RDP 2010-06: Asset Prices, Credit Growth, Monetary and Other Policies: An Australian Case Study 5. Conclusions

The role of policy in responding to asset prices remains a contentious issue. However, support for the approach of responding only after damaging asset price declines are underway has diminished in light of the fall-out from the global financial crisis. An idea that appears to be gaining wider acceptance is that there is a case for policy to focus on financial imbalances more generally, rather than asset prices in particular.

If one accepts that policy should, on occasions, respond in some way to growing financial imbalances then the issue is which policies should be used to respond and how much should they ‘lean against’ these imbalances. In contrast to the earlier debates about whether to burst asset-price bubbles, more attention is now being focused on an intermediate path of leaning against emerging imbalances with a view to reducing their severity and hence the cost of any subsequent financial and macroeconomic disturbances. For monetary policy, this would require, at a minimum, avoiding periods of unnecessarily low interest rates that might exacerbate imbalances. Of course, such a strategy is likely to be more effective if complemented by a tightening of macroprudential and other policies.

One difficulty in this whole debate is that there is little practical evidence about how effective an intermediate leaning strategy might be. The Australian experience of 2002 to 2004 is potentially relevant. A key feature of this episode was the significant influence of investors, as well as the decline in lending standards during the expansionary phase. This raised concerns within the Reserve Bank and APRA regarding the risks associated with such trends.

The Bank highlighted the risks associated with sustained high rates of housing price and credit growth when the cash rate was raised in 2002. This was not inconsistent with the Bank's inflation-targeting framework, which allows for a degree of flexibility, including the ability to account for potential risks to longerterm prospects. From 2002 to 2003, the frequency with which the Bank highlighted the risks arising from housing market developments increased. In late 2003, the Bank raised rates again, highlighting concerns about the pace of housing price and credit growth. This came around the same time as the release of the results of APRA's stress test of housing loan portfolios, the ATO announcement of an increase in the number of audits of individuals claiming tax deductions on rental properties, and the prosecution of a high-profile property marketer by ASIC. A number of measures suggest that housing prices peaked around December 2003. Most importantly, the turnaround in the market was associated with a sharp reduction in the role of investors and clearly demonstrated that large parts of the market can and do experience falling prices.

It is difficult to draw a definitive link between these housing market developments on the one hand, and the policy actions and associated statements on the other. One problem is that it is difficult to come up with a robust structural model of housing prices. Another related problem is the time it takes for policies to gain traction in the face of growing speculative pressures. Some might be tempted to argue that the rise in the cash rate in late 2003 (of 50 basis points) was too small to turnaround the housing market and suggest, therefore, that the market turned on its own accord. However, the timing of the turnaround is consistent with the cumulative impact of the full range of modest but consistent policy actions – by the Bank as well as the regulatory authorities – affecting the dynamics in the housing market. Furthermore, it is difficult to know what might have happened if the Reserve Bank had remained silent, kept monetary policy looser than was the case, and the regulatory authorities had not responded.

Looking beyond 2004, it has been suggested that the turnaround was temporary, that house prices did not fall by much and have subsequently rebounded (Posen 2009). However, this ignores some important and persistent effects of the turnaround that started in late 2003. Perhaps most importantly, it provided a stark and timely reminder that house prices can fall and that those with high rates of leverage are more vulnerable to such corrections. Consistent with this, investors have played a less prominent role in the market since that time. Also, the subsequent rise in loan arrears for non-conforming and low documentation loans clearly highlighted the greater risks associated with these products. Finally, the ratio of housing prices to income has been reasonably flat for a number of years.