Low interest rates have fueled housing affordability crisis, should be made off-limits: former RBA board member Adrian Pagan

With housing developing into a significant political issue, most recently at the New South Wales election, University of Sydney economist Adrian Pagan has argued holding interest rates low during much of the past decade has been "detrimental for welfare" by helping drive a sharp increase in the cost of housing.

Professor Pagan said rents and new housing costs now consumed a quarter of household budgets, up from 16 per cent 20 years ago, and although negative gearing and planning rules were partly to blame, low interest rates were "a major contributing factor".

"The pre-eminent welfare issue in the past few decades has been that of the cost of shelter," he said.

"Since real rates being negative ... has been detrimental for welfare by assisting prices of shelter to rise sharply, it seems that one should keep well away from this."

Professor Pagan suggested an interest rate floor of 1 to 1.5 per cent be set.

The official cash rate is currently well above that at 3.6 per cent and is tipped to go higher as the central bank combats high inflation. But for much of the past decade, it has been 1.5 per cent or lower due to efforts by the RBA to help support growth in the aftermath of the global financial crisis and then the COVID-19 pandemic. This period has coincided with significant growth in house prices.

Professor Pagan made his suggestion in a submission to the review of the Reserve Bank which is due to be delivered to Treasurer Jim Chalmers on March 31.

The review, the first to be undertaken since the start of the current inflation targeting regime, has looked at key aspects of the central bank and its performance, including its structure and objectives, the composition of its board and whether the target of policy should shift from inflation to some other measure.

In a separate submission to the review, University of Queensland economics professor John Quiggin warned that a recession was "highly likely" under the policies currently being pursued by the RBA.

While acknowledging the need to raise interest rates while inflation is high, Professor Quiggin said "the use of contractionary policy to reduce inflation is always risky. An attempt to drive inflation down to the 2 to 3 per cent range is highly likely to generate an avoidable recession".

The University of Queensland economist said the central bank should raise its inflation target from 2 to 3 per cent to 4 to 5 per cent - a move that would likely to lead lower interest rates in the current environment.

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Professor Quiggin said the point at which real interest rates are neutral had steadily fallen since the 2 to 3 per cent target was set in the early 1990s and was now close to zero. This meant that during crises like the pandemic, the central bank not only had to cut its cash rate to almost zero but resort to bond purchases (also known as quantitative easing) to support the economy.

He said this not only created large potential losses for the central bank but, echoing Professor Pagan, generated "high and unstable" asset price inflation.

Professor Quiggin said inflation targeting had delivered sub-optimal outcomes for the community and suggested nominal incomes might make for a better policy target.

"Low inflation has not delivered either full employment or the improvements in living standards that could reasonably be expected," he said, and warned that recent bank failures add weight to concerns about excessively aggressive interest-rate policy.

But others backed the current regime and counselled against any move to target nominal income.

The Australian Banking Association said measures such as nominal income were not well understood or simple to explain or forecast whereas inflation is a familiar reference point for setting prices and wages.

The Australian Financial Markets Association also backed the current inflation targeting regime but said the central bank should provide better explanations when inflation is outside the target range for a sustained period.

The association said that although the RBA was "very competent" in implementing monetary policy in normal periods, during COVID some outcomes had been "sub-optimal".

AFMA said issues with the forward guidance provided by the central bank during this period had hurt investor confidence, resulting in increased funding costs for both governments and private organisations.