One of the pillars of the Australian financial system, the independence of the Reserve Bank of Australia to set interest rates, is crumbling. It will soon be apparent to all that if anyone outside the big banks has the power to set interest rates in Australia, it is Treasurer Wayne Swan.
Successive Australian treasurers, including Swan, have endorsed the independence of the Reserve Bank and this new power is not one that the current treasurer desired. And I am not sure that either he or Treasury have fully grasped that the game has changed.
With the benefit of hindsight we should have realised that the ability of the Reserve Bank to be the main determiner of interest rates was weakened when Australian banks in the past two decades — but particularly in the past 10 years — turned their back on using local Australian savers but rather funded their growth by massive overseas borrowing on the wholesale banking market.
At the time, they could obtain funds overseas much more cheaply than local savings and this was a contributor to the large growth in bank profits and the Australian economy. But if we had thought about it, we would have realised that we had greatly lessened our power over Australia’s interest rate destiny.
On two occasions in the past four years, international events have boosted the cost of this wholesale funding and it is possible the current high cost of overseas bank money will continue for a long time.
Right now the fundamental change is being obscured by a treasurer playing politics and blaming the banks. I am sure Wayne Swan knows that if the banks allowed their profits to fall at this time, the cost of this overseas money would skyrocket further, forcing even higher interest rates. But the government is under pressure so Swan must do his part and pass on blame to the nasty banks.
As it happens the Reserve Bank‘s recent analysis of the Australian economy is suspect. They almost raised interest rates around the April-July period of 2011 but thanks to the stand of Business Spectator and later Westpac economist Bill Evans, they were saved from making a major error. I have stepped back because the Reserve Bank began lowering rates, but its latest statements have rekindled my fear that it is again out of touch with what is happening in the real, non-mining Australian world. But let us not make that judgment yet.
But even if the Reserve Bank reduced interest rates, it only affects part of the bank funding base. In other words, the RBA no longer has full power. In my view the only person with that power is Wayne Swan. Overseas investors are scrambling to buy Australian government paper and the government can borrow at much lower rates than the banks. Swan should be ready to tap that market and fund maturing overseas bank borrowing at much lower rates. This would enable banks to lower interest rates. He would make a profit and set some conditions about pass on, etc. Swan would boost the economy and may even lower the dollar.
No treasurer in modern history has had this power and Wayne Swan has not sought it. But when unemployment in non-mining Australia starts to jump, it will be time to exercise it.
*This article was first appeared at Business Spectator
The interest rate on overnight loans in the money market is merely the Reserve Bank’s TARGET and it INFLUENCES, but doesn’t entirely control, other interest rates in the economy. The Reserve Bank uses its domestic market operations to keep the cash rate as close as possible to the target set by the Board, by managing the supply of funds available to banks in the money market. The cash rate is determined in the money market as a result of the interaction of demand for and supply of overnight funds. The Reserve Bank’s ability to pursue successfully a target for the cash rate stems from its control over the supply of funds which banks use to settle transactions among themselves. These are called exchange settlement funds, after the accounts at the Reserve Bank in which banks hold these funds. If the Reserve Bank supplies more exchange settlement funds than the commercial banks wish to hold, the banks will try to shed funds by lending more in the cash market, resulting in a tendency for the cash rate to fall. Conversely, if the Reserve Bank supplies less than banks wish to hold, they will respond by trying to borrow more in the cash market to build up their holdings of exchange settlement funds; in the process, they will bid up the cash rate.
Movements in the cash rate are quickly passed through to other capital market interest rates such as money market rates and bond yields. These interest rates are also influenced by the risk tolerance of investors and preferences for holding funds in a form that are readily redeemable. The cash rate and other capital market interest rates then feed through to the whole structure of deposit and lending rates. In Australia, most deposits and loans are at variable or short-term fixed rates, so there is a high pass through of changes in the cash rate to deposit and lending rates. But because of the other factors influencing capital market rates, and fluctuations in the level of competition in the banking sector, DEPOSIT AND LENDING RATES DO NOT ALWAYS MOVE IN LOCKSTEP WITH THE CASH RATE.
Interesting idea but I think Labor does not want be attacked more for borrowing money.
The Aussie dollar is considered a relatively safe haven now, so the current un-natural differential in interest rates between central banks add extra encouragement to carry trade and over value the dollar. The RBA should cut 50 basis points more for the economy to be in equi*l*ibrium.
excuse the cross post …
The currency is very much apart of the RBA’s job – as described here in the first paragraph of the RBA’s role on its website
“The Reserve Bank of Australia is Australia’s central bank. It conducts monetary policy, works to maintain a strong financial system and issues the nation’s currency. As well as being a policy-making body, the Reserve Bank provides selected banking and registry services to a range of Australian government agencies and to a number of overseas central banks and official institutions. It also manages Australia’s gold and foreign exchange reserves.”
However, unlike inflation (targeted at 2-3%) there is no specific agreement between the Executive and the RBA as to what the RBA should aim for with the currency unlike it’s inflation target role.
Clearly, the lack of a currency policy – other than to do nothing – is a major deficiency in the operations of the RBA in the circumstances we face in 2012.
That a Labor government can be so willful in ignoring the impact of an overpriced dollar on the nation’s economy is probably the biggest issue in the debate about the economy at present. The only reason they get away with it is that it suits the Libs to do nothing and let Canberra burn. So what if half the country burns with it.
Most Australians are far removed from the immediate impact of the dollar and regard a high dollar as a sign of economic strength. Most of the excess in the dollar (above 90 cents) is due to a mismatch in interest rates, combined with a perception that the overall economy is a good position, and along with a politically weak government it has become a sure bet for the foreign central banks and the hedge funds. In fact it’s better than gold as it’s pays a return – rather than costs (albeit a little) to hold.
The constant prattle of Gillard and Swan and Stevens and Gittins and Dy er and Ke ane on the issue would be funny if the consequences of what is happening were not so serious. 28 years of economic development are being flushed down the drain so a bunch of careerists and denialists can worship at the alter of free market ideology despite being surrounded by an ocean of contempt for such by the rest of the G20.
As a card carrying member of Labor party – I have nothing but contempt for Gillard’s claim to good economic management. The GFC was nearly four years ago. The Gillard government currently has no plan for the future beyond the NBN. Gillard is as lazy as Howard was and is working overtime to waste yet another mining boom – just as Howard did. I rarely if ever invoke nationalism – but for once I think our government should put the nation’s economic interests first and stop pretending that everything is rosy and she’ll be right mate…
I share your sentiment though I’m not a Labor voter. It is unre*a*l*istic to demand Austral*ian industry to restructure when the dollar is “un-natural*y” high. I’ve been posting on this subject in the past week hoping someone wi*ll l*isten.
John;
I agree with your description of the M2 and M3, as I believe they were called, but essentially banks with the use and origination of the derivative market have escaped the control of Reserve banks throughout the Western world.
We are still under the influence of the ongoing repairs to the international banks requirements to repair their balance sheets as a result of the GFC.
The abuse of the ‘carry trade’ by the same banks combined with some gullible politicians is the cause of the current Greek cum Euro crisis.