Working Papers

More Bubble Wrap

Alan Wood discusses the debate on the relationship between monetary policy and asset prices, referencing my CIS Policy Monograph Bubble Poppers.  Wood writes:

Central bankers have always taken asset prices into account in setting monetary policy and in Australia’s case successfully intervened in the housing market via both interest rates and jawboning by then governor Ian Macfarlane and head of Australian Prudential Regulation Authority, John Laker, a former Reserve banker, to cool off reckless lending and overheating in housing prices.

Kirchner dismisses this episode as unsuccessful, and the Howard government certainly didn’t like it. But the ratio of house prices to income fell markedly after 2003, when the RBA raised rates by 0.5 percentage points in two back-to-back hits. And Australia has so far not suffered anything like the housing price collapses in the US and Britain.

To be clear, my argument was that the RBA’s talk was not backed by policy action.  Like the rest of the world, monetary policy in Australia was accommodative in 2003 and the RBA had an explicit easing bias in June of that year.  As I noted in this op-ed, the nominal official cash rate did not reach a neutral level until 2005 and the real cash rate struggled to stay above neutral as inflation increasingly got away on the RBA.  Unfortunately, most media commentators mistake increases in the nominal cash rate for a tightening in policy, ignoring what is happening with real or expected interest rates.  It is this confusion that gave rise to the myth that the RBA presided over a successful bubble popping episode in 2002-03.

As the commodity price boom took off in 2003, population and income was sucked out of the south-eastern property markets and flowed into the resource-rich states.  As the RBA has noted, this saw renewed convergence in capital city house prices, as the heat was taken out of the south-east and shifted to the north-west.  This sub-national variation in house prices cannot be explained with reference to monetary policy, as much as the bubble poppers might like us to believe otherwise. It had a clear basis in sub-national differences in economic performance.

posted on 29 May 2009 by skirchner in Economics, Monetary Policy

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Two things:
First, it’s odd that Wood’s evidence for arguing that the RBA’s bubble-popping efforts were successful is the subsequent change in the Australian house price-to-income ratio. This is and was much higher here than in the US even before the US housing market crash. So, based on Wood’s chosen metric, Australian housing remains in a bubble notwithstanding the RBA’s efforts in 2003-04.
Second, Stephen, you always emphasise real (rather than nominal) rates being relevant to the stance of monetary policy. But debt is nominal, so shouldn’t people respond to increases in nominal rates even if real rates don’t change, at least in the short term and particularly if they are highly leveraged? An increase in nominal rates increases debt servicing costs, even if - because of higher prices - the real value of the debt has fallen. The latter is a benefit, to be sure, but in the short term a leveraged borrower will need to reduce other spending to make increased repayments due to higher nominal rates.

Posted by .(JavaScript must be enabled to view this email address)  on  05/30  at  06:25 PM

For some, I’m sure leverage means that servicing costs rise by more than nominal income, so they have less disposable income after interest.

Posted by skirchner  on  05/31  at  05:36 PM

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