As recently as February this year, the Reserve Bank of Australia supported their guidance that it would maintain interest rates in the highly accommodative territory of 0.1%, until at least 2024. This is despite a Q4 2021 inflation rate of 3.5%, above the 2-3% target band, and with global inflation data heating up. Only several months later, RBA governor Phillip Lowe admitted that such guidance was “embarrassing” and the board “should have done better." How was the RBA so publicly wrong-footed and how do we re-establish conviction in future decisions?
Given the complexity of the RBA’s role, its mandate has been simplified;
The stability of the currency of Australia; The maintenance of full employment in Australia; and The economic prosperity and welfare of the people of Australia. A key proponent of the economic prosperity directive is inflation control, which the bank has been fighting to stimulate over the past decade. The recent guidance misstep was so surprising because the RBA has rarely tried to indicate what the interest rate would be three years in advance, nor does it have a responsibility to do so. Although central banks globally are experimenting with public positioning, ultimately inflation can’t be controlled by statements. Unfortunately for the financial welfare of the Australian people, there is a cost to unwarranted predictions.
An Unwanted Reputation The primary tool used by the RBA to show its commitment to maintaining low-interest rates was to peg the 3yr bond to the cash rate of 0.1%. The 3yr bond rate represents what the market expects the cash rate will be in 3 years. However, by October 2021 the market was questioning the RBA's commitment, pushing up rates on several occasions despite coming up against the weight of money. Governor Lowe found “it difficult to understand why rate rises are being priced in.” That was until Australian, New Zealand and Canadian Q3 inflation data was printed, pushing the 3yr bond peg 5x above its target.
Large trading desks and global hedge funds were in pain - they’d taken significant leveraged bets that the RBA would win in the short term. In an antithesis to the Soros raid of the British pound, this time the 'smart money' had geared up and stood behind the RBA's forward guidance, despite mounting inflation data telling them otherwise.
The issue with the RBA’s broken promise is that egos are bruised, returns are negative, and many sophisticated investors are now shunning Australian bonds. Those on the hunt for higher yields are looking to the greener pastures of New Zealand. The result has been an increased premium in Australian bond yields across short durations – increasing the cost of capital for all Australians. Although Australian bonds have traditionally traded above US bonds, the spread has gradually decreased over the last decade, until recently. It is also hard to explain the divergence in yield with fundamentals, with the U.S. experiencing increased inflation pressures along with a far less interest-rate-sensitive economy. Both indicate that yield spreads should be at historic lows and there is another reason the market is demanding more from Australian bonds.
History in Hindsight The pandemic and subsequent policy responses created challenging conditions for central banks around the world. The Fed’s initial persistence that inflation would prove transitory is arguably as bad as the RBA’s commitment to not raise interest rates. However, the Fed has since made decisive action, regaining confidence from markets, and allowing it to utilise communication to do the heavy lifting. There is a healthy debate that the widening spread is not the result of the RBA’s misstep but rather investors demanding higher rates for Australia’s more cyclical and uncertain economy. Timing does correlate to the volatility spike in markets and an increase in the risk premium embedded in the spread. Realistically, both factors are likely contributors.
You'll also read from the occasional conspiracy economists, that the RBA is aware of what it is doing. Generally touting that the only way out of the enormous debt burden we find ourselves in is to run policies that exacerbate negative real rates. Although the rationale stacks up and such a strategy would provide a further cushion for the tail risk of a Japan-style lost decade of deflation – there is no clear benefactor to this strategy. It is hard to see the RBA negatively impacting Australians today for an unknown tomorrow.
Overcompensation The last 6 months will be one of reflection and will likely form a case study in economy lectures globally. The same RBA now have the public's attention, if not through every second article in the AFR, then via the current interest rate squeeze. In the same way that the RBA was too late in raising rates, are they now making a mistake in the opposite direction – raising too fast? Has the RBA become overly reliant on the market it was so recently burned by to dictate rate pricing? If behavioural finance has taught us anything, a crisis induces bias and the RBA may be primed for overcompensation;
“Once one realizes that they were factually wrong, most try very hard to change that belief, occasionally swinging their beliefs too far in the other direction.”
The current market pricing implies that the cash rate will have to increase at a faster rate than at any time in history. An ascendency many industry veterans were taking with a grain of salt. However, actions thus far indicate there is a real risk the RBA will keep hiking despite increasing evidence that rising inflation is yesterday’s story. In the last month, we've seen the lagging remnants of inflation in the real economy bumping up against the leading indicators of deflation in the financial economy. The RBA’s recent 0.5% hike in August, has placed Australia at a more aggressive pace than almost any other central bank. How did we go from one of the last nations to accept that inflation is here, to the leader in aggressive inflation response, all within 6 months?
Perhaps a more prominent question; Why in Australia, of all developed countries? We are one of few nations whose borrowers are exposed almost entirely to variable-rate debt, that prices directly off the RBA's cash rate. Our allies in countries like the US, UK and New Zealand are primarily exposed to fixed-rate debt and therefore, borrowers are much more insulated from the impact of central bank hikes. Not only that, but Australian consumers have never been more vulnerable to interest rate hikes. Our average household debt-to-income ratio is 187%! Australians are experiencing the sharpest RBA hiking cycle since its experiment with super-sized hikes in 1994, back when households were far less interest-rate sensitive than they are today - with an average household debt-to-income ratio of just 82%. On any metric, it is hard to see why Australia is leading the charge in inflation-dampening policy given our Marco-exposures and late start.
Turning to Tomorrow This article intends to highlight where we are and begin a dialogue around what the RBA of tomorrow might resemble. Australia’s central bank has come a long way since inflation last took control in the 1970s. Today’s modern central bank bears little resemblance to the past; objectives and accountability are clear, and independence is paramount. Anyone in doubt as to whether the RBA falls prey to political pressures should revisit the rate hike 3 weeks before the federal election.
A review of the RBA is already underway. Treasurer Jim Chalmers has overridden the RBA’s generous offer to self-assess and will appoint a panel of independent experts to review the central bank. A sound decision, as it is difficult (read impossible) for any institution to review itself independently and credibly. Former Treasurer and Chair of the Future Fund, Peter Costello, has supported an inquiry into the Reserve Bank of Australia, claiming recent efforts had cast doubt over the credibility of its policies.
Past and present board members of the RBA have rightfully earnt the respect of the Australian public and their insights into this review are imperative. We need to be very careful to not make this process political and encourage an honest assessment of the system.
Monetary policy in Australia has out-sized effects on households. The role of the RBA is arguably the most important in the nation and one we need to get right.
