Reaching again for the rates potion

Has the Reserve Bank's current cycle of easing monetary policy ended? The recent consensus has been that improvements in the global economy mean it has. But hours after the confusion over the Italian national elections started affecting financial markets, one of the Reserve Bank's most senior officials has warned the central bank could cut interest rates even further "to counterbalance the pressures” of the strong Australian dollar.

Speaking in Adelaide this morning, Guy Debelle, the Reserve Bank's assistant governor overseeing financial market operations, made the bank's options more clear: not selling the currency, but cutting rates. He said: "To date in Australia, we have been able to counter the effects of the higher Australian dollar with lower interest rates, as my colleague Phil Lowe described recently. We still obviously retain scope to lower interest rates further, should the need arise, including to counterbalance the pressures of an elevated exchange rate,” he told a business breakfast.

Doubts that Italy's elections would produce a stable government, or even one composed of mature human beings capable of making decisions to set the economy on the straight and narrow, caused bond yields in Europe to jump for Italian debt and the key US 10-year bond yield to drop as the so-called safe haven effect appeared. US shares dropped sharply, down more than 200 points, and ours opened lower, though the Australian dollar fell by more than half a cent in Asian trading.

Markets face a big test Wednesday night, Sydney time, when Italy is due to try to sell 10-year bonds to raise several billion euros. Market volatility has awakened in the last week since the US Federal Reserve and the Bank of England revealed surprise changes in sentiment about quantitative easing and Japan continued to confuse markets with its plans.

It was also the biggest fall in US shares and bond yields since last November. Making life tougher in US markets is the growing game of bluff in Washington over the huge budget cuts that will start flowing from "sequestration” on Friday, March 1. In the face-off the Republicans and President Obama will go as close to the deadline as possible to get their way, worrying the life out of markets in the US.

The Fed split and other developments knocked the value of the Australian dollar down by more than a cent, but it recovered on Friday in the wake of Reserve Bank governor Glenn Stevens' appearance before the House of Reps Economics committee, in which he was more confident than expected about the rebound in the non-resource sector of the economy. But he wasn't all that confident that intervening to sell the dollar to drive it lower would work. Stevens told the committee that while he thought the dollar was "somewhat” overvalued, he doubted the bank would intervene by selling the currency, noting "you need to be pretty confident that it is seriously over-valued, or the market is behaving in some quite irrational way, before you would launch large-scale intervention”.

Debelle's comments suggest, however, that other forms of central bank response to the strong currency were being considered, although he warned that cutting interest rates too far could also create problems for the economy – forcing up the price of assets and causing people to borrow more than they could afford. "It can generate excess credit expansion or asset price inflation or imbalances elsewhere in the economy," he said. "The current experience of Canada, Hong Kong and Switzerland is salient in this respect.”

But Debelle noted that the bank's rate cuts over the past two years had less of an impact on mortgage rates than in the past, due to higher bank funding costs. "‘The cash rate has a large influence on lending rates, but there are other factors such as credit risk premia, competitive pressures in the deposit market, as well as changes in the mix of funding banks use," he added. "Over the past five years, there has been quite a material change in a number of these factors, so that while changes in the cash rate are still the predominant determinant of changes in lending rates, the relationship between them is not one for one.”

He also reflected on the challenges posed by widespread quantitative easing for countries like Australia that retain firmer monetary policies:

"This can leave the countries that are receiving these inflows with a difficult choice. They can decide to offset the effects of the higher exchange rate with expansionary policy too. A number of commentators say this is clearly a good thing for the global economy, and is in stark contrast to the 1930s, where countries responded with tighter policy. The argument is that given a deficiency in global demand, further expansionary policy elsewhere helps to redress the fact that there is no scope in the major economies for lower rates, given they are already at zero.

"The next line of argument is that such concerns can be alleviated by the appropriate deployment of ‘macroprudential' policy tools. But there are large uncertainties about how effective such tools really are.

What Debelle was doing was engaging in the easiest form of central bank intervention, 'jawboning' – giving the markets a nudge and trying to keep them off balance as volatility jumped off the back of the past week's developments. The dollar dipped after he spoke, then rose, all under $US1.30. We can expect more of these nudges, not regularly, but at odd occasions, such as the minutes of various board meetings and speeches by senior officials.

The downgrading of the UK's rating at the weekend will make jawboning less effective because there are now fewer gold-plated AAA-rated economies (those with AAA-stable ratings) – just 11, including Australia. The confusion and tensions in Italy will add to those difficulties, but it can be easier to give the markets a push when they are nervy, rather than bullish and focused on rising, without a care in the world, as there were before the Fed revealed the extent of the split over the future of its multibillion-dollar third round of easing.

This story first appeared on www.crikey.com.au on February 26. Republished with permission.