RBA governor Glenn Stevens has warned that lowering interest rates following an “asset price bust” to stimulate lending can have "toxic consequences".
Stevens highlighted the challenges faced by the RBA in managing rising property prices and boom to bust cycles in a speech published today and delivered to the closed door Bank for International Settlements (BIS) conference co-hosted by the RBA in August.
Stevens said there has been “a long debate about whether monetary policy should respond to asset prices – the so-called lean-versus-clean debate”
The RBA responded to the GFC by dramatically cutting the cash rate by 400 basis points from a setting of 7% in October 2008 to 3% by April 2009, spurred on by the bankruptcy of investment bank Lehman Brothers on September 15 2008.
He said many people had contributed to the lean-versus-clean debate during the conference.
He said the case for leaning into the property price upswing (by raising interest rates) is that “growth cost might be small and the benefits of avoiding future pronounced instability might be great”.
However, he said the argument against this approach is “that we just do not know enough about asset price and credit dynamics to do this with any precision or with the hope of much success, at least without risking serious damage to other parts of the economy".
But he said the flip-side of the argument of “simply expecting to clean up after the credit boom is not sufficient anymore" because "the mess might be so large that monetary policy ends up not being able to do the job when the time comes”.
“Moreover, if the monetary policy clean-up after the asset price bust involves interest rates low enough to prompt some other sector of the economy to leverage up in order to spur the growth, then the clean-up itself might leave its own toxic consequences,” he said.
Regardless of the actions taken by central banks, Stevens said monetary policy cannot succeed in managing cycles, asset values and leverage by itself.
In his speech, Stevens also highlighted how property price crashes had taught Australia painful lessons, dating as far back as 1890 when a combination of foreign capital inflow, speculation and a decline in lending standard resulted in an acute depression in Melbourne, far worse than the 1930s.
He also added that in his lifetime, the liberalisation of the financial system in the 1980s and 1990s created a boom in commercial property prices that then “unwound quite painfully”.
“There is little doubt that property price swings and financial stability are intimately connected, our own experience in Australia certainly confirms that,” said Stevens.
He said the lessons learned from these experiences is that it is crucial to get the underlying monetary framework right.
“Indeed maintaining overall macroeconomic stability is the most important thing that monetary policy can do,” he said, adding that implementation of the flexible inflation-targeting regime nearly 20 years now had enhanced the RBA ability to maintain this stability.
But he said monetary policy built around controlling consumer price inflation though critical not enough.
“Financial stability and monetary policy are related – the relationship is not simple, it is complex, but you certainly cannot divorce the two,” he said.
He said the second lesson was that property and asset prices matter a great deal in forecasting future output and consumer price inflation.
“[Asset prices] matter because property holdings tend to be leveraged. Big swings in asset values where the holdings are not leveraged will not, I conjecture, matter all that much.
“It is property that is being used as collateral for significant lending by financial institutions that makes property prices so important. It is actually the leverage that matters,” he said.
The third lesson learned from previous crashes, Stevens said, was the importance of prudential supervision.
“The most elegantly crafted rules will not make much difference if the capacity and will to enforce them is not in place.
“There is probably too much tendency to fall for the easy line that if only we can craft better regulations and bring the bankers under control then all will be well.
“Actually, it is the application of the rules and the framework that matter.
“After all everybody was using some version of Basel II or Basel I. This was more or less the same set of regulatory arrangements pre-crisis. But not everybody had a collapse of their banking system,” he said.