The Bank of Canada has released a Working Paper by Hajime Tomura titled Optimal Monetary Policy during
Endogenous Housing-Market Boom-Bust Cycles:
This paper uses a small-open economy model for the Canadian economy to examine the optimal Taylor-type monetary policy rule that stabilizes output and inflation in an environment where endogenous boom-bust cycles in house prices can occur. The model shows that boom-bust cycles in house prices emerge when credit-constrained mortgage borrowers expect that future house prices will rise and this expectation is neither shared by savers nor realized ex-post. These boom-bust cycles replicate the stylized features of housing-market boom-bust cycles in industrialized countries. In an environment where mortgage borrowers are occasionally over-optimistic, the central bank should be less responsive to inflation, more responsive to output, and slower to adjust the nominal policy interest rate. This optimal monetary policy rule dampens endogenous boom-bust cycles in house prices, but prolongs inflation target horizons due to weak policy reactions to inflation fluctuations after fundamental shocks.
As summarized in Section 2, cross-country data for industrialized countries indicate that the nominal policy interest rate and the CPI inflation rate have tended to decline during housing booms and rise after the peaks of housing booms. The model explains this observation as follows. When borrowers expect that future house prices will rise, they increase housing investments, which causes a housing boom. Since borrowers are credit-constrained, they work more to finance their housing investments during the boom. At the same time, when savers do not share the optimistic expectations of borrowers, they instead expect the boom to be temporary and increase savings for a future recession. The increases in labour supply and savings reduce real wages and the real interest rate, respectively. Given sticky prices, a resulting fall in the marginal cost of production lowers the inflation rate, and, in response to this, the central bank cuts the policy rate. When the optimistic expectations of borrowers are not realized ex-post, a housing bust occurs, and savings and labour supply decline. As a consequence, the inflation rate rises, inducing a monetary policy tightening.
Since borrowers are credit-constrained, they work more to finance their housing investments during the boom. sounds a little backwards to me. I would say that “Credit constrained borrowers can work more during the boom, which allows them to finance increased housing investments”. I don’t find the rest of the rationale very convincing, frankly.
The problem of the interplay between monetary policy and housing bubbles has been discussed on PrefBlog before; e.g. Taylor Rules and the Credit Crunch Cause, with David Pappell warning
The Fed should respond to inflation, not inflation forecasts, especially in an environment where large negative output gaps are causing forecasted inflation to fall.
… a conclusion supported by the KC Fed paper discussed in KC Fed: Monetary Policy Amidst Deflationary Pressures. The problem was also discussed on Econbrowser in the post The Taylor Rule and the Housing Boom, which discusses the paper Dr. Taylor presented at the 2007 Jackson Hole conference, Housing and Monetary Policy
It strikes me that the Taylor Rule’s greatest strength, simplicity, is also its greatest weakness. Policy failure can result from misestimation of either of the two input variables. For policy purposes, it might be worthwhile to see how well other estimations that measure approximately the same thing can be added into the mix so that, for instance, inflation could be estimated not just by the CPI, but also with raw housing prices; the output gap supplemented by raw unemployment figures, and so on. Hell, I use 23 valuation parameters to assess the value of a preferred share, each of them taking a slightly different look at the problem.