To cut or not to cut?

Joshua Gans:

The RBA Board meets tomorrow for the first time in 2009. As I argued last week, in my view the RBA ought to be cutting far more aggressively, and there is no reason not to use most or all of the ammunition they have available – cutting interest rates to 2% or below. There is no inflation risk, and the macroeconomic outlook looks like being as weak as in any period post-war. In today’s AFR Adam Carr wrote the the RBA should not cut rates so aggressively, as this has encouraged the “boom-bust” cycle in the past, and will just sow the seeds of the next cycle. I agree with the thrust of his argument, that central banks have been too slow to stop asset bubbles, but disagree regarding the need for a cut in interest rates currently.In 2001 the Fed cut interest rates very quickly as the economy weakened after the stock market bubble. Greenspan was then very slow to raise rates after the economy began to recover in 2002 and onward. Many economists were pushing the Fed to raise rates more quickly, to try to slow the bubble in housing prices that seemed to be emerging in the US. Greenspan argued that 1) there was no housing bubble – there were only some localised bubbles in the US, 2) that generally bubbles are difficult to pick, and 3) that central banks should concentrate on cleaning up after asset bubbles collapse, rather than trying to pop them.

On all 3 counts Greenspan was shown to be wrong. There was an asset bubble. Rather than denying a bubble existed, the RBA actions in talking down the housing market in 2003 and 2004 were much more prudent. At least state that there appears to be some excessive house price levels in some parts of the housing market. Central bank jawboning can be quite effective in making people worry about (and act on) what might be a housing price bubble. The RBA action seemed to have some impact on the growth in housing prices, and I would argue that any current bubble in house prices in Australia is far smaller than they got to in the US. On the point about bubbles being difficult to pick, I think that economists do have a view on what the fundamental value of an asset is. It does seem appropriate for central banks to say when they think that asset prices are significantly away from fundamental values. Which leads to the final point – waiting for the mess might lead to a much bigger mess! So why shouldn’t central banks at least jawbone down the market when they think there is a bubble. And to return to Adam Carr’s point, central banks should be willing to raise rates quickly when they see bubbles emerging. Central banks should currently be quick to cut, but when there are signs that the economy is recovering and if there is any sign that asset bubbles are emerging again, they should raise rates quickly. Not neccessarily in 25 basis point steps, but quickly enough to get above the neutral rate.