Significant risks when RBA attempts to burst any housing price bubble: Christopher Joye

In the Australian Financial Review today journalist Adrian Rollins revisits the debate surrounding whether the RBA should use monetary policy to resist burgeoning asset price bubbles. This is well-trodden territory that I have written about more than most, and Rollins quotes my views in his article. While he does an excellent job of outlining the broad contours of the debate, there is some missing nuance that is worthwhile clarifying.

When I first started thinking about this subject I landed in the camp of those who felt that a central bank that autocratically lifted rates to “lean against” asset price increases – in, say, equities or housing – that were being fuelled by unseemly credit growth (e.g., via leveraged buyouts or a mortgage boom) could do more harm than good.

The first problem is one of policy distraction. Central banks typically have a singular policy goal, which is “price stability”. In simple terms, that means keeping the rate of consumer price inflation within a low and ideally stable band of 2% to 3% per annum.

In recent years the RBA has subtly re-cast the standard “inflation-targeting” model by describing its own approach as a “flexible inflation-targeting” regime. (The best summary of the Antipodean differences is offered in this RBA paper authored by Paul Bloxham and colleagues.) The introduction of the word “flexible” has been used by the RBA to denote the fact that it now believes it should have the freedom to deviate, in the short term, from the settings necessitated by its through-the-cycle inflation target if “financial stability” concerns warrant such action. In this context, financial stability is being employed as a euphemism for bubble trouble.

The most oft-cited case-study is the 2003 episode, which the RBA has slyly allowed to be rewritten in history as an example of a prescient central bank staunching an incipient house price bubble from emerging via the application of tighter-than-normal interest rate policy.

When pushed, the RBA publicly acknowledges that this is, in fact, incorrect. That is, monetary policy in 2003 would have been the same with or without rapid house price growth. It was in truth the RBA’s experiment with much more aggressive “open-mouth operations” (exercising moral suasion over punters), and some subsequent changes in APRA’s approach to managing mortgage risk (via the risk-weightings imposed on lenders), which were the tangible policy responses to the asset price innovations at the time.

The first bone fide example of asset prices directly – rather than indirectly – determining the setting of rates in this country was the RBA’s much more rapid than expected normalisation of the cash rate over 2009 and 2010, which I pointed out to Rollins (see here and here for more matter). By this juncture, the RBA had the experience of 2003 and Greenspan’s purported mistakes prior to the GFC behind it.

Within the RBA, those who advocate a more interventionist approach to influencing asset markets felt vindicated by these events. This cohort included Glenn Stevens, Phil Lowe, Tony Richards and Christopher Kent, among others. The weight of evidence (and logic), they claimed, was inexorably falling behind the “lean against the wind” school of thought – subject to the caveat that this was, of course, but a “policy of least regret”, whatever that means.

On the other side of the Australian debate stood the likes of myself, Dr Stephen Kirchner of the Centre for Independent Studies, Dr Guy Debelle at the RBA  (see his speech to the Brazilian central bank) and Dr David Gruen at Treasury (see here).

The alternative argument was that truly damaging asset price bubbles are hard to identify, that the interest rate changes required to resist one could exact tremendous collateral costs across the wider economy, that a “multiple objective” central bank is more likely to lose focus on its core price stability task, and thus make policy mistakes, and, finally, that there are superior “macro-prudential” tools available to regulators to more surgically cauterise such problems.

An illustration of the latter would be changes to the risk-weights and capital charges that APRA requires banks to hold against commercial and residential property loans. Other examples would be defining minimum equity (i.e., deposit) requirements for new lending (or maximum loan-to-value ratios), minimum debt-servicing standards, and/or the removal of external subsidies, such as the first-home owner’s grant, that distort the market’s functions.

After privately debating this with the likes of Tony Richards at the RBA and watching the central bank in action during 2009 and 2010, I evolved my own view, as I have explained elsewhere.

In short, I could see that a disciplined central bank could, at the margin, tilt the rate at which it adjusted policy in concert with activist jawboning (recall Glenn Stevens’ interview with David Koch reminding folks that property is not a “one-way bet”) to assist in helping the market recalibrate expectations of future capital growth, which, most sensible people acknowledge, can become inflated by decision-making biases inherent in humans.

At the same time, I’ve cautioned that there remain significant risks associated with modifying the conduct of policy in this manner. The RBA has a proven policy regime that has the support of both sides of politics and has been formally documented in agreements between itself and the government.

More pointedly, I’ve argued that it is not up to a non-democratically elected RBA to unilaterally decide that it is going to fundamentally change its mandate, and rationalise this change (as some were prone to doing) by reference to extreme ambiguities in legislation enacted more than 50 years ago.

I encouraged a reluctant RBA to seek explicit support for these new measures from the government and to have this support formally documented in the “statement” executed every few years between the treasurer and the governor. I believe that the 2010 statement accommodates this aim via the insertion of large swathes of new text covering the RBA’s “financial stability” responsibilities and by agreeing that RBA instruments can be used to meet these goals.

So today the RBA seems to have more of a mandate to pursue these aspirations. The main risk is that this complicates the challenges policymakers face and boosts the probability of a significant decision-making error. And all central banks, including the RBA, are prone to making mistakes.

RBA officials admit that they lifted interest rates too high in the late 1980s, which gave us “the recession we had to have” and 17% mortgage rates by January 1990. They similarly concede that they reduced them too slowly in the years immediately following (the average mortgage rate between 1990 and 1992 was still a stunningly high 13.7%).

RBA officials also accept that they made nontrivial policy missteps in 2006 and 2007 that allowed core inflation in Australia to surge towards an unacceptably high 5% by mid-2008.

The concern here is that a future governor over-tightens policy in response to benign asset price appreciation and sends our interest rate-sensitive economy careening into recession. This could in turn mortally undermine the RBA’s hard-won constituency with the wider community, and its very fragile political independence.

Only time will tell whether we eventually conclude that the hazards associated with using the blunt interest rate instrument to lean against complex asset price changes are too high for policymakers to tolerate.

Christopher Joye is a leading financial economist and a director of Rismark International and Yellow Brick Road Funds Management. The above article is not investment advice.