced inflation target did even better with 2.1% inflation (Mishkin and Schmidt-Hebbel, 2007). A global transitory factor that has been also very supportive of low inflation, but will not repeat itself again, was the massive entry of China and India into the global economy after decades of closed economy policies.

During an asset boom there is a feedback mechanism between rising asset prices and liquidity as strong asset prices strengthen the balance sheets of financial institutions that are more willing to lend. As a result, the risk premium embedded in interest rates was very low and liquidity was plentiful. As shown by new research in behavioral finance, euphoria often amplifies such liquidity effects (Shiller, 2005).

In the specific case of the US, monetary economist John Taylor has argued that the Federal Reserve set inappropriately low Federal Funds Rates during the period from 2003 to 2006 - these rates were even negative in real terms in 2002 and 2003 (Taylor, 2007). Because long-term rates respond to changes in expected future short-term rates, low short-term Federal Funds Rates may have also lowered interest rate expectations and long-term rates. The excess liquidity associated with this easy monetary policy turned the US housing boom into a bubble. Given the high level of integration achieved in global financial markets, the spillover effects of US monetary policies on global long term rates and other housing markets must have been significant and is the probable reason for the acceleration of global housing prices during the second phase of the boom between 2002 and 2006. Since August 9, 2007, liquidity and the risk premium have been adjusting sharply in the US and the global financial markets.

The third major change has been the significant decline in the volatility of output in advanced economies. Fluctuations in economic growth measured by GDP have fallen by half since the early 1980s. In the US, gains in reduced GDP volatility came from two main factors (McConnell et. al. 1999). The largest contributor is better inventory management linked to 'just-in-time' production supported by corporate IT innovation, the container transport revolution and air cargo. The second is lower residential investment volatility associated with the financial deregulation of housing finance marked by the ending of Federal Reserve's Regulation Q and access to new funding through securitization.8 A third and lesser factor was trade liberalization and more stable trade flows.