A year or so ago, following Glenn Stevens’s historic appearance before the Parliament, I described the RBA as the “Six Million Dollar Central Bank” capable of rebuilding itself. We should recount some of what Glenn Stevens said (with my titles):
Gone is the Pitchford Thesis and the free and easy love of private sector debt: Glenn Stevens
Private debt, on the otherhand, is considerably higher than in some countries. It is probably in the pack for English-speaking countries with which we would compare ourselves, but some of those have had a pretty bad time lately, so we would not necessarily want to stand out too much more on that score. Thatis why I think that the more modest growth of housing credit that we see now is probablysufficient for the economy’s needs, but we do not want to see that ratio of debt to income keepgoing up the way it was. So that is a thing to watch.Gone is faith in asset-based wealth: Glenn Stevens
We have looked at households in other countries getting into serious trouble. I think we have all thought, ‘We ought to be a bit carefulabout rate of borrowing and maybe we should be saving more of our current income as opposedto allowing an assumed rise in asset values to, in effect, do our saving for us.’ I think that is atendency that was there a few years back in many countries. My guess is that there has been akind of sea change in people’s attitudes that we would expect to persist for a while.Gone is faith in private bank prudence: Glenn Stevens
Pretty much every supervisor in the world is telling their banks to rely less onwholesale funding because it is risky. The rating agencies say it. My suspicion would be that, if the financial institutions could have got away with continuing the old pattern, they would have because they found it attractive and profitable, but they did not have that choice. They certainly took decisions to try to raise more deposit funding but it was a decision on which I am not sure they had a great deal of choice in taking.Gone is the efficient market hypothesis: Glenn Stevens
In many areas it is probably the case thatmore competition is always better for consumers, but in banking more competition is good to apoint but beyond a point more competition is not good, because the bankers can be led to dothings that ultimately cause a lot of subsequent damage. I think we have to understand that. Thatis not to say that the current amount of competition we see in any particular market is necessarilyenough, but there is a point beyond which extreme competition in lending money leads to problems.There is inquiry about how to manage guarantees: Glenn Stevens
I think you would also, to be honest, have to in the back of your mind pose the question: in the previous world, without this guarantee, would a government stand by to let the system collapse and do nothing? I cannot think that they would. There was always some unspoken, unquantified support. But it is a very interesting question: should that be made explicit and priced or shouldn’t it? That is one of the issues that I think would probably have to have a discussion about, but today is probably not quite the moment.There is realism about the banks and moral hazard: Glenn Stevens
My very firm view is that we ought to try to get to a position where at that time, whenever that day comes—hopefully not soon—our government will be in a position to say, ‘No, we are not going to give a guarantee and the system can cope with that.’ I think we are much closer to being ableto say that than most countries, but we still have some work to do to get a permanent set of arrangements, particularly for deposits, which can stand the test of time.Gone is the comfort with wholesale funding: Glenn Stevens
They [the banks] have sought to do that to increase the share of their book funded fromdomestic deposits and to lessen the share funded through wholesale sources. It is pretty obviouswhy that happens and I think it is prudent of them to do it. What we have seen in the past severalyears is that those wholesale funding sources, which for some years up to the middle of 2007 were very available, very inexpensive and, apparently, quite reliable and quite stable, changeddramatically after the problems began in 2007 and especially after the Lehman failure in September 2008.Gone is the reticence to ‘lean against the wind early in the cycle’: Glenn Stevens
I cannot think of very many cases in history where we looked back and thought, ‘Yep, we tightened too soon.’ I can think of several times where we looked back and thought we should have tightened a bit earlier. I think that if we are doing it right the decisions will be finely balanced most of the time—that is where we should be—and we will probably move a little bit earlier than the moment when it is clear that you have to. That is if we are doing it well. There is some risk that you do things you do not need to do—I agree with that. We have to balance that risk, obviously, against the risk of getting behind the game. Historically, for many central banks, including us, that has tended to be the mistake that we made.Gone is an easy comfort with trend line growth: Glenn Stevens
So we will see, I think, continued uncertainty about how all this will play out. My guess, as Isay, is that we will see repeat episodes of anxiety every so often for a few years. What thatmeans is that, for us, we balance the possibility that things could go pear-shaped in Europe—they may or may not; we will not know for sure for quite some time.There is some skepticism about commodities and vision beyond: Phil Lowe
If you look forward, we cannot expect the terms of trade to keep rising and we will inevitably go back to a period where growth in our living standards is going to be determined by productivity growth, or, to put it another way, expansion of the supply side. We are not the experts on how to do that. There are obviously areas, in transport, in education, in health, where things can be done to improve the ability of the economy to produce goods and services efficiently. It is not our core area of competency but it isan area that needs to be looked at very carefully.
This appearance was one reason why I believe that the RBA is determined to prevent any reinvigoration of the Australian housing bubble. For some reason the importance of it passed much of the interest rate commentary community by. Perhaps because the RBA itself likes to recast its power as some nebulous choice of the market, rather than what it really is, Australians doing what the RBA tells them to.
But back to the topic at hand, yesterday we had structural confirmation that the bank is structually remodelling itself as an asset price hawk, with the appointment of Phil Lowe to the deputy governorship.
In 2002, whilst working at the BIS Phil Lowe wrote a defining paper (find it below) on the identification and targeting of asset prices. For me, this is very encouraging indeed. Don’t forget that this was during the awe-inspiring reign of Alan Greenspan and his doctrine of cleaning up “after the bust.” No doubt Lowe’s paper played some role in Ian Macfarlane’s 2003 targeting of asset prices, which, sadly, then rested on its laurels.
But that brings me to another Phil Lowe speech delivered more recently on the subtleties of infaltion targeting which reframed the entire first half of Ian Macfarlane’s tenure at the RBA:
This more flexible approach has two advantages. The first is that, in the event that inflation turns out to be unexpectedly too high or too low, the central bank has some flexibility about the pace at which inflation is returned to the target range. Provided the central bank’s commitment to medium-term price stability is credible, this flexibility can deliver better outcomes for the real economy.The second advantage is that this flexibility provides greater scope to take into account not just the central forecast, but also the medium-term risks around that forecast.
Let me try and make this a little more concrete by asking you to think about an economy that experiences a positive supply shock, say an improvement in productivity or lower world prices for the goods that it imports. Normally, this type of shock would be expected to boost economic growth, increase asset returns and lower inflation, at least for a time.
What then is the right monetary policy in this economy? In a world in which the setting of policy is determined solely by the two-year-ahead inflation forecast, the answer may well be to lower interest rates. If inflation is forecast to be below the target midpoint in two years time, lower interest rates, at least for a while, would help get inflation closer to target.
But would lower interest rates be the best response? To answer this I would need to tell you some more parts of the story. If asset prices were rising very quickly, investors were exuberant, and the financial sector was making credit liberally available, then lowering interest rates simply to hit the inflation target at one specific point in the future may not be the best response. Experience has taught us that low interest rates at a time of rapid increases in leverage and asset prices can pose significant medium-term risks to the outlook for the economy and for inflation. Ignoring these risks, and making leverage cheaper by lowering interest rates, simply to ensure that the short-term inflation forecast was at the target, is unlikely to be the best policy.
The general point here is that while the central forecast for inflation itself will often provide a good guide for policy, this will not always be the case. On some occasions, the medium-term risks are just as important.
Regular readers will recognise that these are the precise conditions that prevailed during the first half of Ian Macfarlane’s tenure at the top of the bank. As Lowe’s graph clearly showed, in 1996 Macfarlane inherited an economy in the midst of a productivity shock:
One couldn’t exactly say that Lowe blamed Macfarlane for the Australian housing bubble, but he definitively rejected the doctrine of low interest rates that, in part, caused it. And in doing so he intrinsically redefined the former governor’s legacy from one of bubble-buster to one of bubble-creator.
Phil Lowe is an asset price hawk, and his history shows both the intelligence and fearlessness needed to be an effective senior governor. Bravo.
