Opinion

John Hewson
The RBA’s inflated ego could make the housing crisis worse

Some years ago, I was asked to comment on a draft of a commissioned history of the Reserve Bank of Australia. My overarching comment seemed to catch the author by surprise: “You guys seem to believe that you actually controlled inflation.”

This was coming out of the era where the RBA had created the impression they could fine-tune inflation, colloquially speaking. To the public’s mind, the governor sat up there in his tower at the top of Martin Place with a mysterious black box on his desk, his hand hovering over two knobs, one that could move the cash rate up by about 25 basis points at a time and the other that could drop the inflation rate by a desired amount.

If only. There is no doubt that inflation was brought under control through the 1990s, but there is a real debate about just how much of that was due to the management of monetary policy compared with the impact of a host of other factors including, importantly, Chinese manufacturing flooding the world with ever-cheaper product. Undoubtedly what became the RBA’s obsession with bringing down inflation did probably contribute by lowering inflationary expectations significantly through constant jawboning, but the central bank was not the principal driver.

It is instructive to recall how the RBA responded to the global financial crisis, in comparison with other central banks. The RBA was initially slow to respond, not lowering the cash rate immediately or significantly, as other central banks did. Then, after just a few months, they quickly lifted the rate again, against some perception or fear that inflation was picking up.

It is true there was global concern that the flooding of the world’s financial system, to cushion the likely recession from the GFC, risked a resurgence of significant inflation. After all, it couldn’t be ignored that the GFC was actually the outcome of excessive liquidity that flowed from then United States Federal Reserve chairman Alan Greenspan pushing interest rates down in 2004 and holding them there for too long. That led to a global search for yield and saw the mountain of debt instruments – including Lehman Brothers’ collateralised debt obligations – built on the very fragile base of securitised subprime mortgages. The whole structure came down to a punt on US house prices continuing to increase; when they didn’t perform as assumed, the entire enterprise collapsed.

Because of this, the RBA entered the pandemic with the cash rate still very high – a constraint on growth. Some would argue this was a strong position with considerable capacity to lower rates and in doing so cushion the likely recession that would result from the medical response, including the closure of our international border, social distancing and lockdowns. The Morrison government relied on the RBA to inject considerable liquidity – with a significant reduction in the cash rate to the historically low rate of 0.1 per cent as well as quantitative easing via the bank’s bond operations yield curve management and the Term Funding Facility. This was to support business in general and households especially by underwriting mortgage support.

It was a very high-risk strategy, with household debt levels already among the highest in the world going into the pandemic. As the Hayne royal commission demonstrated, our banking system is willing to lend households more than they know they can service, underwriting a housing boom with very large and often unexpected increases in house prices, obviously compounding the household debt problem and leaving many borrowers seriously exposed to a possible increase in mortgage rates.

The RBA has become its own worst enemy in what is a potential housing crisis of its own making. Having repeatedly created the expectation that it wouldn’t seek to increase the cash rate until about 2024, it is now contemplating an earlier increase in rates, maybe even this year. Indeed, some market analysts are suggesting rates may be increased three or four times by the end of this year.

At its worst this could be a bloodbath for the housing sector, with house prices actually falling, eroding the equity many households believed they had built up in their homes, resulting in banks calling in some housing loans.

Even as the market falls, higher interest rates and deposit requirements will likely still keep out first-home buyers. No one wins.

When challenged about this possibility over the past couple of years, the RBA has generally sought to duck responsibility, claiming at times that the Australian Prudential Regulation Authority has the capacity to regulate bank-lending, which it has attempted a couple of times during this period but with mixed messages.

In his recent speech at the National Press Club, the Reserve Bank governor, Philip Lowe, again resisted the notion that the RBA carried any responsibility for the potential housing crisis. While acknowledging the cash rate may be increased later this year, he tried to link this to the likely out-turn of inflation. Although Lowe tried to create the impression of precision in this decision-making process, linking it to the inflation target, don’t be misled: the decisions are still heavily subjective.

As one of the earliest advocates for an independent Reserve Bank and for inflation-targeting, I must admit to considerable dissatisfaction and concern about how these decisions have been implemented. For example, I never imagined the target would remain fixed at 2-3 per cent, irrespective of how economic circumstances changed. Also, there is no logic to excluding asset price inflation from the target. Clearly, property and share prices have been seriously inflated in recent years of global liquidity expansion.

In his Press Club address, Lowe admitted to the complexity of inflation outlook, claiming recent inflation “reflects both the strength of the economic recovery and the significant disruptions on the supply side”. The big increases have been in petrol prices (32 per cent over the past year) and the cost of constructing new dwellings (7 per cent). On the latter, the cost of building materials has skyrocketed due in part to government pouring funds into the sector, as well as supply-side constraints on building materials and the increased cost of tradie services, all compounding the housing crisis.

There have also been significant increases in the prices of consumer durable goods, in part related to housing construction, and to fresh fruit and vegetables prices, due in part to shortages of workers. Lowe concedes the uncertainties of the likely course of the coronavirus and the behavioural responses of households and businesses is also a factor.

Lowe seemed confident that these price pressures will lessen in the longer term, as governments improve their response to the virus and supply-side distortions are addressed. But we should “expect underlying inflation to increase further over coming quarters”. This is important because if inflation is to be sustained in the target range, the RBA is likely to move earlier to increase interest rates.

The big “known unknown” in the inflation outlook is wages. Lowe says, “over time stronger growth in labour costs is expected to become the more important driver of inflation”. The central forecast is for underlying inflation to be about 3-4 per cent over both this year and next.

Wages growth is back to pre-pandemic rates, although Lowe warned of “substantial inertia” stemming from multiyear enterprise agreements, only yearly reviews of award wages and public-sector wage policies.

Flat wages have been a key element of the cost-of-living issue, with household costs running way ahead of wages. Indeed, real wage growth is negative. However, the major future unknown with wages, conceded by Lowe, is the uncertainty of how wages will respond to unemployment with a three in front of it. One of the most significant factors has been the closing of our border to students, backpackers and immigrants, affecting the supply of itinerant workers particularly.

The main risk to the RBA’s optimistic forecasts is that inflation isn’t controlled here or globally. This will prompt central banks to increase interest rates more than contemplated, perhaps tipping the world towards another serious recession. The supply-side disruptions won’t easily be eliminated – central banks are powerless to do much about them and governments will continue to push for the maintenance of low interest rates, putting real pressure on even fully independent central banks.

Moreover, if the RBA gets its wish on wages, inflation could exceed the target, encouraging them to raise interest rates even further, thereby intensifying the housing crisis. The government will have an uphill battle persuading voters they are superior economic managers, with huge numbers of first-time voters realising that the dream of home ownership may be always beyond their reach.

This article was first published in the print edition of The Saturday Paper on February 12, 2022 as "Matter of interest".

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John Hewson is a professor at the ANU Crawford School of Public Policy and former Liberal opposition leader.

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