Stevens ponders his limitations

Reserve Bank Governor Glenn Stevens has acknowledged that monetary policy must play its part in controlling bubbles – especially the dangerous 'feedback' type – but admits the bank offers no silver bullet.

Two decades after the Reserve Bank and its central bank peers around the globe started pondering aloud about the relationship of monetary policy in creating or controlling asset price bubbles the RBA is still trying to come to grips with its role.

RBA Governor Glenn Stevens, in opening remarks to a conference on property markets and financial stability organised by the RBA and the Bank for International Settlements earlier this year that were published on Tuesday, reprised what has become something of a recurrent theme for the RBA since the property-flavoured banking crisis and recession of the early 1990s.

That is the question of whether central banks should use monetary policy to try to actively and pre-emptively truncate the formation of speculative bubbles.

There are those who say monetary policy is too ineffective and crude a tool and that its use could also create unintended consequences and damage. Monetary policy can’t distinguish between a bubble sector and the real economy – it can’t be deployed with precision – and the bubble can’t truly be identified until after the event. Federal Reserve Board chairman Ben Bernanke has made those kinds of arguments in the past.

The Reserve Bank has for some years come to the conclusion Stevens articulated at the conference – that it should "lean against" asset bubbles that it believes are forming rather than ignore the incentives it creates for risk-taking and leverage.

"I would have thought by this point we have to conclude that simply expecting to clean up after the credit boom is not sufficient anymore; the mess might be so large that monetary policy ends up not being able to do the job when the time comes," he said.

‘’Moreover, if the monetary policy clean-up after the asset price bust involves interest rates low enough to prompt some other sector of the economy to leverage in order to spur the growth, then the clean-up itself might leave its own toxic consequences."

He didn’t refer to the continuing debate about the protracted period of loose monetary policy in the US – the "Greenspan put" – that some believe played a major role in the creation of the massive credit bubble that blew up so destructively in the global financial crisis.

He does, however, appear to subscribe to the view that there are two types of bubble, one of which is far more dangerous than the other.

A former Federal Reserve governor, Frederic Mishkin, made that distinction during the first phase of the financial crisis when he described the dangerous bubbles as those that created positive feedback loops between rising asset prices and the leverage against them. When that feedback loop reverses it creates crises and taxpayer-funded responses by governments and regulators.

The more benign kind, "the pure irrational exuberance bubble" as Mishkin described it, is less dangerous because it doesn’t involve the cycles of leveraging and therefore doesn’t ultimately infect the financial system.

As Stevens and his RBA colleagues know from the painful experience of the early 1990s, when two of the major banks (and most of the state-owned banks) nearly went belly-up while the RBA was their regulator, that leverage and property has traditionally been a very combustible mix in this economy.

While Stevens said that it was critical to establish a credible and enduring framework around controlling consumer price inflation and to get that underlying framework right, it wasn’t enough because financial stability and monetary policy were related, a conclusion the bank had come to from its own experience but which was ‘’writ large in many places’’ around the world today.

He also said that a second lesson learned was that asset prices, and property prices in particular, did matter. Property prices were important because property holdings tend to be leveraged and used as collateral for significant lending by financial institutions – it is the leverage that matters.

If monetary policy has its limitations in trying to control asset price bubbles then Stevens believes in the role of prudential supervision, another recent lesson learned. Where the RBA learned something important from its 1990s experience, the Australian Prudential Regulation Authority was left with useful scars by the collapse of HIH.

Stevens made the point that good supervision is not about regulatory structures and rules but about serious supervision and the way the rules are applied – he said that the quality of supervision mattered more than the exact detail of black-letter regulations.

While there has been a lot of argument about the role of monetary policy in creating and managing asset bubbles there is little doubt that the most important factor in limiting the damage they can do to the real economy is the quality of prudential supervision. If a banking system emerges from a burst bubble relatively unscathed so should the real economy.

The other point Stevens made was that regulators and central banks need good data in order to measure asset price movements and he indicated that the RBA had imperfect property market data to work with, albeit that the information it now had was better than had been previously available.

That admission leaves the fierce debate about whether there is an Australian housing market bubble open, at least until hindsight becomes available.

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