The RBA is likely to hike rates in the second half of 2018, according to the OECD

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The OECD is urging Australia to begin increasing official interest rates, even if inflation remains weak, to cool the housing market and prevent a blowout in risky debt levels.

Forecasting solid economic growth and falling unemployment over the next two years, the OECD said it was time for both monetary and fiscal support to be “gradually withdrawn”.

The Organisation for Economic Co-operation and Development’s latest world economic outlook argues that the Reserve Bank of Australia is likely to begin hiking the official cash rate in the second half of 2018 as a pickup in wages and prices becomes more entrenched.

“A tighter policy stance will ease pressures on house prices and will reduce the threat of the build-up of other financial distortions” in Australia, they said in their report published in Paris on Tuesday.

In lending support for higher official interest rates, the OECD said the growing shift towards normalising monetary policy in the big advanced economies is unlikely to blunt incentives among companies to invest in productive assets.

By contrast, it warns the greatest hurdles to a long-run recovery may include the fact that expectations for future growth have been permanently dampened since the global recession, as well as doubts about trade liberalisation and a decline in the number of new businesses being created in countries such as Australia.

The remarks add to a growing body of commentary by monetary policy experts who question whether central banks should wait for signs of inflation before unwinding crisis-era rates and bond-buying programs. Former Reserve Bank board member John Edwards cautioned earlier this month that inflation may not be the best gauge as to how central bank rates are likely to evolve in the near-term.

The Reserve Bank expects core inflation to remain below the bottom of its 2-3 per cent target for most of the next two years, suggesting it sees no urgency to join the global trend towards tighter policy settings.

That debate is yet to be reflected in the Reserve Bank’s official signalling over the future path of the overnight cash rate, which financial markets don’t expect to be increased until late 2018. Some economists don’t anticipate a hike until 2019.

On inflation – which remains weak around the world – the OECD suggests central bankers will need to ramp up their explanations for weak price pressures and what they mean for official interest rates.

“If inflation is currently held down by forces which are beyond the control of national central banks (like positive technological shocks, regulation or global forces), it would in principle justify a delayed and slower withdrawal of monetary policy stimulus than otherwise.

“However, given the already lengthy period of a very expansionary monetary policy stance, this could aggravate mispricing of asset prices and may not be warranted.”

The OECD indicates there may be a case for higher interest rates even if inflation stays weak, as many economists expect.

“In such a case, some under-shooting of inflation targets may have to be tolerated but should be clearly communicated as being related to exceptional circumstances.”

The OECD said the fact that people expect the Reserve Bank to start lifting the benchmark rate in the second half of 2018, as well as macro-prudential restraints on bank mortgage lending, “are helping to cool the housing market”.

However, it warns that those restraints need to be maintained, not least because Australia is vulnerable to “too big to fail risks, due to its highly concentrated banking sector”.

OECD officials have also urged the Coalition government to stick to its plan of gradually improving the budget. Deficit reductions are currently equal to around 0.5 percentage point of gross domestic product a year. “The pace of consolidation is appropriate given projected growth.”

They added that an easing in fiscal policy can only be justified if the economy weakens suddenly.

On tax reform, the OECD reiterated its long-standing advice that the Commonwealth should widen and increase the goods and services tax, and that more revenue should be derived from land tax and less from stamp duties.

It concludes by warning that any sudden fall in house prices would crunch household spending, damage the construction sector, and drive job losses.

This article originally appeared on the Australian Financial Review. Read the original here, or follow the AFR on Facebook.

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