Recently the Governor of the Reserve Bank of Australia (RBA), Glenn Stevens, made a momentous policy statement about a change in policy for this institution he heads. To date, the main role of the RBA has been to keep inflation relatively low, a goal that has translated into an unofficial target for the Consumer Price Index (CPI) 2-3 growth per annum.

The ongoing impact of the Global Financial Crisis, however, has wrongly convinced Mr Stevens that the RBA, and other international bodies like it, should also act to stop asset price booms from turning into dangerous bubbles – as occurred with housing prices up to mid 2007 in the United States.

Price bubbles in any market are always difficult to define, except in hindsight. During the Dotcom Boom of 1998-2000, for example, even seasoned market analysts felt that despite evidence of any real earnings, the multi-billion dollar valuations applied to many internet companies was warranted because of their potential. This optimism came undone in dramatic fashion in late
March 2000.

Going back to 1986-87, entrepreneurs like Christopher Skase, Alan Bond and Robert Holmes a Court were regarded as darlings of the Australian sharemarket due to their perceived ability to create wealth. Hindsight tells us that the aftermath of the October \'87 Crash put paid to these ambitions.

The harsh reality of asset booms, whether they occur in shares, house prices or even flowers (a la the Dutch tulip mania of the 1630s), is that when prices are shooting up most people convince themselves that \"This time it\'s different\" thus justifying the fiscal madness going on around them. When the inevitable busts occur subsequently, those same people hang their heads, say \"Never again\" to themselves and usually look to the government to pass a new set of laws designed to prevent future outbreaks of normal human stupidity!

Which leads us back neatly to how Glenn Stevens would now like the RBA to act. Right now he is worried about rampaging house price inflation across Australia, which has seen Melbourne properties increase an average of 11-12% in calendar 2009. Rapidly rising residential prices are a valid cause for concern because (a) they reduce affordability for first homebuyers, and (b) as recent events in the US and UK have shown, any subsequent bust can lead to a damaging recession (as the family home is most people\'s major financial asset). As a result, Mr Stevens wants to use interest rates as a means of reducing house price growth.

Unfortunately for the RBA\'s Governor, such a policy prescription is highly problematic for three main reasons:

(1) If the CPI was actually trending downwards at the same time house prices were going up, it\'s not clear under Mr Stevens\'s plan whether interest rates would be pushed down (to combat CPI deflation) or up (to curb house price growth);
(2) If the sharemarket was falling at the same time house prices were rising (a situation which occurred quite dramatically between 1987 and \'89), it is again unclear which asset class (ie shares or residential property) the RBA would feel compelled to target; and
(3) As per the reasons explained above, identifying a bubble ahead of time is extremely difficult to do. Right now, for example, there is a good argument to
say that the strength of Melbourne property prices is a result of \'real\'
factors like population growth and town planning limitations rather
than speculative excess.

In conclusion, Glenn Stevens is right to ponder the role of central banks when confronted by unsustainable and potentially damaging asset price booms. The problem he and others like him face, however, is that the real world rarely conforms neatly to the often simplistic economic models so beloved of policy makers.

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