Can the RBA have its cake and eat it?

The central bank has to weigh up several conflicting forces when it comes to monetary policy at the moment. Rising house prices and the currency are just two of them.

The Reserve Bank of Australia left rates unchanged at its April board meeting and offered a firm statement that they will likely remain that way for some time. But it faces a difficult balancing act between rising house prices and a stubbornly high dollar that monetary policy may not be equipped to fight.

Monetary policy right now is a dance between rising house prices, a high exchange rate and weak business investment.

If we focus predominantly on house prices it is easy to justify raising rates. House price growth is simply too strong and runs the risk of compromising financial stability if left unchecked. By raising rates we can slow the momentum, improve financial stability and potentially create a soft landing for the housing sector.

But unfortunately we cannot assess house prices in isolation and we certainly cannot understate the importance of other sectors of the economy, such as the business sector.

Rates were set low in the first place to facilitate a rebalancing of the Australian economy away from a reliance on the mining sector. That process has begun but it remains a work in progress. More importantly though that process has yet to meet its sternest test: the impending collapse in mining investment.

The situation has been made all the more difficult by the high Australian dollar, which continues to respond to our elevated terms-of-trade. The non-mining sector desperately needs a weaker dollar in order to facilitate export sales but a sudden rate rise would only further compromise that goal.

Analysts will differ on which factor they believe is more important. Can we risk a sudden correction to house prices? Can the economy rebalance with a high exchange rate? How big a hole will the collapse in mining investment leave? Your view on these questions may determine whether you think rates should go up or down next.

Personally I don’t think there needs to be a choice. In fact I’m convinced that the RBA can have its cake and eat it too. But they’ll have to play it smart and be a little crafty. Rebalancing the economy may require tools that are a little less blunt than monetary policy.

House prices can be addressed though non-interest rate policies – known as macroprudential policies – that directly affect lending. On October 1, the Reserve Bank of New Zealand (RBNZ) introduced such measures, which restricted the share of new residential lending with loan-to-valuation ratios over 80 per cent to just 10 per cent of the total value of each bank’s total residential mortgage lending.

Since then the New Zealand housing market has noticeably slowed. Housing effectively stopped being a significant determinant of monetary policy in New Zealand, allowing the RBNZ to focus on fine-tuning policy to meet the needs of the business sector and their rising terms of trade.

If the same could be achieved in Australia then the RBA would no longer face a balancing act regarding the lesser of two evils: high house prices or a high exchange rate. Instead they could moderate house price growth while maintaining loose monetary policy to create enough momentum to allow business investment to collapse without compromising the integrity of the entire economy.

For now it appears as though the RBA has made their choice. They are more concerned with rebalancing the Australian economy than they are with rising house prices. 

At the same time though their jawboning activities have clearly moved from the exchange rate to house price growth. Recent comments in their Financial Stability Review and in public speeches indicate that they are keen to slow the momentum in the housing market – even if they are not prepared to raise rates or intervene directly to achieve it.

The RBA has stated a clear desire to leave rates unchanged for some time yet; however, if their jawboning attempts on house prices fail – as they did for the exchange rate – then they will inevitably face a tough choice. If that time comes hopefully they will choose to follow in the path of New Zealand rather than compromise growth to punish the exuberance of investors.