MLC Market Watch

By MLC Market Watch Team

9 Dec 2009

Highly rated

How the Reserve Bank of Australia controls interest rates and economic growth.

The past 18 months haven’t been easy, but the consensus among Australian economists is we avoided a serious recession. The sharemarket dipped, unemployment rose and business and consumer spending fell, but compared to other developed countries, we got off lightly.

There are various theories as to how and why our economy weathered the global financial crisis (GFC); demand for our exports from China, Government stimulus packages, bank guarantees and our strict banking control system have all been cited.

In any scenario, monetary policy played a major role.

We spoke to three experts about the Reserve Bank of Australia (RBA); what it does and why, and its reaction to the GFC.

Alan Oster is the Group Chief Economist at NAB. Mr Oster is a former Adviser to the Federal Treasury in monetary policy and now looks after NAB’s global economic and financial forecasts.

Peter Switzer is one of Australia’s leading business and financial commentators. Peter regularly contributes to The Australian newspaper, he’s the finance commentator on Vega FM and he hosts his own TV show, Switzer, on SKY News Business Channel.

Brian Parker is an Investment Strategist at MLC.

How much influence does the Governor of the RBA (currently Glenn Stevens) have over the setting of interest rates?

AO: The monthly monetary policy decision is ultimately decided by the RBA board, which is made up of a few senior RBA officials and a group of prominent Australian business people and academics. With the help of RBA economists, the Governor recommends to the board the appropriate movement in policy. As far as we can ascertain, since RBA independence, the Board have never rejected the Governor’s recommendation. Hence, the Governor’s influence in setting interest rates can’t be understated.

PS: There’s a lot of input from research done by the bank’s staff plus there is surveying of around 1500 businesses to get a feel for the economy. The other eight directors put their twopence worth into the debate but they would listen to the RBA Governor. Like a CEO of an organisation, he listens, but the buck stops with him.

How much influence does the Government have over the setting of interest rates?

AO: These days the government has little influence over movements in the cash rate. This is in line with other countries and prevents the manipulation of interest rates for political ends. The independence of the RBA was clearly exemplified by the RBA raising interest rates during the 2007 electoral campaign.

How do you think the RBA handled the GFC? Given we seemed to have escaped a major recession, do you think the RBA deserves credit for that?

BP: I think you’d have to say they handled things pretty well. The economy has weathered the storm so far, and monetary policy has to take a big share of the credit. The Government’s budget measures have helped, but when the RBA needed to change course in 2008, they didn’t stand on ceremony. Rates were cut further and faster than ever before, and that did provide a huge boost to disposable incomes at a crucial time. Because Australians tend to have variable rate mortgages, and the bulk of the rate cuts were passed on, monetary policy in Australia has been extremely effective.

What about the Government’s fiscal stimulus measure? Was the impact of this equal to the heavy interest rate reductions of the RBA?

PS: It’s hard to say; both lower interest rates and the stimulus have helped. There’s no measure to prove it, but the massive rate cuts have helped to repair household balance sheets, cut total debt and helped both business and consumer confidence. My guess is the rate cuts were more important, but it is only a guess. Both policies, plus China’s growth and demand, have helped us avoid a technical recession.

With Australia now moving towards recovery, what key areas will the RBA watch?

PS: Inflation and unemployment are the biggies but that means they’ll look at indicators for economic growth. The whole range of indicators will be watched such as retail sales, car sales, building approvals, job ads, business and consumer confidence as well as the health of the stock market. If some surprise curve ball comes out of left field, they could cut rates but, on present calculations, it’s not expected.

What impact would inflation have on the economy at this point in time, and how likely is it to return as a problem?

PS: Inflation in the short term doesn’t look likely and the RBA would be acting now if they thought inflation was a clear and present danger. Monetary policy works with a lag and that’s why the Bank is moving on rates now. The more inflation we get now, the higher interest rates will go and that will slow up, or even choke, the recovery, though I don’t see this as a big issue now.

After the small rate rise in October, is the cash rate likely to go higher? And by how much in the next two years?

AO: Following a series of consecutive 25bp rate rises (having already begun in October 2009), we expect the RBA to push the cash rate up to 4.25% by early 2010. From there, the Board are likely to pause as they view the flow of economic data and gain confirmation that the recovery is unfolding as expected. We then expect around 50 points in late 2010, bringing the cash rate to 4.75% at the end of 2010.

PS: I think the cash rate of interest is heading to 4% by early to mid-2010 and the RBA will then play the game of wait-and-see. Then in 2011, if the global recovery is on track then the cash rate could track to 5% but I hope there is no rush to this level. We’ve gone through monetary madness and our dollar is very high, which also slows down the economy. We live in new and unusual times, and so I think the RBA’s monetary or interest rate policy might also need to be ‘unusual’. This could mean a lower normal cash rate of 4% or so instead of 5%. Let’s keep our fingers crossed on this one!