Polynomix

Polynomix

Will the real Glenn Stevens please stand up?

The Reserve Bank: waiting for tapering. AAP

Quick quiz: which southern hemisphere central bank governor from a large island continent said this in June 2012?

“There are big benefits to us as consumers from the high currency…We shouldn’t wish too quickly for a lower exchange rate…The (high) exchange rate is one of the devices that is imparting to us the higher wealth that the mining boom brings…That’s how all of us here are actually taking some of that higher wealth.”

Contrast this with his December 18, 2013 statement:

“The Bank has described the exchange rate as ‘uncomfortably high’, and suggested that balanced growth in the economy would probably require a lower exchange rate.”

Well, which is it, Glenn? Are you spreading the wealth or actively diminishing it?

For a month now, Governor Stevens and other RBA members have been verballing the Oz dollar in an attempt to spook markets into driving it down. A bit like a football coach who thinks he can win a match just with the sound of his own voice.

Now, I’m all in favour of handing out bonkers bonuses to people who wear striped shirts, braces and drive Porsche 911s. But I don’t think a central bank governor should be giving speculators a free kick from point-blank range. Especially by telegraphing through a loudhailer that he’s not cutting interest rates further. And that the RBA may intervene to drive the $AUD exchange rate down further.

So now hedge funds have a nice little insight into the deepest policy recesses of Martin Place and can take Australian dollar positions in the secure knowledge that the Bank cannot move on rates until its next meeting in February 2014.

This week, the US Fed may have saved the Australian dollar’s bacon, announcing it will taper its bond purchases, which have injected $85 billion per month into the US economy under its third quantitative easing programme (QE3).

The strength of the Australian dollar is also due to its safe-haven status, as investors fled to strong currencies and gold in the wake of the GFC.

But how did we get into this position? Why do we have high interest rates by global standards and a strong dollar, coupled with a weak manufacturing export sector?

The crux of the problem is this: the RBA and successive federal governments have - mostly - been running policies in direct contravention of each other.

Put on your floaties

It was 30 years ago today (almost) that Sgt. Keating taught the dollar to float. That was the day Australia gave up its monetary sovereignty to often-fickle international currency speculators.

Before December 1983, the Secretary of the Treasury, the Deputy Secretary from the Department of Prime Minister and Cabinet and the RBA governor met Monday-Friday, before 9.00am (when the markets opened), to set the narrow bands of adjustment within which the Bank would defend the Australian dollar exchange rate, buying or selling currencies, as required.

Relative parity (i.e., roughly 1:1) with the US dollar – the most important currency – was the general objective. This was known as a fixed-exchange rate regime (although that descriptor was not particularly accurate). China did roughly the same thing with the US dollar until 2005, ensuring the yuan RMB did not appreciate excessively against the currency of its biggest export market. So: $US down; yuan down.

This worked just fine. Until Australia’s share of world trade halved between 1973 and 1983. This was due largely to the loss of the UK and Commonwealth markets as Britain entered the EU in 1973.

The 1983 float meant Australian joined the rest of the world – a decade late. Nixon’s US dollar float in 1971 was quickly followed by the pound sterling (1971); the deutschmark (for 5 minutes); and the yen (1972). Once Australia floated, the New Zealand dollar was forced to join the 20th century as well. In 1985.

Why float?

The problem with a fixed exchange rate was that the RBA’s hard-earned was being handed to currency speculators on a silver platter. Every time speculators sold the dollar down, the RBA would buy it back again, at a fractionally higher rate. This put millions into the pockets of speculators. And Porsche’s pockets as well.

Presumably, the RBA governor and the bureaucrats also got sick of the sight of each other every morning at 8.00am. Like being married, really.

Mission: Impossible Trinity

One of the immutable laws of economics is that you cannot have all three of the following:

  1. A fixed exchange rate.
  2. An independent central bank setting monetary policy autonomously.
  3. Capital mobility.

This is known, variously, as the Mundell-Fleming model, the ‘impossible trinity’ or the ‘trilemma’.

Put simply, it means a country can only have two of these things at any one time. Governments are forced to pick two options, resulting in trade-offs and compromises.

In 1983, Australia abandoned fixed exchange rates for a floating dollar. Keating boasted he had the RBA “in his pocket”, which meant that Treasury was still calling a lot of the shots on monetary policy. The Bank was not granted formal independence by the ALP; it was left to LNP Treasurer Peter Costello to give the RBA formal independence. By way of gratitude, the Bank raised interest rates during the 2007 election, damaging Howard and Costello significantly.

Interestingly, in his Fightback package in 1991–93, LNP leader, Dr. John Hewson, lifted the Bundesbank’s model and sought central bank independence and statutory inflation-rate targeting set at 2% per annum. The RBA still has an inflation target, but it’s not statutory.

The perils of intervention

The RBA board: does the left hand know what the right hand is doing? RBA

Australia undertook a ‘managed float’ in 1983. This means that the RBA retains the option of exchange-rate intervention when the $AUD rate and the economy are in disequilibrium.

Like now, for instance.

By contrast, a ‘dirty float’ is akin to currency manipulation. Central banks, often in collusion with domestic banks as proxies, deliberately distort exchange-rates by, say, aggressively selling down their own currencies to force rapid depreciation.

The biggest intervention was in 1992/93. The most recent was in October-November 2008. On both those occasions, the RBA intervened to save the dollar from a downward spiral. The 2008 intervention amounted to a piddling 0.47% share of average daily turnover.

Did it work? No.

In the first 10 days of October 2008, the dollar crashed from $US0.796 to $US0.655. By 1 December (i.e., after RBA intervention), the rate was $US0.648.

So the RBA spent $AUD3.75 billion in two months. With zero effect.

One more thing: in November-December and February 2009, the Bank cut the cash rate aggressively by 2.75%. Why did the bank shore up the exchange rate while loosening monetary policy? Did the Board not know what the forex desk was doing?

Why was the RBA running two concurrent, inherently contradictory policies?

The RBA claimed it was to inject liquidity into the system. It had also intervened in 2007, again on the grounds of liquidity.

But global credit markets were frozen. So why bother intervening with a paltry few billion? You’re either serious about providing liquidity or you’re not. The US Fed and the ECB were serious: they implemented virtually-unprecedented monetary policies, domestic rescues and wide-ranging financial market stimulus.

Why Governor Glenn can’t intervene

Governor Stevens: the reluctant interventionist. RBA

In his recent book, Dog Days, Ross Garnaut argues that we need to get the exchange rate down to bridge the productivity gap and, to accomplish this, there’s room for interest rate cuts.

Although I disagree with Garnaut – you can’t cheat your way to genuine competitiveness by undertaking manipulative currency depreciations – Stevens and Garnaut also differ on this point.

The RBA is clearly not going to take the ‘nuclear option’: maintaining the Federal funds rate at close to zero per cent for 20 consecutive quarters has been the ‘exhorbitant privilege’ of the US Federal Reserve, with the advantage of controlling the world’s principal reserve currency.

The European Central Bank has also aped this strategy with progressive cuts to the fixed rate, with euro market lending always several percentage points lower than the RBA. The ECB cut even further as recently as November, dropping the rate to an historically-low 0.25%.

The Bank of Japan sure knows how to make a cheap yen: set interest rates to zero. Yes – zero. It started in 1999. And here’s a recent chart so you can see what a straight line looks like.

Collaborative policy

Spend, spend, spend: the stimulus injected $42 billion into the economy. Krug6

One of the few recent examples of – brief – coordination between the Commonwealth and RBA was during the 2008 GFC. Rudd and the RBA combined to inject a massive dose of fiscal and monetary stimulus, respectively, commencing in the last quarter of 2008. Between September 2008 and February 2009, the RBA almost halved the cash rate from 7.00% to 3.25%.

In February 2009, Rudd delivered up to $950 in cash per person in a $42 billion stimulus package.

Compare that with the RBA’s cash rate and the exchange rate in early 2008. In March 2008, the Bank increased interest rates by 25 basis points to 7.25%. By mid April, the Australian dollar was valued at over $US0.94.

But in the wake of the October 2008 rate cut, the dollar fell 4 cents in late October, crashing to $US0.61.

From convergence to divergence

But from October 2009, the Bank began increasing rates and did not cut again until November 2011. At the same time, Commonwealth fiscal outlays in 2009/10 hit 26% of GDP for the first time since 1994.

That was the last time federal fiscal policy and Bank monetary policy coincided. From 2010/11, the ALP cut spending significantly, under increasing pressure from the LNP opposition.

The outcome? A roaring Australian dollar appreciation.

To summarise: the RBA got it wrong on at least three occcasions. First, Bernie Fraser’s maintenance of very high interest rates in the late 1980s, helping induce the 1990s recession; second, the RBA’s monetary policy in 2007/08 saw rates continue to rise through early 2008, even though the implications of US sub-prime crisis were clear by mid-2007; and, third, the Bank’s rate increases in 2009–10, even as the Commonwealth stimulus was pulled back, served to push the dollar beyond parity in 2011.

The consequences

Don’t fall asleep. Pay attention at the back there, Stevens. What were the consequences of these divergent two-track policies?

  1. Fiscal spending cuts: this withdraws capital from the economy. Oz dollar up? Check.
  2. RBA increases cash rate and holds. Oz dollar up? Check.
  3. Trade surplus blows out to deficit in 2012 as we board 17-hour Qantas flights to LA. Oz dollar up? Check.

On point (3), remember how the RBA didn’t cut rates again until November 2011? They only cut because the $AUD blew out to $US1.0199 in mid October.

It took the RBA almost two full years before it cut the cash rate to 2.5%. Too slow. Too late.

The $AUD did not drop below $US1.00 until May 2013. Not-entirely-coincidentally, that was the month Ford announced the closure of its local manufacturing operations.

Why currency manipulation won’t fix everything

We should all be concerned that the RBA appears to have no long-term strategy to address the fundamental disequilibria in the Australian economy: the profitable resources sector versus the uncompetitive manufacturing sector; the gap between the demands of property investors versus the issue of housing affordability; the need for savers to derive a reasonable return on their deposits; and the maintenance of a high level of consumption demanded by the retail sector.

Instead, the assumption of all federal governments since 1983 has been that “the exchange rate will fix everything.” It hasn’t. And it won’t. Depreciated exchange rates merely disguise factor productivity underperformance; they do not resolve what are structural issues in the Australian economy.

No guru. No method. No teacher.

Commonwealth governments should also shoulder much of the blame for the unhappy patchwork quilt they have assembled over the last 30 years. The manufacturing centres of Victoria and South Australia risk becoming rust belts as manufacturing is ignored in favour of resource extraction in Western Australia and Queensland.

As the mining boom slows and the Commonwealth derives decreased revenues from hollowed-out manufacturing states – not to mention the pressures on Australia’s food growers – the budget deficit is likely to expand, rather than shrink, unless the Abbott government takes drastic measures to reduce the structural deficit (or it borrows more).

Neither interest rate cuts nor exchange-rate depreciation will do much to alter these unpleasant realities. Both the Commonwealth and the RBA are constricted in terms of their options. Drastic cuts to middle-class welfare (such as reforming negative gearing) are politically unpalatable to any government that seeks re-election. Equally wage cuts, pauses or freezes to increase labour productivity (in the form of a Work Choices 2.0) are politically improbable. Work Choices lost Howard the 2007 election; Abbott will not be crossing that Rubicon anytime soon.

Equally, no RBA board will sanction action in the form of either drastic exchange-rate intervention, or extreme monetary policy measures to force down the dollar. The RBA has never been a policy entrepreneur. And it’s not about to start now.

Let’s conclude with a bit of mischievous scuttlebutt about why RBA officials might have a vested interest in maintaining the investment property market Ponzi scheme (in case you missed it in 2010):

“Interestingly, it appears that Reserve Bank officials are the keenest investors in rental properties…Of the 200 occupations classified by the Australian Tax Office, the employees at the Reserve Bank topped the list with respect to their investment property exposure.”

Ah, bankers. They never die. They just lose interest.

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