RDP 2010-06: Asset Prices, Credit Growth, Monetary and Other Policies: An Australian Case Study 4. Australian Policy Developments

This section summarises the statements by, and actions of, the relevant policy authorities, including the Reserve Bank, in the period from 2002 to 2004 in response to housing market developments. This is based on an examination of public statements. For the Bank, these include the quarterly Statement on Monetary Policy (SMP), statements to parliamentary committees,^[30] media releases related to policy announcements and speeches by senior Bank officials. A detailed summary of these statements is provided in Appendix A. It is also worth noting that over this period, the Bank devoted considerable resources to the analysis and research of trends in Australian housing prices and housing finance. This included a careful comparison with developments in a range of other relevant economies. The results of these efforts were released in a number of articles, including an extensive submission by the Bank to the Productivity Commission Inquiry on First Home Ownership (RBA 2003b).^[31]

While the wider debate surrounding the role of monetary policy in responding to asset prices was particularly vigorous in this period, these issues had been under consideration by the Reserve Bank for some time. In the late 1990s and early 2000s, the Bank released a number of papers dealing with issues of asset-price bubbles, credit cycles and episodes of financial instability. Some provided an examination of Australia's historical experiences of financial instability, while others undertook more abstract analysis using a more structured framework.^[32] The broad conclusion was that rapid growth in asset prices and leverage, accompanied by declining lending standards, can pose a risk to financial and macroeconomic stability more generally. This was echoed by a number of participants at the Reserve Bank's 2003 conference on asset prices and monetary policy (Richards and Robinson 2003).

4.1 Policies and Discussions

As the previous Section describes, there were fundamental factors underpinning the rise in housing prices over the second half of the 1990s and the early 2000s in Australia. However, developments in 2002 and 2003 began to cause some unease for policy-makers, as the pace of growth in housing prices and credit were accelerating to very rapid rates and there were signs that lending standards were declining in a number of important respects. The very prominent role of investors in the housing market also suggested a strong speculative element.

The broad approach of the Reserve Bank can be summarised as follows. The Bank attempted to draw attention to the longer-term risks associated with recent trends, especially the high rates of growth of housing prices and housing credit. In particular, the Bank drew attention to the fact that it was unlikely that these trends were sustainable over the medium term, and that borrowers entering the market based on expectations that prices would continue to rise at a rapid rate were taking a significant risk, particularly if highly leveraged. Similarly, the Bank drew attention to the risks associated with declining lending standards. During the period, monetary policy continued to be set on the basis of medium-term prospects for inflation and output and the Bank was not targeting housing prices or credit growth. However, developments in the housing market were an important factor in the Bank not delaying a tightening of monetary policy that was likely to be required on more general macroeconomic grounds.^[33] The Bank's explanations of its monetary policy decisions also highlighted the risks in the housing market.

The Reserve Bank started raising concerns about housing market developments in early 2002. Between 2002 and late 2003 there was a clear progression of themes relating to housing price and credit growth in Bank statements as it endeavoured to use ‘open mouth operations’ to draw attention to the risks. While the approach to the housing market developments could not be described as an explicitly coordinated strategy, regulatory agencies and governing bodies also provided pointed discussion of market developments and took some regulatory actions.^[34] In 2002/03, APRA undertook a comprehensive stress test of the resilience of housing lending portfolios of banking institutions, which led subsequently to a tightening of prudential capital requirements for non-standard loans and for lender's mortgage insurers. Federal taxation authorities sought to better enforce the tax code relating to deductions stemming from investment properties, and state governments tightened regulations regarding the conduct of auctions. The Australian Securities and Investments Commission (ASIC) and the Australian Competition and Consumer Commission (ACCC) also played a role by investigating alleged illegal activities by a number of property marketers.

4.1.1 Developments in 2002

Prior to 2002, housing price developments were often discussed by the Reserve Bank in the context of positive wealth effects, as the domestic economy attempted to shrug off the headwinds associated with slow global growth. As the recovery gained momentum domestically, the focus turned to the possibility of overbuilding in some segments of the medium-density housing market, and to the question of the risks associated with rapid growth in credit and house prices.

The Bank tightened monetary policy in May 2002 and again in June (by 25 basis points on each occasion) (Figure 9). In explaining the Bank's general strategy, the May 2002 SMP highlighted that while inflation was expected to ease to around the middle of the target through 2002, inflationary pressures were expected to pick up over the course of 2003 as the economy strengthened. The Bank, however, also suggested that low rates risked fuelling imbalances associated with a strong rise in house prices and household borrowing over a number of years. For example, in the statement accompanying the May 2002 monetary policy decision it was noted that:

To persist with a strongly expansionary policy setting … could fuel other imbalances such as the current overheating in the housing market, potentially jeopardising the economy's continued expansion. (RBA Media Release – 8 May 2002)

While the structural shift in the availability of housing finance and macroeconomic conditions more generally justified strong growth in house prices in the late 1990s and early 2000s, low interest rates and tax arrangements were encouraging investors and subsidies were boosting first-home buyer demand. Poor returns on alternative investments in the wake of the dot-com bust were also emphasised (Macfarlane 2002b, Stevens 2002). Further, the Bank noted that:^[35]

… whenever [a structural shift] of this type occurs, there is the risk that prices may overshoot, as some purchasers extrapolate past movements as a guide to future capital gains. This may be occurring at present, since the low rental yield on property, and high rental vacancy rates, seem inconsistent with rapidly rising house prices. (SMP – May 2002, pp 31–32)

This line of argument continued throughout 2002 with the clear goal of highlighting the risks:

… the potential for further capital gains in the housing market [is] likely to be countered by increased supply of rental properties, rising vacancy rates and falling rents in some areas. (SMP – August 2002, p 2)

However, over the second half of 2002, deterioration in the prospects for global growth and a marked increase in the volatility of global share markets led to an increased focus on near-term downside risks to the domestic economy. Growth in output and inflation failed to reach the rates forecast when the 2002 tightenings were conducted, and in spite of the risk posed by rapid growth in credit and house prices, further moves towards a more neutral monetary policy setting were judged not to be appropriate (SMP August and November 2002).

An impact of the policy tightenings and the accompanying statements on the housing market was not obvious in the near-term. For example, loan approvals to investors for housing continued to grow rapidly, increasing by more than 40 per cent in 2002. The Governor, in testimony to a parliamentary committee, emphasised, however, that:

… the market works, but with long lags during which people are encouraged to take decisions based on little more than optimistic extrapolation of what happened in the past. Developers will continue to put up new apartment blocks while there are investors willing to precommit to buy. These are the investors who turn up at seminars where they are told by the developers how they can become very rich if they highly gear themselves and buy an apartment. (Macfarlane 2002b)

Discussion by the Bank of the sustainability of the high rate of price increases continued throughout 2002 (Stevens 2002, for example). The Bank also began to highlight the role of speculation, the risks associated with rapid growth in leverage, and emerging evidence of a reduction in lending standards (see below). Initially, the focus was on the prospect of financial hardship for overburdened investors in the event of a substantial correction in the housing market, but attention was also directed to the potential effects of increased loan defaults on financial stability.

4.1.2 Developments in 2003

In early 2003, the Reserve Bank reiterated its concerns in the SMP about these risks:

… the run-up in housing prices and associated expansion in housing-related debt were a source of concern for most of the past year, given the potential of such a process to remain disconnected from fundamentals and develop into a significant imbalance over time. (SMP – February 2003, p 3)

At the same time, some comfort was taken from the tentative signs that pressures in the housing market were easing, particularly in the investor segment. As it turned out, these signs did not persist as the year progressed.

In a speech in April 2003, the Governor outlined the Bank's concerns regarding rising household indebtedness (Macfarlane 2003a). The worry was not so much that a housing market downturn would directly impinge upon financial stability, but rather that it could have adverse consequences for household consumption and economic activity more generally.^[36] Also, the increasingly dominant role of investors in the housing market reinforced earlier concerns that some households did not adequately appreciate the risks and were simply extrapolating recent price trends.

Through 2003, the Reserve Bank repeatedly drew attention to the risks associated with ongoing rapid growth of house prices and housing credit. It also acknowledged that there might be occasions when monetary policy might need to be tightened in response to emerging financial imbalances. The contention was that such a response could be justified within its flexible inflation-targeting framework, which allowed longer-term considerations to be taken into account. If imbalances in the housing market could pose a threat to medium-term economic stability, it made sense to tolerate a higher policy rate than that which was justified by shorterterm inflation pressures. In a speech, the Deputy Governor explained this in terms of a risk-management approach to policy decisions (Stevens 2003b):^[37]

… a case might be made, on rare occasions, to adopt a policy of ‘least regret’ so far as asset prices are concerned, if financial and macroeconomic stability were thought to be at risk.

It is worth noting that while the Reserve Bank of Australia did not raise rates until late 2003, it stands out as having not cut rates through the year, whereas monetary policy in every other developed economy, and in most of the large developing economies, was eased at some point during 2003 in response to subdued inflationary pressures (and fears of deflation in some cases) (IMF 2003).

Meanwhile, unease surrounding lending practices was being aired by APRA. In late 2002, APRA wrote to the chief executives of authorised deposit-taking institutions (ADIs),^[38] calling for a conservative approach to risk and urging them to avoid the temptation of relaxing lending standards in the wake of such a long and sustained economic upswing; this correspondence was made public soon after the fact (APRA 2002). While APRA acknowledged the generally healthy state of Australian financial institutions, through 2003 it raised a number of concerns about some emerging trends in the mortgage market, including the growth of brokeroriginated and ‘non-conforming’ lending, as well as the substantial increase in the use of lenders' mortgage insurance.^[39] APRA noted that: ‘… the psychology of home lending has changed from a credit rationing process to a product marketing process’ (Littrell 2003). This had contributed to an increase in average LVRs for mortgages, an over-reliance (by lenders) on collateral as a signal of a borrower's suitability, and a decline in the attention given to the ability to repay loans. So while APRA's stress test of institutions' housing lending portfolios around that time revealed that the financial system was well placed to weather a downturn in the housing market, it raised some concerns, particularly for some institutions that were not compiling important information regarding the extent and nature of their exposures (Laker 2003).^[40]

The Reserve Bank also commented on the increased level of risk on the balance sheets of financial institutions. At a parliamentary committee in December 2002, the Governor highlighted deposit bonds as a key factor fuelling speculation and increasing risks for more vulnerable investors:

… there are new financial instruments such as deposit bonds that have been created that just make it so easy for people to do it [invest/speculate in property]. People can actually make these investments on almost 100 per cent gearing. (Macfarlane 2002b)

In addition, the Reserve Bank's Annual Report for 2003 (released in September) noted the increased risk posed by non-standard products such as home equity loans and redraw facilities, which allowed borrowers to build up more debt and run it down more slowly than had previously been the norm.

One factor that appeared to play some role in drawing attention to the risks in the housing sector was the crackdown on property investment seminars, in particular, the high-profile case of ‘spruiker’ (or promoter) Henry Kaye and his companies. In March 2003, ASIC commenced legal proceedings, alleging dissemination of false and misleading information by Mr Kaye and others.^[41] When ASIC uncovered evidence that the law had been breached it appointed administrators and receivers to each of the companies involved. The effect of this on the confidence of investors was reinforced by the commitment of the ACCC in September 2003 to crackdown on deceptive conduct by property marketers, and by increased scrutiny of tax deductions stemming from rental expenses by the ATO. Also, in September 2003, regulations governing sales of residential property at auctions were tightened in New South Wales and Victoria; in particular, the legislative changes were aimed to reduce the number of dummy bids at auctions.^[42]

Towards the end of 2003, the Reserve Bank raised the cash rate, by 25 basis points in November and again in December. The accompanying media release in November cited the strength in the demand for credit as a reason not to delay a tightening that was called for on general macroeconomic grounds. At the same time, the inflation forecasts were revised in light of further appreciation of the exchange rate and stronger-than-expected growth in domestic demand, with inflation expected to trough somewhat lower than 2 per cent in 2004 but with a more pronounced pick-up, to 2½ per cent in the second half of 2005 (SMP November 2003; Figure 9). It is worth noting that because of the predominance of variable rate housing loans in Australia, increases in the cash rate were quickly passed through to higher costs for existing and new borrowers.^[43]

In the months that followed, the Reserve Bank pointed to data suggesting that the rate of increase in housing prices was slowing and the housing market had turned down:

It remains to be seen to what extent the weakening in the inner-city property markets in Sydney and Melbourne will spread more widely across the national market. However, it is clear that sentiment about the property market has softened. (SMP – February 2004, p 27)

Following this, there was discussion of the need for credit growth – which up to mid 2004 had yet to show any real weakening – to slow to more sustainable levels.

Finally, a number of developments appeared to have reinforced the housing market correction over 2004. In particular, the ACCC took further action against property marketers and purveyors of ‘get-rich-quick’ schemes involving property where there were concerns about fraud; and the NSW Government instituted a new tax on investment housing aimed at reducing the influence of speculation (although this was partly offset by a reduction in other taxes).^[44]

4.2 Media Reports of RBA Statements

While it is difficult to quantify the effect of the Reserve Bank's ‘open mouth operations’ over this episode, we can at least confirm that the Bank's statements were widely reported at the time in the popular press. A survey of some of the major papers from around Australia shows that coverage of the Bank's comments on housing market issues increased noticeably between 2002 and 2004. Based on a keyword search of articles mentioning the Reserve Bank of Australia and interest rates, the proportion that also mentioned housing increased from an average of 10 per cent in 2001 to 18 per cent in 2002 and 26 per cent in 2003, before trending down in the following couple of years (Figure 10). The timing of these changes aligns with the pattern of Bank statements over this period.

A similar exercise shows that the proportion of articles on the Reserve Bank and interest rates which also discussed credit increased between 2002 and 2003, although the series is much more volatile from one month to the next. This share was sustained at a high level in 2004 (at around 10 per cent on average), at the height of Bank statements regarding the need for a return to more sustainable levels of credit growth.

Approaching the question from a slightly different perspective, it was found that the percentage of articles mentioning housing that also contained a reference to the Reserve Bank of Australia also trended up significantly over the period, peaking sharply around the November 2003 cash rate increase, before trending down through 2004 and 2005.

Footnotes

See Macfarlane (2002a, 2002b, 2003b, 2003c). [30]

This type of analysis and research continued beyond 2003. For example, in 2004 the Bank, in conjunction with private sector firms and the Australian Bureau of Statistics, made considerable effort to develop robust and timely measures of housing prices (see the July 2004 RBA Bulletin, Hansen 2006 and Prasad and Richards 2006), many of which are used in this paper. [31]

For detailed consideration of Australia's historical experience with asset-price bubbles see Kent and D'Arcy (2000) and Kent (forthcoming). For a more theoretical approach regarding the case for monetary policy to act against asset prices ex-ante, see Kent and Lowe (1997a, 1997b). Gruen et al (2005) highlight arguments against pre-emptive action. [32]

Combination forecasts from a suite of macroeconomic forecasting models (using the current vintage of data and current parameter estimates) confirm this. The central tendency of the cash rate projections from the models suggested gradual increases in the cash rate from around mid 2002 and late 2003. The increase in rates in May and June 2002 left the cash rate about 30 basis points above the median combination forecast around that time. Similarly, the increases in November and December 2003 left the cash rate about 35 basis points above the median forecast around that time. For a discussion of the combination forecasts, see Gerard and Nimark (2008). Jääskelä and Nimark (2008) describe the DSGE model used in the suite; a fourth ‘Minnesota VAR’ model has also been included. [33]

The Council of Financial Regulators (CFR), which has representatives from APRA, ASIC and the Federal Treasury and is chaired by the Reserve Bank Governor, provides a formal link between these institutions. There is evidence in the CFR's Annual Report, published in September 2003, of growing concerns about the housing market, particularly that the ‘exceptionally fast increase in borrowing for investor housing has clearly increased risk and that the accompanying rapid expansion in apartment building shows all the signs of a seriously over-extended market’ (CFR 2003, p 19). [34]

See also Macfarlane (2002b, 2002c) and the July 2002 RBA Bulletin. [35]

Stevens (2003c) provides further discussion of this point. [36]

Macfarlane (2002c) and Stevens (2003a) provide similar arguments in support of intervention. [37]

ADIs (which we also describe loosely as ‘banking institutions’) include banks, building societies and credit unions. [38]

See, for example, APRA (2003), Esho (2003) and Littrell (2003). [39]

One illustration of these points is provided by Laker (2007), which notes that some banking institutions had – drawing on their own stress tests – perceived credit losses on their mortgage portfolios to be in the order of 10 basis points, some 10 times lower than suggested by APRA's own stress tests of 2002/03. [40]

Aside from legal breaches, there were allegations that marketers charged sizeable consultancy fees for investment advice, such as to purchase properties in which advisors had undisclosed financial interests (http://www.theage.com.au/articles/2003/09/21/1064082867568.html). [41]

See, for example, http://www.austlii.edu.au/au/legis/nsw/consol_reg/psabar2003476/. [42]

See Bloxham and Kent (2009) for a comparison of the US and Australian housing markets in this regard. [43]

The NSW Government levied a 2¼ per cent stamp duty on properties (excluding own homes) where the sale price was more than 12 per cent higher than the purchase price; although, this vendor duty could be claimed as a deduction against capital gains tax, thereby reducing its effective rate. The duty came into effect on 1 July 2004 and was withdrawn on 2 August 2005. [44]