The same is essentially true of the RBA’s decision-making processes. On a purely fundamentals basis, the RBA was probably justified in raising rates in November 2007, and February and March 2008. There were further ‘de facto’ rate hikes between March 2008 and September 2008 by virtue of the fact that the RBA permitted lenders to boost lending rates to offset their funding cost pressures (the RBA could have cut the cash rate to neutralise these effects).
My chief criticism at the time was more nuanced than the arguments that many politicians made leveraging off Harry Hindsight. My thinking was simply: (1) we are possibly in the middle of the biggest credit crisis seen in 75 years; (2) the high inflation being experienced at that point was primarily due to once-off commodity price pressures that would only continue to impact future inflation if prices kept on growing at the same high rates, which was extremely unlikely (the point being that the discrete spike in these prices would generally pass through the inflation data like a pig through a python once the second-order effects had been processed); (3) it has been conventionally thought that there are long and variable lags between changes to monetary policy and its impact on the real economy; and, in light of these considerations, the RBA should have stopped hiking at the end of 2007 when it was possible that the GFC was not going to disappear, and there was still nontrivial risk that conditions would quickly deteriorate. Simply put, I felt the RBA should have “exercised the option to wait.”
This is another poorly understood characteristic of options: there is value associated with delaying the decision to exercise the option if you think there will be a significant opportunity cost doing so. This is precisely why in the famed Black Scholes option pricing model the value of an option rises as a function of time—the more time you have, the higher the probability that the option will one day be “in the money” due to uncertainty. And by ‘uncertainty’ we mean ‘risk’. This is also why the more uncertain you are about the future state of the world, the more valuable options become. And I would put the financial markets in December 2007 in the exceedingly uncertain category.
I guess my summary is that the RBA rolled the dice aggressively in 2008 when it could have more prudently waited for new information on the state of the economy to materialise (remember also that rates were already in clearly ‘restrictive’ territory by the time the GFC hit). The RBA’s gamble in the first half of 2008 proved to be a very bad call—hence its need to suddenly reverse course and slash rates from what were among the highest levels in the developed world.
The question now is whether the RBA can learn from its mistakes and improve its approach to solving these problems. Because one gets the impression that it is rapidly approaching a similar cross-roads: do they now pause for a period of time to allow the economy to absorb the five rate hikes since October 2009, or do they once again bet the house (aka our economic welfare!) on the possibility that a terms of trade boom will place sustained upward pressure on prices? No prizes for guessing what road I would take.
One of the RBA’s brightest sparks, Dr Guy Debelle, told parliamentarians yesterday that the cash rate was “not far away” from average levels while “the economy is growing at about trend rate.” Of course, when setting rates, the RBA is thinking about future growth and inflation outcomes, as opposed to the current state of those variables, which are inherently backward-looking in nature. Having said that, the present pace of inflation and growth are informative inputs vis-à-vis their future trajectories.
This brings me to another gamble the RBA has recently made: its jawboning of house prices, which I have been generally supportive of. The RBA has gone to great lengths to carefully articulate its intellectual framework for thinking about asset price booms and busts. There are now many speeches and papers that it has produced on this subject. And what we know is that the RBA believes that we should not lose sleep over big rises and falls in the value of assets if they are not being fuelled by rapid credit growth. And if they are not being driven by debt, there are likely to be other fundamentals-based explanations for the observed changes (eg, population growth and inert supply).
The RBA’s repeated argument has been that we are only really interested in the insidious feedback relationships between asset prices and credit growth, which can generate speculative bubbles the eventual bursting of which can in turn trigger a sudden and possibly cataclysmic deleveraging cycle that has adverse consequences for the wider economy.
In recent Australian history the two best examples of this phenomenon are the commercial real estate and business lending booms and busts experienced during the 1991 recession and the 2007-09 GFC. In 1991 the unwinding of these two bubbles seriously threatened the solvency of our entire banking system.
Adam Carr of ICAP highlighted a point yesterday that had been weighing on my mind, but which I had refrained from remarking on. In the April statement by the Governor on the monetary policy decision, he commented that “credit for housing has been expanding at a solid pace.” It was immediately obvious to me that this observation was being used to justify the Governor’s unprecedented bout of open mouth operations apropos the housing market. But the problem is that housing credit does not appear to be running at a solid pace (see the chart below). In fact, credit growth has been demonstrably weak, at least compared with the experience of the last 20 years.
My recent criticisms of the Governor’s jawboning (see here) were that while he might give a few mums and dads some pause, the much greater impact was likely to be on the credit officers inside banks that lend to builders and developers seeking to produce new housing supply. You see the RBA has made a big deal of Australia’s housing shortages, and knows that we need to encourage investment in new housing if we are too avoid excessively strong rises in prices.
But one of the key reasons why supply has not been coming online in the quantities required is because of the difficulties developers are having getting access to finance. And the reason banks have been risk-averse in their lending practices is precisely because new development is typically the riskiest part of the housing sector (since these properties tend to be located on the fringes of cities with questionable demand prospects and weak infrastructure support). Long story short, a combination of some poorly targeted RBA commentary combined with rising rates is the best possible recipe for killing the supply-side.
If you want to see just how weak credit growth has been in an historical context, check out this chart that I have prepared using the RBA’s latest data. Today total owner-occupied and investor credit is growing at around 8 per cent per annum, which is way down on the long-term average since 1990 of 11.5 per cent.
We have been arguing for the last six months that we expected to see a cooling in conditions during the course of 2010 back to single digit rates of growth. And I don't think we have any reason to change that view, save for the fact that the market has remained stronger for longer than we originally anticipated.
