Can monetary policy lean against housing bubbles?

• Published in: Economic modelling 2022-05, Vol.110, p.105801, Article 105801
• Main Authors: André, Christophe, Caraiani, Petre, Călin, Adrian Cantemir, Gupta, Rangan
• Format: Article
• Language: English
• Subjects: Asset pricing; Bubbles; Housing; Leaning against the wind; Monetary policy; VAR
• ISSN: 0264-9993; 1873-6122
• DOI: 10.1016/j.econmod.2022.105801

Gali and Gambetti (2015) found protracted episodes in which stock prices rise in response to monetary policy tightening. This counter-intuitive result suggests that raising the policy rate in response to a perceived asset price deviation from fundamentals may fail to contain an emerging bubble. Since housing is often at the epicenter of deep and protracted recessions, it is essential (from a monetary policy perspective) to assess whether the result from Gali and Gambetti (2015) also holds when one considers housing instead of stock prices. Thus, we estimated a Bayesian VAR model based on an asset-pricing framework allowing for rational bubbles in the United States, the United Kingdom, and Canada. In addition, this estimation framework separates the fundamental component of housing prices from its bubble component, derived as the deviation of observed prices from the fundamental values. This allowed us to examine the responses of both components to a monetary policy shock and assess how bubbles may affect the responses of housing prices to monetary policy tightening. According to the results, we found that housing prices respond negatively to an interest rate hike, as common intuition would imply. This indicates that monetary policy may play a role in fighting housing price bubbles. •In a model with a rational bubble, a higher policy rate can lower housing prices.•This finding is in contrast to that of Gali and Gambetti (2015) on stock prices.•Monetary policy may play a role in fighting housing bubbles.•Monetary tightening entails costs in terms of lower output and inflation.