School of Profit



Before the crisis of 2007-8, central bank policy-makers generally felt that directly targeting house prices was not their job. The role of central banks, they felt, was to control inflation.

Inflation is generally defined as consumer goods inflation. Housing is categorized as an investment good, not a consumption good. Therefore it is left out of the inflation statistics. Only housing costs, i.e., rents, are included in the inflation numbers.

So house price inflation is not inflation?

To those focused on the housing markets this seemed utterly perverse, both in theory and in practice. A massive and clearly inflationary spiral in house prices was taking place. It was having enormously expansionary effects on the world’s economies. The wave of house-price inflation was giving jobs to armies of realtors, investment bankers, and developers. Not to ‘count’ this made no sense.

Asset price inflation clearly is a form of inflation - which however escapes the official inflation statistics, which use imputed rents as a proxy for housing costs.

Will attitudes change?

In recent years the Bank for International Settlements (BIS) has been paying more attention to house prices, because past housing busts have had disastrous economic impacts, notably in Japan and Sweden.

Yet this change of mood was not general. Until 2008, the consensus amongst economists had not shifted. The view that central banks should not target house prices directly, but instead target inflation, remained the dominant consensus until the eve of the crisis.

It seems impossible to imagine the crisis won’t have some effect on attitudes: The US 2008 house price collapse has generated a torrent of criticism of Greenspan.

  • Greenspan’s free-market ‘hands off’ approach to regulation has been the critics’ main target.
  • But Greenspan’s indifference to mounting evidence that there was a severe housing bubble, on the ground that bubbles are impossible to unequivocably identify, has also come under fire.

Attitudes seem likely to change. We feel most central bankers would now, in their hearts, admit: ‘Of course central bank policy should explicitly target house prices!’ The risks of not doing so are simply too high.’


Our reading list on this question has a somewhat old-fashioned feel, because the published articles reflect the pre-crisis consensus. The reality is that the causes of this crisis are still unclear. It took years for a consensus to form on the cases of the Great Depression (1929-33). It will probably also take a very long time for theorists to agree exactly why this crisis took place. Meanwhile, here are some articles representative of the pre-crisis consensus:

House prices and economic activity
OECD Economic Outlook No 68, December 2000

Should house prices be targeted as a sign of impending inflation? No, say the reports’ authors, because house price rises do not always lead to inflation. Instead, bank supervision needs strengthening.

Asset prices, financial and monetary stability - exploring the nexus
BIS Working Papers No 114, Claudio Borio and Philip Lowe, July 2002

Financial imbalances can build up in a low inflation environment, the authors argue, and in some circumstances it is appropriate for policy to respond to contain these imbalances.

Asset price bubbles and their implications for monetary policy and financial stability
Jean-Claude Trichet, April 2002

Should central banks react to asset-price movements? No, says the European Central Bank head.

Monetary policy and asset price volatility
Ben Bernanke and Mark Gertler, February 2001

Argues that central banks should focus on underlying inflationary pressures, since the effects on market psychology of targeting asset prices are dangerously unpredictable Asset prices become relevant only to the extent they may signal potential inflationary or deflationary forces. Rules that directly target asset prices appear to have undesirable side effects, argues the chairman of the Federal Reserve Board and his co-author.

What lessons can be learned from recent financial crises? The Swedish experience
Urban Bäckström, August 1997

Discusses whether the Riksbank could have better prepared for the Swedish banking crisis in 1990-92. Concludes that supervision of the financial sector should have been tougher, and the authorities more vigilant.

Housing and the business cycle
Edward Leamer, UCLA, August 2007

Weaknesses in residential investment have contributed 26% of the weakness in the economy in the year before the eight recessions since WWII. Weak housing starts fell off sharply (e.g.) three years before the 1929 crash.

The temporal ordering of the spending weakness is:

  1. residential investment,
  2. consumer durables,
  3. consumer nondurables and consumer services before therecession, and then, once the recession officially commences,
  4. business spendingon the short-lived assets, equipment and software, and, last,
  5. business spending onthe long-lived assets, offices and factories.

Conclusion: If an aim of central banks is to smoothe the business cycle it is well worth paying attention to housing starts. A note of realism!

Financial bubbles: what they are and what should be done
Dean Baker, CEPR Basic Economics Seminar, November 2005

A robust left-wing view of bubbles and their impact on the economy, putting in stark and simple terms the case that the Federal Reserve Board has the responsibility to identify, intervene and deflate bubbles.

Irrational Exuberance.
Robert Shiller, Princeton, NJ: Princeton University Press, 2005

Still the best book on the bubble, which clearly explained, well in advance of the crash, that there was a bubble. Written by one of the founders of behavioral economics.