Australian Monetary Policy: Too Much of a Good Thing

It is indeed an old adage that while goods things are to be preferred over bad things, it is possible to get too much of the former. Looking at recent comments from the governor of the Reserve Bank of Australia, it is not difficult to imagine how these, albeit old and worn, pearls of wisdom may well have inspired Mr. Stevens in his effort to tiptoe the tightrope between signalling the intention to raise rates into an expected economic recovery and trying to prevent the Aussie shoot of on helium into the sun with wings of wax on the other.

To quote Bloomberg:

Australia’s central bank Governor Glenn Stevens signaled a surge in the nation’s currency to near parity with the U.S. dollar has given him scope to slow the pace of future interest-rate increases.

Stevens, who yesterday became the first central banker in the world to raise borrowing costs twice in 2009, said the 28% gain in the currency this year may hurt exports and cool inflation, allowing him to “gradually” raise borrowing costs. Just last month, he warned it may be “imprudent” to keep rates at “emergency levels.” The local currency and bond yields fell as traders slashed bets on another quarter-point boost next month, after Stevens raised the overnight cash rate target to 3.5%from 3.25%. Investors have been driving the Australian dollar toward parity with the greenback, betting China’s economic growth will boost exports from Australia, the biggest shipper of iron ore used in making steel.

Policy makers “are probably glad for the parity talk as it reduces the amount of work they need to do with monetary policy,” said Matthew Johnson, an interest-rate strategist at UBS AG in Sydney. “A December move is a 50-50 proposition.” Traders are betting there is a 50% chance Stevens will increase the key rate by another quarter point on Dec. 1, according to Bloomberg calculations based on interbank futures on the Sydney Futures Exchange at 12:22 p.m. today. Prior to Stevens’s comments, they had a 96% bet on such a gain.

Mr. Stevens' comments followed in the heels of the recent push by part of the Aussie toward parity with the US dollar, reflected primarily in the fact that the RBA has already raised twice in 2009 (from 3.00 to 3.5%) as well as a growing risk sentiment which is a fundamental prerequistie, in the current market, for observing investors react to (growing) yield differences. In so many words, this is all about carry trade, and more specifically about the fact that in a world where the G3 and others are still fiddling with quasi- or outright QE it takes a brave sould to initiate a hiking process since it will mean an immediate reaction in the currency market. This is especially the case when the liquidity anchor effectively constitutes the US. Thus, while the US pump priming keeps a floor under risky assets and volatility at low levels it becomes a veritable turkey shoot to gun for those currencies whose central banks are on the hike.

Following Mr. Stevens' comments, the Aussie did lose a bit of its steam even if many currency punters still see it racing towards parity over the course of the coming year (click to enlarge).

For example, David Forrester, who is currency economist at Barclays Capital, expects the Aussie to test the parity level in 2010, a call based on the idea that the RBA will have hiked rates to a full 5.5% by the end of next year. Needless to say, in a world where risky assets continue to fly and risk aversion is kept in check this will provide a juicy interest rate differential vis-a-vis the G3 and thus the carry trade flows (be they actual carry trades or simply spot market piggy backing) will be plentiful.

The question is of course: can you blame the RBA for wanting to raise rates?

As it turns out, not really and particularly not in light of global central banks' new found focus on asset prices in setting the policy rate. You know, it was all Greenspan's fault and all that jazz. Still, for those worried about a too rapid V-shaped recovery, Australian house prices seem to offer plenty of things to worry about.

From Q3-08 to Q1-09 the house price index (weighted for the 8 biggest cities) fell a modest 5.6%, a drop which has been decisively paired in Q2/Q3-09 with the index rising a cumulative 8%. This picture is repeated if we look at a general gauge for consumer spending in the form of a sector break down of retail sales.

Consequently, the annual as well as monthly flow of retail trade turnover never really went decisively into negative in the context of the financial crisis, which has no doubt contributed to the fact that the RBA never really contemplated a move into ZIRP and QE.

What happens next, then?

Well, as I noted recently, the burden of rebalancing may be tough to carry for those economies who have central banks brave enough to raise interest rates. Ironically, of course, and if it is really asset prices you are worried about, the risk is naturally that you just end up sucking in liquidity as you which in itself defeats the purpose of the hiking campaign (see Edward's recent piece on Norway for a Scandinavian perspective on this).

Naturally, you can resort to Brazil-like capital controls, but in a world where capital flows freely and where the global economies are largely interdependent, this is like trying to stop a freight train with a VW Polo.

Also, allow me to finish with a small quibble of mine in relation to the sudden urge by part of central bankers to target asset prices. I mean, this is fine and all and, for those who know a little bit about monetary policy, this is not something completely new. The problem is merely that targeting asset prices may not only be counterproductive in a world where asymmetric liquidity conditions and carry flows are the norm. Targeting asset prices also entail targeting a price which is considerably more volatile than traditional prices (because I assume that forecasting long term asset prices is not as easy as many believe). In this way, a steady gaze at asset prices may also conflict with central banks' general propensity to favor incremental and gradual moves.

Whether this is the case in Australia, only time will tell. Yet, from the lovely fjords of Oslo to the beaches of Rio and on to the Great Barrier Reef, policy makers may soon learn that you can indeed get too much of a good thing.

Comments

[Dave Wrixon:]

When the US dollar final goes into free fall, I don't think interest rates are going to have much influence on capital flows. They certainly didn't when US interest rates were at zero and the US was bizarrely described as a "Safe Haven". The only questions that will be asked, are how much and how quickly.

Nov 07 07:04 AM

[bob adamson:]

Thank you, Mr. Vistesen, for a very useful perspective. There has been much loose speculation recently whether Canada and some other countries should follow the lead of Australia and Norway and whether, generally, it is now time for a clear upward adjustment in interest rates. It is therefore timely to revisit the actual situation faced by Australia and Norway, exceptions though they are in the current global economic situation.

Nov 07 01:19 PM

[Claus Vistesen:]

Thanks for the comments guys ...

@ Dave: While this may be true it will take someone else to skyrocket if the USD has to enter a free fall and it is here I see the difficulties not so much because I cannot see that the USD has to fall, but because the Euro for instance cannot take it alone. As for the AUD? Well, we will see once parity is breached ...

@ Bob: Exactly, I agree ... this is needs to be treated on a case by case basis since some economies may be able to "handle" it better than others. Investors would be wise to make this discrimination very clear when they place their bets.

Claus

Nov 08 10:44 AM