The Hindu Business Line : Asset price inflation leaves Greenspan cold

IN a recent testimony to a British Parliamentary Committee, the Bank of England's Governor, Mr Mervyn King, was asked if the housing boom in the UK influenced the Bank's monetary and interest rate policy.

His reply was that the Bank did not directly target house prices, but was worried about the rapid rise in borrowing and leverage involved in buying house properties in a rising, perhaps speculative, market.

This exchange clearly illustrates the dilemma of central banks in modern times - whether they should concern themselves with asset price inflation, a phenomenon particularly evident in the nineties.

The most obvious signs of rising asset prices are booming property and stock markets. These do not form part of any inflation index.

House rents are, of course, a component of the index, but, in recent times, their behaviour has diverged widely from movements in the underlying asset prices, because they have lagged the rise in capital values.

Stock prices are also out of inflation measurements. Thus, the two most visible icons of asset prices do not find a place in general price indices.

Among the three countries, the US, the UK and Australia, which are witnessing rising house prices, the last two have been on a course of monetary tightening for some time now.

The Bank of England has pushed up its repo rate from 3.5 per cent to 4.5 per cent while the Reserve Bank of Australia (RoA) has moved its reference rate from 4 per cent to 5.25 per cent, both in the last twelve months.

It is not as if inflation was a major risk in these economies. In fact, it has been restrained. But their central banks took the view that low rates led to unduly high credit expansion, possibly for speculative purposes. It was better to nip such tendencies in the bud by hiking borrowing costs.

Both the BoE and RBA seem to be clear that they will continue with a hawkish policy till consumer borrowing cools.

On the other side of the Atlantic, the US Federal Reserve Chairman, Mr Alan Greenspan, is more sanguine.

He thinks there is no reason to link asset prices and interest rates. Throughout the Wall Street boom of the late nineties, Mr Greenspan was firm in not allowing booming markets to influence Fed policy.

In fact, his fear was that if the Fed started to raise rates just to curb stock prices, the economy could tumble.

His critics argue differently. When the Fed finally has to put up rates, house prices would fall and significantly reduce or even turn negative the equity component in capital values.

If, in the meanwhile, the economy gets into a downturn, the ability of many to meet their mortgage payments would weaken. Large-scale defaults will, in turn, impact the health of financial institutions and worsen economic conditions.

Mr Greenspan feels these fears are overblown. He is sure enough of his deft handling of monetary policy to ignore asset bubbles as well as his central banking cousins in the UK and Australia.

Still, America's borrowing binge-households are in hock to banks and the country is in hock to foreign investors in Treasuries - this poses risks. If foreigners start selling US assets in a big way, the dollar could crash and send bond yields soaring.

Mr Greenspan will keep rates relatively soft but must hope that enduring recovery will be in place before anything precipitous happens.

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