ECB backs asset price bust predictor

Examining lending growth,long-term interest rates, investment patterns and moves in house and stock prices can help to predict asset price busts up to twoyears ahead of time, the European Central Bank said on Friday.

In its latest Financial Stability Report, the ECB road-tested an asset price indicator developed in-house and found a snapshot of conditions in late 2006 would have predicted the "bust" in 2008 with a probability of 40 percent or more.

Taken since 1974, the model would also have predicted a number of other asset price crises which were not defined as busts, for example in 1989-1992 when German reunification drove up house prices in Germany but not overall.

The finding comes amid increased debate about the role central banks should play in heading off asset price bubbles, potentially by raising interest rates pre-emptively, although policy makers such as Axel Weber have said rates are not the right tool to tackle asset price bubbles.

The report said the findings vindicated the ECB's regular analysis of money and credit growth as this could flag asset price imbalances and allow a "timely" response to the risks to price and financial stability.

"According to statistical tests, credit aggregates, nominallong-term interest rates and the investment-to-GDP ratio, together with developments in either house prices or stock prices, turn out to be the best indicators that help to predict asset price busts up to eight quarters ahead" the ECB said.

The model could be used as input for financial supervision and assessment of systemic risks, which will take on a greater role in the European Union with the planned establishment of a new European Systemic Risk Board, to be headed by ECB President Jean-Claude Trichet.

The ECB said in its report that the effectiveness of the new body would depend largely on the quality of its risk assessments and on its ability to make affected parties act on its recommendations, given these would not be legally binding.

"The fact that the ESRB may decide on a case-by-case basis whether to make a warning or recommendation public may increase the pressure to follow up on the recommendation, but it couldalso trigger adverse financial market reactions" the report said.