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Macfarlane: RBA did not burst 2003 house price bubble with interest rates

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Former RBA Governor, Ian MacFarlane's, incredibly prescient final 2006 Boyer Lecture comprehensively lays to rest some white lies about the RBA's legacy. In this speech, Macfarlane takes my original position, and the David Gruen/Guy Debelle view, on what the RBA should and should not do in respect of asset price bubbles that threaten financial stability. He very clearly – and repeatedly – argues that it is simply not part of the RBA's (old) inflation-targeting ‘mandate’ to use interest rates to respond to them. And he contends that the RBA would have to get its mandate formally varied if it did want to embark on such action.

I am pretty sure I was the only person making this same point a couple of years ago (I had not read the Boyer Lecture, for what it is worth!), and called on the RBA to change the Statement it signs every few years with Government to more explicitly incorporate agreement on using monetary policy as a tool to help maintain financial stability. This is exactly what they eventually did, although the changes to the Statement, which are regarded internally and by the RBA's historian, Selwyn Cornish, as substantial, went totally unnoticed in the media.

There was also a contemporaneous RBA Research Discussion Paper published by Bloxham et al, which seemingly contradicted the Macfarlane position by positing that the RBA's ‘flexible’ – seems increasingly flexible these days – inflation targeting model allows it to use its cash rate to influence asset price innovations on the rare occasion that such decisions are warranted. Today the RBA would maintain that this school of thought has won-out over the Greenspan view of the world post-GFC.

Macfarlane also throttles the claim that he pricked a house price bubble in 2003 using interest rates. I and the likes of Rory Robertson have made this same observation too many times to count. The RBA's official historian, Selwyn Cornish, also validates it. But still the media and some analysts would have us believe the myth.

As a related aside, I am confident that the first time the RBA did, in fact, use interest rates to staunch bubbly asset price growth was, in fact, in 2009 under the new Stevens/Lowe regime (both of whom are enthusiastic 'asset price influencers' if the 'policy of least regret' warrants it). This was a post-crisis period when house prices were rising at a 12 per cent annualised rate, and the nontrivial concern within the Bank was that the house price growth could feed back into credit growth, and so on until the problem became too big to control. So the cash rate was normalised a little quicker than might have otherwise been the case, and we did get a soft-landing in the housing market. Round one to the bubble poppers!

1. Setting the record straight: the RBA did not use rates in 2003 to burst a house price bubble.

In the RBA-commissioned history of the Bank, Selwyn Cornish makes it categorical that rates were not used to dampen house price appreciation in 2003. To quote, "Rather than using interest rates as the policy instrument to dampen activity in the property market, public speeches by Bank officials were used to highlight the risks." As we shall see shortly, the Governor at the time, Ian Macfarlane, was equally opposed to employing rates to assault asset prices in part because he did not believe the RBA had a mandate to do so, and, even if it did, the policy was unlikely to be successful.

I was not previously aware of this, but in a September 2002 speech Macfarlane commented, "Monetary policy has to be directed towards how the average of the whole economy is evolving, not to what a particular sector [ie, housing] is doing... Although we should not allow our perceptions of developments in the housing sector to determine our stance on monetary policy, in our view that does not mean we should remain silent on the subject, and we have not."

In December 2003, Governor Macfarlane further confirmed that the RBA did not use rates in response to house prices, arguing that, "[S]igns of overheating in the housing market were clearly evident through the second half of 2002 and all through 2003, yet the Bank did not change monetary policy. It was only when it became clear that good economic growth had returned both globally and domestically that rates were raised."

A final germane anecdote was the June 2003 opinion expressed by Governor Macfarlane in parliamentary testimony, when he claimed, "There is a view that has gained currency that the only way the housing market will slow down would be if interest rates go up. I do not believe that."

2. Governor Macfarlane did not think the RBA had a mandate to lean against asset prices

In his final Boyer Lecture, Macfarlane makes the case that using interest rates against asset prices is a very questionable idea (consistent with his decisions in 2002-03), and that the RBA does not have a mandate to do so in any event.

This is fascinating for me personally, as I initially argued the first point, but relented upon persuasion from the Bank. I did, however, persist with the second in the face of opposition from the Bank, which felt that these actions could be regarded as consistent within their 1959 powers.

I called for them to explicitly modify the Statement, which they eventually did, incorporating a new ‘Financial Stability’ section with the crucial words, "Without compromising the price stability objective, the Reserve Bank seeks to use its powers where appropriate to promote the stability of the Australian financial system."

Yet in his 2006 manifesto, former Governor Macfarlane very clearly sympathised with the Greenspan perspective on the rates-asset price puzzle. Here is what he said:

"Many people have pointed out that it is difficult to identify a bubble in its early stages, and this is true. But even if we can identify an emerging bubble, it may still be extremely difficult for a central bank to act against it, for two reasons.

“First, monetary policy is a very blunt instrument. When interest rates are raised to address an asset price boom in one sector, for example, house prices, the whole economy is affected. If confidence is especially high in the booming sector, it may at first not be much affected by the higher interest rates, but the rest of the economy may be.

“Second, there is a bigger issue which concerns the mandate that central banks have been given. There is now widespread acceptance that central banks have been delegated the task of preventing a resurgence of inflation, but nowhere to my knowledge have they been delegated the task of preventing large rises in asset prices which many people would view as rises in the keeping of his wealth. Thus if they were to take on this additional role, they would face a formidable task in convincing the public of the need.

“Even if the central bank was confident that a destabilising bubble was forming and that its bursting would be extremely damaging, the community would not necessarily know that this was in prospect, and could not know until the whole episode had been allowed to play itself out. If the central bank went ahead and raised interests rates, it would be accused of risking a recession, to avoid something that it was worried about, but the community was not.

“If in the most favourable case, the central bank raised interest rates by a modest amount, and prevented the bubble from expanding to a dangerous level, and it did so at a relatively small cost in terms of income and employment growth foregone, would this be regarded as good monetary policy? Almost certainly not. As the public would see only the short-term cost to output and employment, and probably some undershoot of the inflation target, it would not be aware of the boom and bust in asset prices that had been avoided. In all probability, the episode would be regarded by the public as an error of monetary policy because the counter-factual could never be observed...

“Central banks have some credibility and authority which can be used in a public awareness campaign to make people recognise the risks they are taking in plunging into an overheated market. This campaign takes the form of speeches, parliamentary testimony, and research papers, which can then be taken up by the media and spread more widely to the community. At the Reserve Bank, we had some success with this approach during the recent house price boom, as indicated by the statements emanating from the real estate industry at the time.

“But this still leaves the central bank with a very limited armoury with which to fight against a potentially dangerous asset price boom. The interest rate, which it does not have a clear mandate to use, and public persuasion, which is of limited effectiveness; how would it cope if it faced an asset price boom of the magnitude of those that occurred in the United States in the 1920s or Japan in the 1980s?

“Not very well, I expect, and it would probably be held largely responsible for the distress that accompanied the bubble's eventual bursting."

Published: Friday, August 19, 2011

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