IN DEPTH - How to steer a super tanker Page 1 of 5 January 31 Upfront Indepth Platform Plus IN DEPTH Data How to steer a super tanker Insight By David Clark Explore: Economy Contents for this issue: Asset, May 2001 This Barrie Dunstan Tony Muston Peter Bobbin Michael Rice David Drucker is all bull.... about the science of monetary policy. All bull ... Every month for years we had papers on credit growth, the yield curve, etc, the relation to GNE, and it was never any good at prediction. Never. You have to be able to feel what is happening.' (Former treasurer and prime minister, Paul Keating, quoted in John Edwards' Keating: The Inside Story). Further In Depth articles this issue: Would you like fries with that? Revolution Login Contents Calculators Margin Rates Advertise Register About Us Newsletters Back Issues Feedback Help Try the Asset Invesco Australia Longevity Risk calculator for investment professionals. Monetary policy setting in the 21st century is best likened to trying to steer a giant super tanker through a very dangerous, narrow strait. Not only does the Reserve Bank have to anticipate the reefs long before they are nearby, it is uncertain just how quickly or significantly the brake-less economy ship will react to any interest rate change-induced adjustments to its course. Worse, it has to keep its eyes open for unpredictable, destabilising currents, which are the product of previous monetary policy decisions or inactions, or massive unpredicted fogs, like the Asian crisis of 199798, which can also send its compass spinning furiously. Portfolio's new ringmaster After the revolution Are you breaking the law? Hedge funds get defensive It also has to deal with academic and business economist seagulls Looking at who try to distract its course-setting by bombing it with media alternatives campaigns and other self-promotion exercises. Shopping for the right fund And, making comments about the navigation of a ship, looking backwards from its stern is a lot easier, and safer, than looking forward from its bridge. No wonder investors - and their advisers - have trouble assessing the likely impact of any interest rate changes. What is so important about the RBA decision each month about whether to change the 'cash rate'? Related sites AFR AFR Boss Boss Asia BRW CFO MIS Money Manager Personal Investor Shares Trading Room http://www.assetmag.com/stories/20010501/9693.asp This term refers to official rates in the short-term money market. Here, intermediaries borrow money from those who want to keep their funds highly liquid - 'at call' - and invest it in appropriate assets. The RBA aims to achieve a target overnight interest rate (the 'official cash rate') - the interest rate on overnight loans in the short-term 31/01/2003 IN DEPTH - How to steer a super tanker Page 2 of 5 money market. (This is where money can be parked, earning interest, until needed) This rate defines the price at which RBA will supply reserves (short term government securities) to the shortterm money market. Thus, to increase the money supply, the RBA buys government bonds from the public. Conversely, to decrease the money supply, the RBA sells government bonds to the public. Each month, usually on the first Tuesday, the Reserve Bank board meets to decide whether it should alter its current target cash rate and the decision is announced a day later. In making its decision, it looks well into the future. It is not reacting to the latest economic news but to what it thinks will be the news several months down the track. It also has to make assumptions about what will happen to the global economy, world interest rates and the value of the $A over that period. Worse, it has to look backwards as well as forwards. The trouble is it can take many months before the full effects of its previous interest rate decisions come through the economic pipeline and it has no simple guidance as to how long such transmission effects take. It does know, however, that interest rate changes can affect economies via six main variables - and investors and investment advisers should note these carefully: ? ? ? ? ? ? Postponed consumption, or what economists fancily call 'intertemporal substitution'. For example, a fall in rates may encourage less saving and more consumption. Wealth and perceptions of wealth. For example, a fall in rates can reduce the wealth of persons whose incomes are heavily tied to interest rate levels. Credit supply. For example, a rise in rates may increase the supply of funds. The exchange rate. For example, all other things being equal a fall in our interest rates relative to those of other economies may reduce the demand for the $A and hence its relative value. Borrowers' liquidity and ability to service their borrowings. For example, lower interest rates can mean that borrowers can afford to borrow more and/or the cost of servicing their existing borrowings falls. Expectations of what the effect of any change or nonchange may have on future inflation and growth. For example, after high inflation and interest rates relative to most other economies in the 1980s, it has taken nearly a decade of much lower levels of both to apparently change expectations about future inflation and rates. The length of the transmission lags from monetary policy to output has been the subject of much research over the years, but there are serious problems in isolating the lags with any precision. One 1997 Reserve Bank study by David Gruen and others used a simple econometric model of Australian output to try to estimate the length. It concluded that output growth falls by about one-third of 1 per cent in both the first and second years after a one percentage point rise in the short-term real interest rate, and by about one-sixth of 1 per cent in the third year. This implies an average lag of about five or six quarters in monetary policy's impact on output growth. Note that the researchers http://www.assetmag.com/stories/20010501/9693.asp 31/01/2003 IN DEPTH - How to steer a super tanker Page 3 of 5 admitted, however, that 'each of these estimates is subject to considerable uncertainty'. There is also the question of how quickly changes in the cash rate are passed on to bank customers. In recent years, banks generally have been quicker to pass on interest rate rises than cuts. The Howard Government has been particularly active in putting pressure on the banks to do so in recent years. Why is it so difficult to predict the effects of interest rate changes? Reserve Bank and other research suggests three main reasons: The first is that much of the theory of monetary policy rests on assumptions for which there is only limited empirical support. One key example suffices here. Are financial markets forward or backward looking when it comes to their expectations about inflation and interest rates? Most monetary theory assumes the former. However, an OECD study of what determines interest rates found that a country's credibility regarding inflation control is a key factor and that it can take up to a decade for markets to get over past poor inflation. Yet, in recent years markets have consistently over-estimated inflation and although economic modellers like to appear scientific, they have also a poor record regarding inflation and inflationary expectations. The second reason why interest rate effects are so difficult to predict is a 'chicken-and-egg' problem - or to use the fancier term, simultaneous causation. This means that effects of interest rate changes can be very difficult to determine if the changes themselves are largely systematic responses to movements in other macroeconomic variables - for example, the growth and/or unemployment rates - that they also affect. For example, the level of our interest rates relative to those of other economies can affect the demand for our currency and its value relative to other currencies. In turn, our exchange rate can affect our relative interest rates. The third and final reason is that it is very difficult to separate the effects of recent interest rate changes on the economy from the delayed effects of previous interest rate changes. http://www.assetmag.com/stories/20010501/9693.asp 31/01/2003 IN DEPTH - How to steer a super tanker Page 4 of 5 True, such uncertainties have been reduced a little by the following - admittedly reluctant - steps taken by the Reserve Bank in recent years to make its conduct of monetary policy more transparent: ? ? ? ? Changes in policy and related reasons are now more clearly announced and explained. The bank has improved its public commentary on the economic outlook and issues bearing on monetary policy settings, through public addresses and its regular quarterly report. The release of bi-annual statements on monetary policy and the role it is playing in achieving the bank's objectives. These statements include information on the outlook for inflation and on recent developments in financial markets. Twice yearly appearances by the Governor before the House of Reps standing committee on financial institutions and public administration, which enable members to crossexamine the Governor on the RBA's decisions. What have we learned about monetary policy over the past decade? Three big lessons stand out: The first lesson is that the effects of interest rate changes are asymmetrical - that is, rises in rates tend to have a bigger and quicker impact than reductions in rates. In technical language, in recessionary times expectations of low sales and profits overwhelm the positive cashflow effects of lower interest rates. But we have no simple guides to either the length of the lags or the magnitude of their effects. The second is that it is very difficult to separate the effects of current interest rates on the economy from the delayed effects of previous interest rate changes. Hence, when the Reserve Bank makes decisions about whether to change the cash rate - or simply leave it unchanged - it is uncertain not just about the present and the future but about effects still to come from its previous interest rate decisions. The third is that monetary policy cannot be used to super fine-tune the economy - and business should not expect the RBA to be able to predict the full effects of its actions or inaction. The lags are simply too unpredictable. Finally, one should remember that the mere announcement of a rate change - or of a change in the RBA's general philosophy - can in itself change the mindset of key markets. But such changes are exactly what Ian Macfarlane wants to achieve. This was first pointed out 20 years ago by a governor of the Bank of England. More recently, a US economist, Robert Lucas, got a Nobel Prize for re-iterating the point. Indeed, the next time the Reserve Bank or the US Federal Reserve announces another change in interest rates, pin the following sagacious remarks to your keyboard: The best time to change monetary policy is always six months ago. Useful web site: www.rba.gov.au/MonetaryPolicy/ Dr David Clark teaches business economics at the University of NSW http://www.assetmag.com/stories/20010501/9693.asp 31/01/2003 IN DEPTH - How to steer a super tanker Page 5 of 5 Copyright © Asset, Fairfax Business Media, 2001. Advertise with us | Conditions of Use | Member Agreement Any unauthorised use, copying or mirroring is prohibited. Your use of this site is protected by our Privacy Policy http://www.assetmag.com/stories/20010501/9693.asp 31/01/2003