Why what the RBA says matters – but what they do matters more

The Reserve Bank of Australia (RBA) is a powerful institution. Not only does it drive financial conditions in the economy, but the markets hang on to its leaders’ every utterance.

The rationale for this focus is straightforward.

In the first place the RBA employs a highly trained group of experts to analyse the state of the economy. It also has access to an international network of the latest thinking on practical monetary policy and international conditions.
Its assessment of conditions is subject to robust internal discussion and is not an off-the-cuff reaction. It is tasked specifically with obtaining the “economic prosperity and welfare of the Australian people”.

For these reasons it has gravitas and influence when it gives its opinion on economic conditions and a motivation that engenders trust from the public – and the market listens.

A second reason the market listens is that there is always the possibility that the RBA will signal a change in its policy preferences, a change in emphasis on how important some parts of the economy are in influencing its decisions.

A good example in the current environment is the fears of significant future housing price rises.

There is little historical evidence that central bank interventions can act to curb excessive house price rises. But many economists have commented recently on their concerns that current conditions may exacerbate climbing house prices. Loose monetary policy in the late 1980s is certainly credited with part of the rise in house prices at that time – and with precipitating the early 1990s recession.

The RBA has clearly been taking note of these concerns, prompting a specific comment on its intention to liaise with other regulators in the June monetary policy decision release to contain these risks. This presumably refers to working with the Australian Prudential Regulatory Authority, but unfortunately does not seem to indicate that the fiscal authorities are yet willing to engage wholeheartedly with this difficult issue.

So it makes sense that the markets react to pronouncements of the central bank. And that when the RBA makes a move, or even says a few words, that are not expected, that markets will react – sometimes violently.

The May 2015 easing of monetary policy saw general market approval. The Australian dollar appreciated, although nowhere near as much as it did in response to the Federal Budget which was less austere than expected.

In both the interest rate cuts of February 3 and May 5 the yield curve steepened, indicating that the market assessed these moves as better for long term growth. Historically there is a positive relationship between the slope of the yield curve and growth.

The reaction to the less-austere-than-expected fiscal policy of the Federal Budget is an interesting case in point.

One of the first lessons an economics undergraduate student learns is that it is not a good idea to have monetary policy and fiscal policy working in opposite directions. Monetary policy has been undoubtedly eased in the last several years. However, the political rhetoric has been adamant that budget surplus is an absolute good.

If monetary policy is expected to accommodate not only the monetary policy aims of stimulating the economy, but also to offset tighter fiscal policy to meet rhetoric around budget surplus, the outcomes will be confused.

This explains why the Australian dollar appreciated in response to the less draconian than expected fiscal announcements. Coupled with the gentle prodding from the last few RBA statements on the outlook of subdued public spending, there has been at least some small indication that both major arms of policy are aware of the contradictory approaches to the state of the economy. As an aside these incidents also emphasise the importance of having an independent central bank.

So it is sensible for markets to react to monetary policy announcements. However, they can be misleading on a short-term basis.

Market sentiment is capable of ignoring underlying fundamentals for a relatively long period. Markets may react to marginal news – so that finding out that the fiscal austerity is not as tight as it could have been is relatively good for the Australian dollar in the short-term.

This does not indicate that the whole package of economic policy is on a good track.

If policy does not create a coherent base for strong economic fundamentals for the whole economy, with good investment prospects in future productivity for both human and physical capital, sensible redistribution policies which are not distorting resource allocations (such as the current incentives to over-invest in housing), and a strategic plan for managing its finances through the economic cycle then ultimately our relative position in the world’s economies will falter – and then financial markets will punish our lack of attention to these important aspects of our societal choices.