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Will Claudio Borio, Philip Lowe’s 2002 study on asset bubbles guide the RBA now?

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Claudio Borio is a thought leader among the world’s central bankers. And his belief that higher interest rates are needed to deflate dangerous asset bubbles can be traced back to his collaboration with a young Australian economist – Philip Lowe.

Borio is the head of the monetary and economic department at the Bank of International Settlements, known as “the central bank of central banks”.

Borio is the head of the monetary and economic department at the Bank of International Settlements, known as "the ... Borio is the head of the monetary and economic department at the Bank of International Settlements, known as “the central bank of central banks”. Photo: supplied

The 30-year BIS veteran says policymakers need to “de-emphasise” inflation targeting as their guiding star of policy setting and instead shift the focus towards financial stability risks, even if that means leaning against asset price bubbles.

Borio said he started doing “quite a lot of serious work” on this topic around 2000. It was also the year that he recruited Lowe, now governor of the Reserve Bank of Australia.

In 2002 the two men published a paper titled Asset prices, financial and monetary stability: exploring the nexus. That work helped form the basis for 15 years of research undertaken by the BIS around the potentially damaging feedback loop between low interest rates, credit growth, and asset price booms and busts.

In the paper, Lowe and Borio argued that “financial imbalances can build up in a low inflation environment and that in some circumstances it is appropriate for policy to respond to contain these imbalances”.

The implication is that “in some situations, a monetary response to credit and asset markets may be appropriate to preserve both financial and monetary stability”.

That conclusion is remarkable for what it shows Lowe believed then, and perhaps still believes now. Did Lowe’s research into financial cycle theory in the rarefied air of Basel survive the ensuing years of work within the straight-laced environment of the RBA’s Martin Place offices? If Borio knows, he certainly is not saying. In fact, he refuses to be quoted on anything related to our governor.

But the link between the RBA boss today and his work a decade and a half ago is tantalising. Particularly so given a simmering debate around whether by maintaining a devoted focus on inflation the central bank has helped, or is helping, sow the seeds for a potentially devastating crash in house prices.

The financial cycle theory developed by Borio and his colleagues over the years “very, very much” puts the build-up of credit and debt at the centre of economic cycles.

“If I had to choose one single variable at the heart of this it would clearly be debt and credit,” Borio says as he also describes the snow falling outside his window at BIS’s Swiss headquarters. “But, of course, the interaction with asset prices is very important.”

That’s because “these booms in credit and asset prices – often in property markets – if left run unchecked can lead to damaging busts.”

The role of excessively easy monetary settings in driving financial instability is clear.

“The combination of rather low inflation with upward pressure on the exchange rate and strong capital inflows [have] contributed to the choice of very low interest rates, which in turn fuelled the build-up of financial imbalances,” Borio says.

Policymakers here and across the ditch in New Zealand have enthusiastically embraced regulatory interventions, such as limits to lending to investors or tighter borrowing criteria. Borio is in favour of such measures, but warns against relying too heavily on these “macropudential tools”.

Indeed the popularity of these tools has come with a sting, Borio says.

“As a result, central banks felt that they did not need to adjust monetary policy”.

This is a mistake.

“The line the BIS has consistently taken is that you cannot deal with these financial booms and busts by relying exclusively on the macroprudential lever,” Borio continues. “You need to combine it with monetary policy.”

“As history shows, strong build-ups in credit and asset prices – or financial imbalances – have commonly occurred even as inflation has stayed low and stable, or even falling – or even negative, in fact,” Borio says.

“It’s the conjunction of the financial cycle with the inflation determination process that is really at the heart of the whole issue”.

Thus far, other than revealing heightened worries around the housing market in Sydney and Melbourne, there are no signs the RBA is reconsidering its mandate.

One can do no more than imagine a furious debate behind boardroom doors in Martin Place. But it is a debate that will either play out now or at the time of the next bust.

So what does the ideal monetary policy mandate look like?

“The key would be to find a way to respond more systematically to financial booms and busts so as to ensure that the financial side of the economy is never too far away from an even keel – so that it does not become a source of major problems down the road,” Borio says.

“Because of the weak link between inflation and financial booms and busts, you need to de-emphasise inflation point-targets in order to gain the necessary flexibility.

“The result would be a systematic response to the financial cycle: you would lean against the financial booms even if inflation was low, stable or even possibly declining, and then you would not ease as persistently during the financial bust.”

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