RBA jawboning needs more bite

Glenn Stevens' ‘jawboning’ on Thursday evening had an immediate effect, with the dollar dropping sharply in response to his comment that the Reserve Bank remained “open-minded” about intervening in the market for the Australian dollar. 

But given that the Reserve Bank has been loath to intervene in the past, jawboning may not be sufficient to bring about the devaluation Stevens would like to see.

In fact, intervention (selling the dollar) might prove ineffective. This partially explains the Reserve Bank’s historical reluctance to do anything other than ‘lean’ against the currency to smooth – rather than alter – its path.

Apart from the costs of intervention —Stevens referred to the ‘‘negative carry’’ of selling Australian dollar assets with positive yields to buy foreign assets with negligible yields – the RBA has been well aware that trying to stand against the tide of global capital flows is probably a fruitless exercise.

The significance of external factors in the dollar’s trading value was evidenced this week when the US Federal Reserve Board’s Open Market Committee released the minutes of its most recent meeting. In the minutes, it said it might decide to slow the pace of its $US85 billion-a-month purchases of bonds and mortgages at one of its “next few meetings”.

That sent a few shudders through markets and played the larger part in the sharp decline in the value of the Australian dollar this week, which fell from US94.5 cents to just over US92 cents this morning.

As speculation about the start of the Fed’s tapering of its quantitative easing program has strengthened, the dollar has traded down from US94.5 cents only a month ago. The Fed has a lot more influence over the future course of the US dollar than the RBA at present.

Apart from trying to talk down the dollar or ‘leaning’ against it by selling Australian assets, the RBA has a limited toolkit. Official interest rates are already at historic lows, with the cash rate at 2.5 per cent.

In theory, the RBA could cut the cash rate further, given that rates in comparable jurisdictions are close to zero. But it would be concerned that additional cuts might cause a housing market that is already heating up to move into bubble territory.

It might also push even more savings into risk assets in search of yield. This might have some unintended consequences if and when the US tries to normalise its monetary policy settings and offshore support for higher-yielding assets starts to unwind.

Ross Garnaut’s ‘solution’ to that dilemma, outlined in his new book Dog Days and his recent KGB TV interview, is to use macroprudential tools to deal with the potential side effects of lowering the cash rate.

He argues that changing the preferential risk-weighting of housing loans for the banks’ regulatory capital requirements would be a more effective approach, while freeing up the Reserve Bank to lower official rates to drag down the dollar and take some of the pressure off the non-resource economy.

Garnaut is not alone in making that argument.

The problem with playing around with the prudential regulation framework is not that it wouldn’t be effective. If banks have to hold more capital against home loans, they would lend less or charge more – which would lead to the desired result. Rather, the problem is that central banks and bank regulators have trouble identifying bubbles.

Over a protracted period, the Reserve Bank has looked at whether it could or should use monetary policy to try to defuse asset price bubbles before they are fully formed. It came to the conclusion that it shouldn’t. Financial bubbles are generally only obvious with hindsight.

The potential for adverse unintended consequences is real. Central bankers are reluctant to take pre-emptive action, whether that involves monetary policy or macroprudential interventions.

Joe Hockey’s financial system inquiry doesn’t address the question of whether the Reserve Bank should be given a wider range of tools to help manage the currency, or be able to call on the Australian Prudential Regulation Authority for help via macroprudential measures.

However, the draft terms of reference direct the inquiry to take account of (but not make any recommendations on) the objectives and procedures of the Reserve Bank in its conduct of monetary policy.

Given the interconnectedness of the financial system and the broader economy – and the pivotal role that currency plays in the allocation of capital flows – the place of macroprudential policies in regulators’ armoury should be given some serious thought.

It is conceivable that if the US taper gets under way early next year, debate about how to respond to the damaging effects of an over-valued Australian dollar on the economy might also recede. If talk about the start of the taper can have a meaningful influence on currencies and capital flows, you’d expect the impact of the reality of winding back the program to be far more material.