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The illusion of stability: low inflation in a bubble economy

The Bank of England was granted independence in 1997 with a remit to control consumer price inflation. Research by Marcus Miller and colleagues shows that while this narrow focus preserved the semblance of stability for some time, neglect of the growing bubble in the housing market meant that stability was always an illusion.

Economists are deeply divided on how deregulated housing markets work. Some take an "efficient market" view, where house prices satisfy the arbitrage relationships of households making decisions in the light of current and future fundamentals. This is in line with the current mainstream "dynamic stochastic general equilibrium" (DSGE) perspective of how the economy as a whole functions.

Robert Shiller of Yale University, on the other hand, warns that house purchase is an area where "social contagion" plays a large role and buyers can easily lose sight of economic fundamentals.

This perspective finds support from behavioural economics. Using examples from US regional housing markets to show that arbitrage relationships have, in fact, been "broken," David Laibson of Harvard University argues that the prevalence of "trend-chasing" and the acceptance of "social proof" can promote prolonged asset price bubbles – and have done so.

Neglecting house prices is as sensible as ignoring icebergs when steaming across the North Atlantic

What about the UK where house purchase and finance have been progressively deregulated since mortgage rationing ended in the late 1970s? As Figure 1 shows, house prices adjusted for inflation show two pronounced surges above trend since then, with peaks in 1988 and 2007 (when prices stood about a third above the trend line for the last 30 years).

Figure 1. Real House Prices in the UK, 1975 to 2009

Real House Prices in the UK

A. "Big Bang" in the City.
B to C. Most building societies become banks.
D. Andrew Oswald and IMF warn of house price bubble.
E. Stephen Nickell of the MPC denies existence of bubble.

Source: Nationwide Building Society. Average house prices are deflated by the change in the Retail Price Index, based on 2009 (Q1) = 100. The upward trend is 2.9% per year.

While Robert Shiller’s index of real home prices in the United States (the Case-Shiller index) increased 85% between 1997 and the peak in 2006, real house prices in the UK more than doubled from 1997 – when the Bank of England was granted independence with a narrow remit to control consumer price inflation.

In both countries, the "doctrine of denial," espoused by Alan Greenspan (Federal Reserve chairman, 1987-2006), prevailed: since bubbles are difficult to detect and control, the central bank should restrict itself to coping with the after-effects of bubbles that burst.

Studies confirm that changes in real house prices in the UK have a momentum that can lead to prolonged departures from the trend or "equilibrium" prices. For example, a report by the International Monetary Fund (IMF) in 2003 provides evidence of excess valuation after deregulation in the 1980s, and of growing "disequilibrium" after 2000.

The IMF gave a clear public warning of asset price disequilibrium four years before UK real house prices peaked, as indicated in Figure 1. So too did our University of Warwick colleague Andrew Oswald, who, in early 2003, forecast a coming fall of 30%.

Two years later, however, Stephen Nickell, then the longest-serving member of the Bank of England’s Monetary Policy Committee (MPC), took a very different view – effectively endorsing the efficient markets perspective.

New policy instruments require closer coordination between the Bank, the Treasury and the Financial Services Authority

What if a housing bubble affects aggregate demand via a "wealth effect," boosting consumer spending excessively as rising house prices make people feel better off? Our research shows that a narrow focus on consumer price inflation – while neglecting a growing bubble in housing – may preserve the semblance of stability for some time.

But with the bubble-distorting policy on the way up and wreaking havoc on the banking system when it bursts, this is an illusion. A policy of neglecting house prices in these circumstances is about as sensible as ignoring icebergs when steaming across the North Atlantic!

What should be done? As Charles Bean, Deputy Governor of the Bank of England, has recently acknowledged, new instruments of policy, such as dynamic capital requirements and loan-to-value limits, are needed as a complement to interest rate setting for a bubble-prone economy. Effective use of these new instruments will surely require closer policy coordination between the Bank, the Treasury and the Financial Services Authority.

Publication details

This article summarises "The illusion of stability: low inflation in a bubble economy," by Marcus Miller, Ishita Mohanty, and Lei Zhang, published in in 2009 in The Manchester School 77, Supplement 1, pp 126-149.

The authors

The authors are in the Department of Economics at the University of Warwick; Miller is Professor, Zhang is Associate Professor, and Mohanty is a graduate student.