The extraordinary rise of residential property prices over recent years has led most to the view that not only the growth of prices, but also their level
- at least in some segments of the market - are unsustainable. The cause of that boom has been a set of factors which combined to fuel a firestorm.
Partly, the price growth was itself a correction - the tendency of the market to make lagged jumps rather than smooth adjustments. The relative unattractiveness
of equities also contributed excessive investor interest in housing. This was underpinned by a deep Australian conviction of the inevitability of real capital
gain in residential property, further supported by negative gearing. Bad policy - the first-home buyers' grants and, perhaps, reduced capital gains taxation -
added yet more tinder to the flames. Finally, low interest rates eased borrowing constraints.
The last of these factors is the preserve of the Reserve Bank. But how well has it handled its responsibilities in this developing situation?
In May 2002, when the Governor fronted the House
of Representatives Standing Committee on Economics, he clearly signalled the view that rates were well below normal levels and should be expected to rise. In central bank parlance, official interest rates were substantially below "neutral"
and playing an expansionary role in the economy.
But apart from a one-quarter percentage point rise, the foreshadowed rate
rises never came. That was not a mistake: various uncertainties - not least, a
war in the Middle East - intervened.
More surprising was that 12 months on, in June 2003, again appearing before
the House Committee, the Governor made a volte face. Now, instead of rates
rising towards "neutral" (around six per cent), they were mooted to
Certainly his June 2003 commentary was hedged with qualifications. But the
core judgement was that the RBA faced something of a policy dilemma - with the
balance of probabilities favouring a rate cut.
The dilemma was that international factors were looking to be contractionary
for the economy (favouring a cut), whereas the domestic housing boom needed to
be reined in (favouring, if not an increase, then at least holding rates steady).
The fear in relation to housing was and remains that a downward correction
in prices will induce "distress", which in turn might significantly
impact upon domestic economic activity. More generally, the growth of household
debt makes interest rate increases a very delicate operation for the policy makers.
Then, two months after the mid-2003 statement to the House Committee the RBA
shifted again. Its August
Statement on Monetary Policy (pdf, 26kb) indicated that the prospect of a
rate cut was now off - a conclusion confirmed last week. The balance of forces
had shifted: the international outlook had improved and the housing boom was showing
rather limited signs of abating.
Now, the RBA is not merely an observer of these forces. It is an influence
as well. The Governor's mid-2003 statement contributed to maintaining the housing
boom. Many in the housing market (and in the market for loans for other purposes,
drawing on housing equity) took that statement as grounds for a belief that their
borrowing capacity would not be curtailed in the near future - and might even
The June 2003 commentary was an error of judgement by the Governor.
No doubt some disagreement has occurred within the RBA over the appropriate
settings for monetary policy in the tricky circumstances the Australian economy
has been in. The key issue is the extent to which monetary policy should concern
itself with asset, as well as commodity price, inflation. The answer partly hinges
upon the linkages between asset price behaviour and aggregate expenditures.
(In further relation to policy disagreements, the leaking of Treasury's view
in mid-2003, that a rate cut was warranted, was an extraordinary and unprecedented
instance of apparent bureaucratic vandalism in relation to the conduct of monetary
In any case, the RBA's public shifts of judgement over the past 16 months
compromise the credibility of its future statements. And it seems to have been
unnecessary. What would have been lost if no foreshadowing of rate rises in mid-2002,
and of rate falls in mid-2003, had occurred?