by Calculated Risk on 4/03/2008 05:21:00 PM

The IMF has a new report out on housing: The Changing Housing Cycle and the Implications for Monetary Policy (hat tip Glenn)

Note: the IMF chart on page 13 is incorrect. This is the same error Bear Stearns made last year: see Bear Stearns and RI as Percent of GDP. It doesn't make sense to divide real quantities, since the price indexes are different. Dividing by nominal quantities gives the correct result. This Fed paper explains the error in using real ratios from chained series, and recommends the approach I used. See: A Guide to the Use of Chain Aggregated NIPA Data, Section 4.

The IMF piece analyzes the connection between housing and the business cycle (housing has typically led the business cycle both into and out of recessions). They also discuss the spillover effects of a housing boom on consumer spending, and finally the IMF argues the Central Banks should 'lean against the wind' of rapidly rising asset prices.

The main conclusion of this analysis is that changes in housing finance systems have affected the role played by the housing sector in the business cycle in two different ways. First, the increased use of homes as collateral has amplified the impact of housing sector activity on the rest of the economy by strengthening the positive effect of rising house prices on consumption via increased household borrowing—the “financial accelerator” effect. Second, monetary policy is now transmitted more through the price of homes than through residential investment.

In particular, the evidence suggests that more flexible and competitive mortgage markets have amplified the impact of monetary policy on house prices and thus, ultimately, on consumer spending and output. Furthermore, easy monetary policy seems to have contributed to the recent run-up in house prices and residential investment in the United States, although its effect was probably magnified by the loosening of lending standards and by excessive risk-taking by lenders.

We've discussed this many times: increasing asset prices (and mortgage equity withdrawal) probably increased consumer spending significantly as asset prices increased, and declining assets prices will likely now be a drag on consumer spending.

And on Central Bank policy:

[C]entral banks should be ready to respond to abnormally rapid increases in asset prices by tightening monetary policy even if these increases do not seem likely to affect inflation and output over the short term. ... asset price misalignments matter because of the risks they pose for financial stability and the threat of a severe output contraction should a bubble burst, which would also lower inflation pressure.