In the first two parts of this series, I outlined the circumstances of Australia’s current position and the issues which are underpinning our sub trend growth at the end of the resources boom. This is essentially summarised as high levels of borrowing by our banks and institutions with credit being leveraged into unproductive assets, diminishing the already weak competitiveness of our industries through higher input costs and ruining future prospects in growth and productivity.
In light of these problems, how can our Central Bank respond to a lacklustre environment and what trade-offs exists when key decisions are being made? What are the tools available to the RBA in a world of zero bound interest rates and unconventional policy settings?
Firstly, let us take a look at the conventional policy toolkit available to the RBA. The RBA’s main goal is to achieve stability of the currency (“low” inflation), with a focus also on full employment and sustainable economic growth. Its most common tool is using open market operations to target the cash rate on exchange settlement accounts, commonly known as setting the interest rate. It can also manipulate the value of the Australian dollar by buying or selling currencies on the foreign exchange market (dirty float) or jawboning (talking up/down the value of the Australian dollar and economic activity).
By setting monetary policy, the RBA can affect real economic activity through a variety of transmission channels. Some of these channels are interest rate channels, asset price channels and credit price channels which ultimately impact how the RBA reaches its goals. Generally speaking, monetary policy is set counter cyclically, that is, contractionary during booms (high interest rates) and expansionary during troughs (low interest rates).
So what is the problem with using monetary policy to stimulate the slowing Australian economy?
The problem with setting lower interest rates now is it reduces the cost of debt (credit price channel), increasing speculation growth into the property market and high value mortgages. As I have mentioned previously, this causes a build-up of systematic risk and reduces intertemporal efficiency as income is shifted towards paying off future debt instead of being used in more productive areas.
Such risk is further compounded by close to zero growth in real wages and uncertain prospects for future levels of employment, making debt harder to service in the future.
Another problem with lower interest rates is that it reduces the return on low risk investment instruments such as general savings, term deposits and government bonds. The real return on savings is essentially zero, providing greater encouragement to seek out riskier investments such as equities in the ‘hunt for yield’.
Combine this with high amounts of private leveraging and portfolios will be extremely vulnerable to negative shocks, multiplying the losses on the initial capital.
Essentially, the weakness of monetary policy is that it is a blunt instrument, meaning it cannot be tailored specifically to industries and can cause different channels to dominate others depending on the circumstances.
Despite these issues, there is a strong case for dropping interest rates further. Dropping the interest rates or setting the expectation for lower rates will put downwards pressure on the Australian dollar. This gives much needed relief to trade exposed industries, especially with the declining terms of trade. Delaying the recent interest rate cuts may have choked businesses and consumers out further, damaging already diminishing growth prospects.
However, even cash rate effects on the exchange rate have its limitations. In the most recent policy decision, the Australian dollar increased almost a cent after a brief decline in response to the cash rate being lowered by another 25 basis points. Several factors can attribute to this response such as the perception that the RBA dropping the easing bias in its policy statement. But it is the sensitivity of foreign exchange markets to various influences which makes the RBA’s desire for a lower currency a difficult task.
Thus, there exists a trade-off of using monetary policy to boost growth in Australia. How can we lower interest rates to boost activity without also encouraging reckless speculative behaviour?
There is another option available to the RBA and the Australian Prudential Regulation Authority (APRA) which has been endorsed by the IMF and utilised by several other countries to combat very similar issues.
Macro-prudential regulations are rules which target areas of instability within the financial system, curbing the build-up of risk from unstable asset price growth. As defined by the Reserve Bank of New Zealand, macro prudential policy uses “regulatory instruments to help reduce the system-wide (or “systemic”) risks that can develop during boom-bust financial cycles… promot[ing] greater financial system stability by:
– building additional resilience in the financial system during periods of rapid credit growth and rising leverage or abundant liquidity; and
– dampening excessive growth in credit and asset prices”
Some tools as part of these regulations include restricting high loan to value mortgages (LVR, which is the proportion of money you can loan relative to the value of the asset), stress tests, limits on interest only loans and higher capital requirements for banks. David Murray, chairman of the Murray Inquiry, has also raised concerns about the amount of capital our banks are holding against loans and the inherent risks of our financial system.
Stricter policies and consequences on riskier loans can help reduce investor demand in the property market and dangerous amounts of leveraging into a potential asset bubble. This will allow the RBA to reduce interest rates further if necessary without the dangers of fuelling further speculation growth.
Indeed, the RBA has voiced their concerns about rising housing prices in Sydney and Melbourne, with APRA threatening action against risky practices by our banks; wiping $20 billion in share market value.
However, even if stricter financial regulations were implemented, some commentators have put forth concerns that monetary policy is ineffective at stimulating weak demand and are instead only useful in growing asset bubbles.
Lowering interest rates may give a temporary boost to the economy, but this is simply treating the symptoms of a much more complex disease. Encouraging spending and credit growth through lower rates only treats the symptoms of low confidence, but is not the solution to Australia’s structural (and competitive) woes. The central bank has the tools available to make monetary policy more effective, but even so, lower rates are only part of the solution in our deteriorating economic environment, not the focal point of reform.
In my final piece of this series, I will look at fiscal policy and the recent history of the political economy.