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Asset Prices, Monetary Policy, and the Business Cycle

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
January 1995
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UNUSUAL conditions leading up to the business cycle of 1989–93 made it difficult to recognize inflationary pressures. Several industrial countries pursued expansionary policies that caused their economies to overheat; policy corrections then led to asset-price deflation and severe recessions. Valuable lessons can be drawn from this experience.

In several industrial countries—Australia, Japan, the United Kingdom, the United States, and the Nordic countries—the 1980s were characterized by soaring asset prices and rapid accumulation of private sector debt. Structural and macroeconomic changes that led to increased demand for real estate and other assets were partly responsible. At the same time, financial liberalization and innovation in a number of countries led to greater access to financial markets, the creation of new financial intermediaries and instruments, and an increase in the supply of credit.

The confluence of structural changes and macroeconomic policies, including exchange rate policies in some countries (Japan, for example), made it difficult for central banks to recognize inflationary pressures in asset markets; they believed, at first, that asset-price increases were due to relative price adjustments. And, because asset-price increases were not accompanied by increases in conventional measures of inflation, such as consumer price indices or GDP deflators, as in earlier business cycles, central banks had no reason to question their initial assessment. They continued to pursue policies that, with the benefit of hindsight, were overly expansionary. Policy adjustments in the late 1980s to reduce inflation caused asset prices to plummet and led to a deep and prolonged recession in some countries.

In an increasingly global financial environment, business cycles are likely to become more complex and interrelated. Lessons from the business cycle of 1989–93 may help policymakers assess inflationary pressures more accurately in the future to avoid overheating and costly policy adjustments.

From boom to bust

During the boom of the mid-to-late 1980s, there was a massive buildup of private sector debt to finance consumption and investment. Although debt accumulation is common during periods of expansion, it was unusually large in the 1980s, relative to income and asset values, and was widespread among households and both large and small businesses.

Inflationary pressures. The buildup of debt was associated with a prolonged period of sharp price increases in real estate markets, markets for a wide variety of collectibles (including art, books, jewelry, and yachts), and, in some countries, stock markets. Although asset-price increases during economic expansions are not uncommon in certain markets (the real estate market, in particular), the number of asset markets affected, the volume of asset turnover, and the speed and persistence of the price increases were unusual. But the sharp increases in asset prices (especially real estate prices) were generally not passed on to the goods and labor markets in the form of higher prices and wages. And, in countries where increases in asset prices were ultimately transmitted to other markets, there was a considerable time lag, and transmission occurred with less intensity than in previous expansions. This was the case in the United Kingdom, for example.

Slowdown. The downturn in economic activity that followed the expansion of the mid-1980s was also unusual. In retrospect, it appears that the overheating—output was well above trend levels—was either worse than in previous expansions or much greater than policymakers believed at the time, even though it was not fully reflected in conventional measures of inflation, such as the consumer price index. Because inflationary pressures were highly concentrated in asset markets, monetary tightening led to an asset- price deflation—the bursting of the “asset- price bubble”—that was very severe in many countries (including Australia, Japan, and some of the Nordic countries); at the end of 1990, relative asset prices dropped to the levels of the mid-1980s. The private sector thus entered the recession with a relatively large debt overhang and high debt-service payments, which were difficult to manage in an environment characterized by rising real interest rates, declining incomes, and rapidly diminishing employment opportunities.

The prolonged adjustment process that followed dampened consumer and business confidence in the early 1990s. This, combined with declining asset values, led to deep, long- lasting recessions in Japan, the United Kingdom, and the Nordic countries. Even after the economic recovery was under way, households and businesses in some countries continued to reduce their debt burdens and cut spending. Economic recovery in the United States, in particular, was weak in comparison with previous business cycles (Charts 1 and 2), even though short-term interest rates were reduced significantly—well below long-term rates and, in some cases, to historically low levels (Charts 3 and 4). There was good news, however. Inflation continued to decline even after the recession ended, and many countries enjoyed the lowest inflation rates seen in 30 years.

Garry J. Schinasi,

a US national, is Deputy Chief of the Capital Markets and Financial Studies Division of the IMF’s Research Department.

Business cycles in the United States Economic recovery in the early 1990s has been slow

(dates indicate cyclical troughs for GDP)1

Chart 1

index, trough = 100

Chart 2

index, trough = 100

Chart 3

(percent)

Chart 4

(percent)
Source: IMF data.1 As identified by the National Bureau of Economic Research (NBER).2 Employees on nonagricultural payrolls.3 Three–month treasury bill rate.4 Three–month treasury bill rate deflated by consumer price index (percent change from four quarters earlier).

Causes

The mid-to-late 1980s was a period of intense financial activity. Countries that experienced asset-price inflation during the 1980s also experienced some form of financial restructuring, as the result of either financial deregulation and liberalization (Australia, Japan, New Zealand, the United Kingdom, and the Nordic countries) or innovation following deregulation and liberalization (the United States). Financial intermediaries ventured into new markets and created instruments that were more flexible than traditional ones. The nonfinancial private sector responded to new financial opportunities by borrowing on a massive scale to finance consumption and investment. Additional incentives to borrow stemmed from long-standing features of tax systems (as in the Nordic countries) or from tax reforms that either favored certain credit-intensive sectors or encouraged businesses to finance their activity with debt rather than equity. (This was the case in Japan, the United Kingdom, and the United States.) With the coming of age of the baby boomers, demand increased for tangible assets and new financial instruments, including variable-rate assets and liabilities.

Although these factors led to increases in the supply of, and demand for, credit, it is unlikely that they alone were responsible for the buildup of private indebtedness and sharp asset-price adjustments. Expansionary—in many cases, overly expansionary—macroeconomic and fiscal policies were largely responsible for the creation of excess liquidity and credit, the accumulation of large public sector debt, and exchange rate instability.

Excess liquidity. Why were inflationary pressures in the 1980s concentrated in asset markets and not distributed more broadly in goods and labor markets? One important reason is that the transmission of monetary policy to goods, labor, and asset markets was affected by demographic and structural changes, including tax reforms that favored investment in real estate and other assets, and financial liberalization that encouraged financial innovation and home ownership. Excess liquidity and credit were channeled to large institutions, affluent individuals, and other groups that responded to economic incentives by borrowing to accumulate assets.

Inflation in Japan

(percent change from four quarters earlier)

Chart 5Land prices and CPI

Sources: Nikkei Services and National Land Agency, Land Price Publication (various issues).

Chart 6Land prices and GDP deflator

Financial innovation and tax reforms in the United States provided new investment opportunities and incentives—particularly to the corporate sector and high-income earners. Credit was used to finance mergers and acquisitions, leveraged buyouts, and acquisition of commercial and residential real estate. In Japan, tax provisions created incentives for the construction of apartment houses and condominiums, and changes in the tax treatment of capital gains from real estate transactions encouraged upgrade purchasing. Spending shifted significantly in the late 1980s toward luxury goods and components of demand typically financed on credit, such as business investment, home construction, and purchases of durable goods. In the United Kingdom, increased borrowing after financial liberalization was more broadly based and appeared to be a response to pent-up demand. Although conventional measures of inflation increased, real asset prices rose even more.

Financial liberalization and innovation led to an erosion of the role of banks, expanded roles for nonbank financial institutions, a general squeeze on profit margins, and greater competition among financial intermediaries. With key safety nets, such as deposit-insurance systems, still in place, the removal of restrictions on lending practices led to increased risk-taking. Lending for highly leveraged transactions and real estate purchases and other asset-market activity increased. But supervisory and oversight systems did not keep pace with deregulation, and institutional inertia may have encouraged excessively speculative behavior.

Once asset-price inflation began, expectations of additional capital gains fueled demand. To the extent that past price increases determined expectations of future price increases, the real cost of borrowing for investment in asset markets was often negative in Japan, the United Kingdom, and the United States. During 1986–89, for example, building-society loan rates in the United Kingdom remained below 15 percent, and were often below 12 percent, while housing prices rose annually by 20 percent, on average. In Japan, the average rate for new loans was below 6 percent, and it declined for most of 1985–89, while stock prices were increasing at an annual rate of 27 percent.

Macroeconomic policy. Why did policymakers fail to recognize inflationary pressures? First, the confluence of structural changes made it difficult to assess asset-price increases and to distinguish them from relative price adjustments. Second, because of structural changes likely to boost demand for real estate, relative to existing supplies, it was easy to believe that real estate was undervalued, relative to a basket of consumption goods. In the initial stages of the housing boom, it was not unreasonable for central banks to maintain their monetary stance.

Another important factor was the extensive restructuring of financial institutions during the 1980s. Banks and nonbanks alike began to engage in new types of activity, and the management of assets and liabilities became increasingly sophisticated. Financial sector balance sheets were being restructured, and financial activity was expanding rapidly, leading to a sharp increase in both financial assets and liabilities—that is, in total domestic credit and monetary aggregates. As a result, the monetary variables on which central banks based their policy decisions were no longer supplying reliable information, either about the effect of monetary policy on the banking system or about the transmission of policy changes to real economic activity. Central banks recognized these problems and began paying attention to a broader range of economic indicators.

The framework for conducting monetary policy during the 1970s proved inadequate in the mid-to-late 1980s for at least two other reasons. First, it did not take into account the ways in which deregulation and related structural changes affected the workings of monetary policy. Second, information about asset markets received less weight in monetary policy than did information about goods and labor markets.

There was limited understanding of how changes in monetary instruments brought about changes in money and credit markets. One such change was the removal, in Japan and the United States, of fixed ceilings on bank-deposit interest rates in the 1980s. Before the ceilings were removed, central banks could tighten credit by reducing the supply of bank reserves until market interest rates were higher than bank-deposit interest rates. This caused depositors to withdraw funds from the banking system in search of higher returns. As deposits contracted, bank credit—the bulk of private credit at that time—declined. To ease monetary conditions, central banks would reverse the process, supplying reserves to the banking system until market interest rates fell below bank-deposit interest rates. In effect, the existence of ceilings dampened swings in market interest rates during the business cycle. After the ceilings were removed, monetary policy affected credit markets in a more general way. In the new environment, it would have been reasonable to expect that greater changes in interest rates would be required at turning points of the business cycle to reduce demand when the economy was overheating and to stimulate demand when the economy was at, or near, the trough of a recession.

An additional complication was the creation of many new types of financial intermediaries that were not subject to direct monetary control—for example, US financial intermediaries that were not direct users of Federal Reserve System reserves. Credit became less directly responsive to withdrawals or injections of reserves by central banks. To tighten policy, central banks would have to withdraw a greater amount of liquidity—and interest rates would have to rise more to remove a given amount of liquidity/credit from the system. This was not recognized at the time the changes in the financial sector occurred, however.

Another major flaw in the monetary framework was that asset-market developments did not get enough scrutiny. Because of the close relationship seen in previous inflationary periods between housing price inflation and increases in consumer prices and the GDP deflator (Charts 5 and 6 show this relationship in Japan for land prices), monetary authorities in many countries viewed the housing market as the initial channel through which monetary tightening influenced aggregate demand, in part through the quantity-of-credit rationing mechanism. Sustained increases in housing prices served as an indicator of inflationary pressures, which could then be confirmed by subsequent changes in consumer prices. Based on experiences in the 1970s, housing price increases in the mid-to-late 1980s should have led to much higher inflation in the prices of goods—but this relationship had changed.

There were at least two early warning signs of growing financial imbalances, however. The first, the buildup of private debt, was not widely seen at the time as sufficiently problematic to merit a policy response, despite calls for a more cautious attitude toward debt accumulation and for greater attentiveness to the asset side of banks’ balance sheets. Had policymakers recognized earlier that asset- price inflation could not have occurred without the rapid buildup in private sector debt, they could have acted to limit asset-price overshooting and avoid the dramatic and costly real economic adjustments entailed by asset- price deflation, by tightening monetary policy earlier. However, the 1980s were marked by uncertainty about how to conduct monetary policy, and credit creation and expansion were not well understood; a widely held view was that central banks had more control over banks’ liabilities than over their assets.

The second warning sign, the stock market crash of October 1987, was viewed as a potentially deflationary impulse that would, through negative wealth effects, plunge the global economy into slow growth, if not recession. The payments system was at risk, and many brokers, dealers, and financial intermediaries were exposed to a massive potential liquidity crisis. The industrial countries’ central banks responded rapidly, by supplying whatever liquidity was necessary to allow the tremendous backlog of stock transactions to take place, and thus prevented a global crisis. But, after the crisis ended, many central banks failed to return to their medium-term objective—low inflation—initially, by not adequately mopping up the liquidity provided in the aftermath of the crash and, later, by continuing to supply excess liquidity. In the end, the policy response to the crash led to a significant increase in inflation in the late 1980s.

Lessons about the business cycle

What have we learned?

• An excessive buildup of private debt to finance asset accumulation can have adverse macroeconomic consequences, including deep recessions, slow economic recoveries, and sharp and costly adjustments in the business and household sectors.

• Even though asset prices are more volatile than other measures of inflation, central banks should pay more attention to asset-price movements when there are corroborating signs of excess liquidity. Inflationary pressures can be concentrated in asset markets before surfacing in conventional price indices. This does not mean that monetary policy should respond to every sharp sustained movement in asset prices. If rapid asset-price movements reflect asset-portfolio adjustments or other fundamental changes in the real economy, the role of monetary policy is to ensure that relative price adjustments occur in a stable financial environment. But, if these movements can be traced to excess liquidity and credit, there is a threat of more inflation, and policy should be adjusted accordingly.

• The analytical framework used to assess monetary policies in the 1980s was not adequate to evaluate developments in key asset markets. It relied too heavily on average price measures covering a relatively small subset of total economic transactions, namely the flow of goods and services. It would be useful to divorce the concept of “inflationary pressure” from particular measures of inflation and to construct price indices that cover a broader set of transactions (see, for example, the indices suggested in the paper by Alchian and Klein in the box); if properly constructed, such indices would not change when asset-price movements reflected portfolio shifts from one asset to another but would capture a systematic increase in asset prices driven by excess liquidity or credit.

• The experience of many countries—especially Japan and the Nordic countries—suggests that enhanced prudential regulation and oversight are desirable, particularly during periods of rapid and extensive financial deregulation and liberalization, to ensure that gains from increased competition in financial markets are not offset by systemic weakness arising from the insolvency of financial institutions. Regulatory and macroeconomic policies need to be better coordinated and supervisory practices strengthened—especially when structural change is expected. Policymakers also need to pay more attention to the sequencing and pace of reform, and to coordination between regulatory and supervisory bodies.

• Economic policy should remain flexible during the business cycle, especially at turning points, without necessarily sacrificing important medium-term economic objectives.

Perhaps the most important question is whether the recent business cycle was unique, or whether future business cycles, in a liberalized global financial environment, are likely to have a similar profile. Uncertainty about this issue reinforces the need for monetary policy to remain flexible in the future and for the development of more reliable tools for monitoring cyclical developments—including tools making it possible to assess asset-market conditions with greater accuracy.

This article is based on the author’s “Asset Prices, Monetary Policy, and the Business Cycle,” an IMF Paper on Policy Analysis and Assessment (PPAA/94/6), March 1994, and draws on the detailed country analyses in “‘Boom, and Bust’ in Asset Markets in the 1980s: Causes and Consequences,” by the author and Monica Hargraves, in Staff Studies for the World Economic Outlook, World Economic and Financial Survey, IMF, December 1993.

Suggestions for further reading: “On a Correct Measure of Inflation,” by A. A. Alchian and B.

Klein, Journal of Money, Credit and Banking, February 1973, Vol. 5, No.l, pp. 172–91; Alexander Hoffmaister and Garry J. Schinasi, “Asset Prices, Financial Liberalization, and the Process of Inflation in Japan,” IMF Working Paper (WP/94/153); Seyed Hossein Samiei and Garry J. Schinasi, “Real Estate Price Inflation, Monetary Policy, and Expectations in the United States and Japan,” IMF Working Paper (WP/94/12).

Garry J. Schinasi

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