Enhancing Financial Stability and Monetary Analysis in the Core Model of the SARB

Abstract:

Central bank models without a well-articulated credit channel and links between the financial sector and the real economy may misrepresent the timing and profile of monetary policy transmission and risks to financial stability. This paper draws on international literature to propose improvements to the Core econometric policy model of the South African Reserve Bank (and a recent extension adding a banking sector). Real estate plays a major role in the monetary transmission mechanism, but the Core model misses the crucial elements. There is almost no role for credit conditions, and no explicit role for house price expectations. Empirical evidence on expectations of house price appreciation suggests a potential for overshooting of house prices (currently not captured in the model) and of mortgage debt, followed by painful corrections. We propose a forward-looking approach to incorporate income expectations in the consumption equation through modelling permanent income (currently not in the model). The consumption equation should include changing credit conditions and relax the net worth restriction on household wealth to capture the separate impacts of housing wealth, illiquid and liquid assets, and debt. The long-run solution of the house price equation should improve by incorporating the supply side, with explicit roles for credit conditions and house price expectations, as well as interest rates. House prices transmit strongly into mortgage debt. We propose replacing the single aggregate household debt equation by separate equations for mortgage debt and non-mortgage debt and capturing not just a direct interest rate effect but also the indirect effects of interest rates via house prices and shifting credit availability. House prices also transmit strongly to residential investment, and we propose including a residential investment equation, currently missing in the Core model. We propose adjustments to the banking sector equations to enhance the understanding of linkages with macro-prudential policy. Improving the database on commercial real estate, closely tracking loan-to-value ratios and credit spreads in the mortgage market and modelling the consequences of changing credit availability for consumption, debt, house prices and investment, should enhance the understanding of financial stability risks in South Africa.