A senior executive of the Reserve Bank has ruled out lifting interest rates to head off asset bubbles.

In a speech to a financial conference in Brazil delivered almost a week ago, the RBA’s assistant governor in charge of financial markets, Dr Guy Debelle said “monetary policy, narrowly defined as the setting of the policy interest rate, should be confined to targeting inflation.”

He rejected suggestions that central banks should try and use monetary policy to head off developing asset bubbles (the stockmarket or housing, for example) by lifting interest rates pre-emptively because the social cost, such as a sharp rise in unemployment, would prove too much for the community.

“It is asking too much of the single monetary policy instrument, namely, the targeted short-term interest rate to target both financial excesses and inflation”, he said, in a paper on inflation targeting and Australia’s experience. While the views are his, as one of the top executives in the bank, the speech would not have been delivered without some tacit approval of Governor, Glenn Stevens.

In that respect it is a ‘quasi- official RBA view’ and one intended to make a case against arguments emerging in the US, UK and Europe for central banks to take a more proactive role in trying to ‘lean against the wind’ and puncture asset bubbles before they get out of hand.

“I do not think it would be socially acceptable or desirable to endure the level of unemployment that would come with the high interest rates necessary to pop the bubble,” he said.

“Nor do I believe there is much to be achieved by ‘leaning against the wind’.

“The wind that is blowing in most episodes of credit booms is generally at least gale force. Setting interest rates a bit higher in such circumstances is likely to be close to futile when such credit dynamics take hold.”

He said that using interest rates primarily to achieve the inflation goal “contributes to sizeable social gains” and that “a departure from that runs the risk of losing the nominal anchor that the inflation target provides.”

But he also said “other tools, most notably the much-touted (although not clearly defined) macro-prudential instruments, should be used to address asset price and credit imbalances. I do not think that a slightly tighter setting of interest rates would have prevented the development of the imbalances that have led to the current financial crisis.

“The Australian and Scandinavian experience in the late 1980s shows the sort of interest rate settings required to achieve such an outcome. In that example, a credit boom and bubble-like asset price dynamics took hold and only a very high setting of real interest rates ultimately curtailed that, but at the cost of a historically high level of unemployment.

“I would argue that other instruments should be deployed that more directly address, at the source, the provision of the excess credit that leads to these imbalances. That is the discussion which needs to be (and is) taking place. These instruments would be a supplement to the setting of the monetary policy instrument to achieve the inflation target.

“I am not arguing that these alternative instruments will be successful in countering asset price bubbles and credit imbalances; because I think bubbles are a permanent feature of the landscape resulting from entrenched human behaviour. Rather instruments other than the interest rate tool are likely to be more effective without some of the attendant social costs.

“This assumes that it is possible to identify that excesses are indeed occurring. I do not see this as being as large an obstacle as others, most notably Alan Greenspan (at least his earlier pre-crisis views).

“Identification of over-inflated asset prices and excess credit expansion is no more or less easy than the identification of consumer prices pressures. Moreover, a number of macro-prudential instruments under consideration would have some measure of automatic stabilisation built-in, reducing the need for discretionary decision-making.”

Peter Fray

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