In the aftermath of the recent global financial crisis, central banks have been widely criticised for having kept interest rates too low for too long. Several authors have argued that exceptionally low interest rates spurred excessive risk-taking in the banking sector, leading to the build-up of imbalances and finally the crisis (see *eg* Ciccarelli *et al* 2011 or Altunbas *et al* 2010). Since property prices have been shown to play an important role during episodes of financial instability (see among others Goodhart and Hofmann 2007 and Bank for International Settlements 2004), understanding the link between monetary policy stance and the emergence of housing bubbles has become an important and topical issue for policymakers.

Some authors have called for central banks to react to movements in asset prices (Borio and Lowe 2002, Cecchetti *et al* 2000), while others have shown that using monetary policy to lean against asset-price fluctuations may not be a sensible strategy (Assenmacher-Wesche and Gerlach 2008).

In a recent study (Hott and Jokipii 2012), we analyse the role that monetary policy plays in the emergence of housing bubbles. More precisely, for 14 OECD countries^{1} we estimate the impact of short-term interest rates that are too low for too long on the emergence of housing bubbles. This article briefly presents our results and main policy conclusions.

# Deviations of house prices from their fundamental level

To estimate the effect that monetary policy stance has on the emergence of housing bubbles, we need to define and identify bubble periods. To do this, we compare actual and fundamentally justified house prices.

There are various possibilities to estimate the fundamental value of houses. One way is to look at indicators like the price-to-rent or price-to-(per capita) income. These indicators have some drawbacks. First, they only consider a single factor (*eg* rent as an indicator for the return or income as an indicator for the affordability) and, second, the relationship between a fundamentally justified price and this single fundamental factor is not necessarily stable (*eg* because of changing interest rates).

We instead obtain the fundamental value by calibrating a theoretical house price model for each of the 14 OECD countries in our sample. This house price model implies that the fundamental value is given as the sum of future expected imputed rents. Imputed rents, in turn, are assumed to depend positively on GDP (as a measure of demand) and negatively on construction activities (as a measure of supply).

The calibration of the model shows that actual prices fluctuate much more than fundamentally justified. Housing bubbles (meaning positive deviations from the fundamental value) can be observed in many countries around 1990 as well as around 2007. The recent overvaluations were especially strong in the two Eurozone countries Ireland and Spain. By contrast, in Germany, Japan, and Switzerland house prices have remained below their fundamental level since the mid-1990s.

**Figure 1.**

# Deviations of interest rates from their benchmark level

Determining whether monetary policy is ‘too loose’ or ‘too tight’ requires an assessment of whether observed rates deviate from some policy rule or economic model. We adopt the Taylor rule (Taylor 1993) as the benchmark rate from which to assess policy stance. For each country in our sample, we calculate interest-rate deviations by comparing observed short-term interest rates with Taylor-implied rates. We acknowledge the fact that the Taylor rule is not a rule that should necessarily be followed systematically by a central bank taking policy decisions. However, we use the Taylor-implied rates since it is a benchmark rate that can be estimated for a broad sample of countries from which to determine whether monetary policy was generally too tight or too loose.

Relative to the Taylor rule, of the 14 countries in the sample, five (Finland, Ireland, Spain, Switzerland, and the US) have interest rates that have, on average, been too low over the sample period. In Finland, interest rates remained relatively low for much of the 1980s and early 1990s. Since the introduction of the euro in 1999, rates have been consistently too low relative to those implied by the Taylor rule. In Ireland and Spain, observed rates were too low in the early 1980s and similarly to Finland, have remained consistently too low since 1999. In Switzerland and the US, rates were generally too low in the late 1980s and early 1990s and again from the late 1990s.

# What is the impact of too-low interest rates on the emergence of housing bubbles?

To assess the impact that deviations of short-term rates from the Taylor-implied rate have on housing bubbles, we use the Seemingly Unrelated Regression methodology.

For most countries, we find that interest-rate deviations have a significantly negative impact on housing overvaluation. The finding provides evidence that interest rates that are *too low* relative to the Taylor rule are statistically linked to housing bubbles. The relationship is strongest for Ireland where interest-rate deviations explain up to 50% of housing overvaluation. Here, a 1% deviation of interest rates from Taylor-implied rates results in a 7% overvaluation. Ireland is one of the countries that experienced significant variation in the growth of both actual and fundamental house prices. Within the Eurozone the impact of interest-rate deviations on housing bubbles is greatest for Ireland, Finland, and Spain, the three Eurozone countries with the lowest mean interest rate relative to Taylor-implied rates over the sample period. These countries experienced growth of both actual and fundamental house prices that were significantly above the sample average. These findings highlight the difficulties associated with a single policy interest rate that is confronted with a heterogeneous development of house prices.

# What if interest rates are too low for too long?

Our findings suggest that rates that are too lowcan lead to emergence of housing bubbles. To assess whether the duration of interest-rate deviations has an additional impact on house price overvaluation, we create additional variables that capture the number of consecutive periods that observed short-term rates are lower than those implied by the Taylor rule.

For each of the 14 countries in the sample, we show that the longer the rates deviate from the Taylor-implied rates, the higher the housing overvaluation. The durationeffectis strongest for Ireland, Spain, Finland, and the US. These are the countries for which we observe the largest average deviation of interest rates from Taylor-implied rates over the sample period. The average R-squared* – *a measure of the strength of the relationship – increases from around 20% to 35% when we account for the duration of the rate deviation. For Ireland, the length and the extent of the deviation from Taylor-implied rates together account for around 80% of housing overvaluation. For Finland and the Netherlands the corresponding fraction is around 50% and around 20% for Switzerland, Germany, and Norway.

# What does this mean for policymakers?

Our analysis has shown that interest rates that are set too low for too long have a significant impact on the creation of housing bubbles. The strong link between deviations of short-term rates from Taylor-implied rates and housing bubbles suggest that in order to lean against house price fluctuations, it is not necessary to consider house prices directly in monetary policy decisions if policymakers set interest rates at levels close to those implied by the Taylor rule.

Our results highlight the additional complexity of maintaining an appropriate policy interest rate for a group of countries like the Eurozone that experience substantial heterogeneity in both the real estate markets as well as in the real economy. As we have seen, Taylor-implied rates as well as the development of house prices differ substantially between some Eurozone countries. Since it is not possible to react to this with a single monetary policy, country-specific measures should be taken to compensate for *too low* interest rates and in order to avoid a build-up of housing bubbles. This compensation could be achieved, for example, by introducing macroprudential instruments like countercyclical capital requirements for banks, limits for loan-to-income and loan-to-value ratios, or a countercyclical tax treatment of real estate holdings.

# References

Altunbas, Y, L Gambacorta, and D Marques-Ibanez (2010), “Does Monetary Policy Affect Bank Risk-Taking?”, ECB Working Paper 1166.

Assenmacher-Wesche, K and S Gerlach (2008), “Financial Structure and the Impact of Monetary Policy on Asset Prices”, Swiss National Bank Working Paper 2008-16.

Bank for International Settlements (2004). “Bank Failures in Mature Economies”, BCBS Publications: Bank for International Settlements Working PaperNo. 13.

Borio, C and P Lowe (2002), “Asset Prices, Financial and Monetary Stability: Exploring the Nexus”, BIS Working Paper No 114.

Cecchetti, M, H Genberg, J Lipsky, and S Wadhwani (2000), *Asset Prices and Central Bank Policy*, Geneva Report on the World Economy 2, London: CEPR and ICMB.

Ciccarelli, M, A Maddaloni, and J-L Peydró (2010), “Trusting the Bankers: A New Look at the Credit Channel of Monetary Policy”, ECB Working Paper No 1228.

Goodhart, C and B Hofmann (2007), *House Prices and the Macroeconomy: Implications **for Banking and Price Stability*, Oxford: Oxford University Press.

Hott, C and T Jokipii (2012), “Housing Bubbles and Interest Rates”, *SNB*, Mimeo.

Taylor, J (1993), “Discretion versus Policy Rules in Practice”, Carnegie-RochesterConference Series on Public Policy, 39:195-214.

^{1} Australia, Canada, Finland, France, Germany, Ireland, Japan, the Netherlands, Norway, Spain, Sweden, Switzerland, the UK, and the US.

## Comments

## House prices in The Netherlands

I was wondering whether the autors had taken the Dutch tax system into account. In The Netherlands mortgage relief reduces the actual interest burden with approximately 40%. A low interest rate is therefore even lower. This could explain why a low interest rate in The Netherlands has had a stronger effect on the pricing bubble than in Germany.