Indecision by the Federal Reserve is driving financial market behaviour and leaving policy-makers increasingly helpless. Data limitations and the self-imposed restrictions used by the Reserve Bank of Australia to govern monetary policy – infrequent policy movements, reversal reluctance and inaccurate forecasts – leaves the Australian economy vulnerable if the Fed does not taper soon.
Setting interest rates is always difficult but during periods of great uncertainty getting it right is more luck than logic. Right now the domestic economy faces more uncertainty than at any time since the beginning of the global financial crisis and though the risks appear balanced they are significant on both sides.
On one hand, low interest rates are gaining some traction in the broader economy, consumers are beginning to spend a little more and asset prices have increased. On the other hand, we have a non-mining sector that remains fairly subdued, an exchange rate that is ‘uncomfortably high’ and the uncertainty surrounding the Fed’s taper.
The Fed’s taper is the game changer right now. Sort that out and a lot of the uncertainty goes away. The outlook will suddenly be much brighter for the Australian non-mining sector and the broader economy.
Not since the days of a fixed currency regime has Australian monetary policy been held hostage by the whims of another central bank. Certainly Australian policy is often affected by foreign central banks – we are of course a small economy by global standards – but never to this degree. Never has a single decision by a central bank had such significant consequences for the RBA.
The next move the RBA makes will depend to a great extent on when the Fed chooses to taper, but who knows when that will be? The RBA certainly doesn’t and market sentiment seems to change by the day. For all the Fed talk about ‘forward guidance’ we still remain in the dark and policy-makers do too.
So why is the RBA not doing more? Why wait on the Fed to make up its mind?
To understand the RBA’s decision-making requires an understanding of the self-imposed restrictions that the RBA uses to set interest rates.
The RBA sets several restrictions on its behaviour, which are not written down anywhere but help guide monetary policy. These restrictions make it more difficult for the RBA to make decisions during periods of great uncertainty.
First, we need to recognise that the RBA does not want to change policy frequently. The theory behind this is that it allows the RBA to communicate its intentions more effectively, helping market participants shape their expectations.
Second, central banks hate the prospect of quickly reversing a policy decision. If the RBA has to regularly reverse policy moves then it is an acknowledgement that they stuffed up. From their perspective this needs to be avoided at all costs.
Finally, we know that forecasting the economy is difficult, in fact there is ample evidence that the RBA cannot forecast the economy with anything near the accuracy required to be certain of policy moves (Why guesswork has a place at the RBA, November, 2012).
From an economic perspective, we are dealing with an uncertain environment and growth forecasts that are often not worth the paper they are printed on (or the bandwidth used to view them). From a policy perspective, we have a Reserve Bank that is terrified any move made right now might need to be reversed. It is hardly a surprise that it is in wait-and-see mode. That won’t change until the Fed’s intentions become clearer.
Right now the economy is weak enough to justify another cut but if the taper begins soon then that cut may not be necessary. Similarly, the RBA could raise rates on taper expectations but then find it needs to reverse the decision if the Fed delays the taper.
At the moment the RBA may only have to wait a couple of months for the Fed’s taper. But if the Fed strings markets along and does not provide any clear indication of its intentions then the RBA could quite realistically be left paralysed, remaining hostage to the Fed and without any clear policy direction.