How to steer a super tanker T

IN DEPTH - How to steer a super tanker
Page 1 of 5
January 31
Platform Plus
How to steer a super tanker
By David Clark
Contents for this
Asset, May 2001
Barrie Dunstan
Tony Muston
Peter Bobbin
Michael Rice
David Drucker
is all bull.... about the science of monetary policy. All bull ...
Every month for years we had papers on credit growth, the yield
curve, etc, the relation to GNE, and it was never any good at
prediction. Never. You have to be able to feel what is
happening.' (Former treasurer and prime
minister, Paul Keating, quoted in John
Edwards' Keating: The Inside Story).
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Monetary policy setting in the 21st century
is best likened to trying to steer a giant
super tanker through a very dangerous,
narrow strait. Not only does the Reserve
Bank have to anticipate the reefs long
before they are nearby, it is uncertain just
how quickly or significantly the brake-less economy ship will react to
any interest rate change-induced adjustments to its course. Worse,
it has to keep its eyes open for unpredictable, destabilising currents,
which are the product of previous monetary policy decisions or
inactions, or massive unpredicted fogs, like the Asian crisis of 199798, which can also send its compass spinning furiously.
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It also has to deal with academic and business economist seagulls Looking at
who try to distract its course-setting by bombing it with media alternatives
campaigns and other self-promotion exercises.
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And, making comments about the navigation of a ship, looking
backwards from its stern is a lot easier, and safer, than looking
forward from its bridge.
No wonder investors - and their advisers - have trouble assessing
the likely impact of any interest rate changes. What is so important
about the RBA decision each month about whether to change the
'cash rate'?
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This term refers to official
rates in the short-term
money from those who want
to keep their funds highly
liquid - 'at call' - and invest it
in appropriate assets.
The RBA aims to achieve a
target overnight interest rate
(the 'official cash rate') - the
interest rate on overnight
loans in the short-term
IN DEPTH - How to steer a super tanker
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money market. (This is where money can be parked, earning
interest, until needed) This rate defines the price at which RBA will
supply reserves (short term government securities) to the shortterm money market.
Thus, to increase the money supply, the RBA buys government
bonds from the public. Conversely, to decrease the money supply,
the RBA sells government bonds to the public.
Each month, usually on the first Tuesday, the Reserve Bank board
meets to decide whether it should alter its current target cash rate
and the decision is announced a day later.
In making its decision, it looks well into the future. It is not reacting
to the latest economic news but to what it thinks will be the news
several months down the track. It also has to make assumptions
about what will happen to the global economy, world interest rates
and the value of the $A over that period.
Worse, it has to look backwards as well as forwards. The trouble is
it can take many months before the full effects of its previous
interest rate decisions come through the economic pipeline and it
has no simple guidance as to how long such transmission effects
It does know, however, that interest rate changes can affect
economies via six main variables - and investors and investment
advisers should note these carefully:
Postponed consumption, or what economists fancily call
'intertemporal substitution'. For example, a fall in rates may
encourage less saving and more consumption.
Wealth and perceptions of wealth. For example, a fall in
rates can reduce the wealth of persons whose incomes are
heavily tied to interest rate levels.
Credit supply. For example, a rise in rates may increase the
supply of funds.
The exchange rate. For example, all other things being
equal a fall in our interest rates relative to those of other
economies may reduce the demand for the $A and hence its
relative value.
Borrowers' liquidity and ability to service their borrowings.
For example, lower interest rates can mean that borrowers
can afford to borrow more and/or the cost of servicing their
existing borrowings falls.
Expectations of what the effect of any change or nonchange may have on future inflation and growth. For
example, after high inflation and interest rates relative to
most other economies in the 1980s, it has taken nearly a
decade of much lower levels of both to apparently change
expectations about future inflation and rates.
The length of the transmission lags from monetary policy to output
has been the subject of much research over the years, but there are
serious problems in isolating the lags with any precision. One 1997
Reserve Bank study by David Gruen and others used a simple
econometric model of Australian output to try to estimate the length.
It concluded that output growth falls by about one-third of 1 per cent
in both the first and second years after a one percentage point rise
in the short-term real interest rate, and by about one-sixth of 1 per
cent in the third year.
This implies an average lag of about five or six quarters in monetary
policy's impact on output growth. Note that the researchers
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admitted, however, that 'each of these estimates is subject to
considerable uncertainty'.
There is also the question of how quickly changes in the cash rate
are passed on to bank customers. In recent years, banks generally
have been quicker to pass on interest rate rises than cuts. The
Howard Government has been particularly active in putting
pressure on the banks to do so in recent years.
Why is it so difficult to predict the effects of interest rate changes?
Reserve Bank and other research suggests three main reasons:
The first is that much of the theory of monetary policy rests on
assumptions for which there is only limited empirical support. One
key example suffices here. Are financial markets forward or
backward looking when it comes to their expectations about
inflation and interest rates?
Most monetary theory assumes the former. However, an OECD
study of what determines interest rates found that a country's
credibility regarding inflation control is a key factor and that it can
take up to a decade for markets to get over past poor inflation.
Yet, in recent years markets have consistently over-estimated
inflation and although economic modellers like to appear scientific,
they have also a poor record regarding inflation and inflationary
The second reason why interest rate effects are so difficult to
predict is a 'chicken-and-egg' problem - or to use the fancier term,
simultaneous causation.
This means that effects of interest rate changes can be very difficult
to determine if the changes themselves are largely systematic
responses to movements in other macroeconomic variables - for
example, the growth and/or unemployment rates - that they also
For example, the level of our interest rates relative to those of other
economies can affect the demand for our currency and its value
relative to other currencies. In turn, our exchange rate can affect
our relative interest rates.
The third and final reason is that it is very difficult to separate the
effects of recent interest rate changes on the economy from the
delayed effects of previous interest rate changes.
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True, such uncertainties have been reduced a little by the following
- admittedly reluctant - steps taken by the Reserve Bank in recent
years to make its conduct of monetary policy more transparent:
Changes in policy and related reasons are now more clearly
announced and explained.
The bank has improved its public commentary on the
economic outlook and issues bearing on monetary policy
settings, through public addresses and its regular quarterly
The release of bi-annual statements on monetary policy and
the role it is playing in achieving the bank's objectives.
These statements include information on the outlook for
inflation and on recent developments in financial markets.
Twice yearly appearances by the Governor before the
House of Reps standing committee on financial institutions
and public administration, which enable members to crossexamine the Governor on the RBA's decisions.
What have we learned about monetary policy over the past
decade? Three big lessons stand out:
The first lesson is that the effects of interest rate changes are
asymmetrical - that is, rises in rates tend to have a bigger and
quicker impact than reductions in rates. In technical language, in
recessionary times expectations of low sales and profits overwhelm
the positive cashflow effects of lower interest rates. But we have no
simple guides to either the length of the lags or the magnitude of
their effects.
The second is that it is very difficult to separate the effects of
current interest rates on the economy from the delayed effects of
previous interest rate changes. Hence, when the Reserve Bank
makes decisions about whether to change the cash rate - or simply
leave it unchanged - it is uncertain not just about the present and
the future but about effects still to come from its previous interest
rate decisions.
The third is that monetary policy cannot be used to super fine-tune
the economy - and business should not expect the RBA to be able
to predict the full effects of its actions or inaction. The lags are
simply too unpredictable.
Finally, one should remember that the mere announcement of a
rate change - or of a change in the RBA's general philosophy - can
in itself change the mindset of key markets. But such changes are
exactly what Ian Macfarlane wants to achieve.
This was first pointed out 20 years ago by a governor of the Bank of
England. More recently, a US economist, Robert Lucas, got a Nobel
Prize for re-iterating the point.
Indeed, the next time the Reserve Bank or the US Federal Reserve
announces another change in interest rates, pin the following
sagacious remarks to your keyboard: The best time to change
monetary policy is always six months ago.
Useful web site:
Dr David Clark teaches business economics at the University of
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