Though markets had somewhat priced in an Australian interest rate cut yesterday, many analysts and commentators were still left surprised.
The rate had not been cut for 18 months. Over that period commentary varied over the entire gamut of the need for both increased and decreased rates. But the markets have until this point been largely satisfied with the expectation of little change.
This time the markets were concerned. The falling value of the Australian dollar showed their uncertainty about the likelihood of a move (although the direction was fairly well expected).
What can we learn from the market reactions and the extent of the cut?
Norwegian economist Tore Ellingsen and Swedish central banker Ulf Söderström have argued that the behaviour of the yield curve following a rate cut clearly indicates the nature of the surprise experienced by the market. To sum up, if the yield curve simply shifts this represents the extent to which the change in the interest rate reflects changes in the economic environment as assessed by the central bank. On the other hand, if the yield curve rotates this represents communication of changing preferences over the economic aims of the central bank.
This simplification of their theoretical model is useful in the current context. First of all, it is very evident that the Australian yield curve did not rotate in reaction to the news yesterday. There is no evidence the central bank has changed its preferences in relation to its economic aims. The rhetoric in the bank’s statement and the market actions as a result do not show any inconsistency with the policy concerns that all players in the market are familiar with. This should be comforting.
The fact that the yield curve shifted means the markets were surprised by the action to some extent. One mechanism of surprise can be that the markets are waiting for validation of the expert view in the market from the central bank in the face of considerable uncertainty – and this may well be the most compelling argument for the current action.
Many academic economists (myself included) supported a continuation of the 2.50% rate as the most appropriate path last week. However markets were unsure; in this case the cut seems to have served to increase transparency about policy and the economic situation, helping to anchor expectations. Taken to its extreme the transparency argument suggests that a central bank with strong rhetoric will almost never surprise financial markets, as expectations will be managed via other communication means.
So how does the Reserve Bank of Australia (RBA) perform in communicating its policy intentions in general?
A steady hand
New research in collaboration with former Treasury economist Edda Claus (based on a methodology we developed), compared the policy surprises generated at the RBA, Bank of Canada and the US Federal Reserve over the last two decades, and found the RBA is less likely to surprise.
The RBA appears to be particularly good by international standards in providing clear policy guidance to markets and sticking with a consistent policy agenda. Even during periods of significant market stress, the changes in policy preferences and direction do not surprise the market to the extent evident in Canada and the US.
The global leadership of the US markets may explain some of the greater evidence of surprise in Fed actions, but the comparison between Canada and Australia is of considerable interest. Studies that use institutional factors to measure transparency clearly favour the Bank of Canada as more transparent than the RBA. Yet, the market evidence, which directly addresses the question of “do the markets understand the actions?”, clearly favours the strategies of the RBA.
The actions of the RBA in reducing the cash rate, accompanied by the rhetoric in the press release, seem to be part of the RBA’s consistent moves to clarify its current assessment of the economic situation for the market. This has reassured the market that there is no departure from its policy aims and agenda.
The reassurance that monetary policy is well in hand is likely to be a calming influence in what are unsettled international conditions over which Australia has no control. This has to be a good thing.