The RBA’s impossible position on monetary policy

The Reserve Bank of Australia (RBA) should exercise caution in using the blunt instrument of monetary policy to respond to runaway property prices. 

The RBA recently articulated a theoretical ‘normal’ interest rate of 3.5 per cent for Australia, two percentage points above the current cash rate. This announcement stunned financial markets with the Australian dollar breaking through the US 80 cent barrier in the following days. Was this simply intellectual speculation about the neutral interest rate, or was the RBA hoping to cool the housing market?

The answer may be found in a paper published twenty years ago by the now Reserve Bank of Australia’s Governor Phillip Lowe and Assistant Governor Christopher Kent. In Asset-price Bubbles and Monetary Policy, Lowe and Kent argued that in some cases central banks should raise interest rates to burst property bubbles.
 

As is often the case, what may be true in theory is more complicated in reality and we believe the RBA should exercise caution in normalising the current cash rate.

East coast properties versus the economy

Lowe and Kent reasoned in 1997 that property bubbles pose significantly greater risks to the nation’s financial system than other asset-price bubbles, like technology stocks in the dot-com boom. This is primarily because real estate acts as the security for most business and personal loans, and is the largest asset for most Australian homeowners. A steep decline in the prices of properties would impair corporate balance sheets and limit the ability to borrow or lend across the economy. Australian households would lose confidence and consumer demand would suffer.

Viewed against historical and international standards, property prices in Australia’s east coast appear elevated. With the surge in prices in Sydney, Melbourne and some areas of Brisbane largely driven by record low interest rates, the RBA has notably increased its cautionary tone on property prices. However, many cities and towns throughout the nation have experienced significantly less price growth with some declining in value. Interest rate rises impact the nation as a whole, not just those geographic areas where property prices are elevated.

In our view, the RBA is eager to increase interest rates, however capacity in the employment market and low inflation, in particular wage inflation, is holding it back.

The prudential pathway 

Lowe and Kent argued that while regulation of the financial system can limit the likelihood and impact of a bubble, only monetary policy can respond once a bubble emerges after regulation has failed.

The Australian Prudential Regulation Authority’s (APRA) two rounds of lending limitations have so far failed to slow the momentum in house prices. The first round, introduced in December 2014, comprised a 10 per cent limit on property investor loans and included additional loan serviceability tests. In March 2017, APRA limited the flow of new interest-only lending to 30 per cent of new residential mortgages and introduced strict guidelines on loan-to-valuation ratios.

We believe there is room for further limitations on borrowing in the property market before monetary policy is employed. For example, if the east-coast property market does not respond to the last two rounds of APRA’s lending limitations, it could introduce a 20 per cent limit on interest-only loans and a 7.5 per cent limit on property investor loans.

The bubble and the blunt instrument

Lowe and Kent argued monetary policy should be tightened “in response to an emerging asset-price bubble, in order to burst the bubble before it becomes too large”. The underlying argument is that the ramifications of letting bubbles run away are more dangerous than bursting them early.

While this may be true, if Australia’s property prices are inflated, this is limited to the east coast. Monetary policy, however, affects all asset classes and geographies. In our view, it should be used as a last resort and under the right economic conditions. Using a blunt instrument to burst a localised bubble would have negative consequences for the entire Australian economy.