Tuesday, August 21, 2007

Tuesday column: Just because the US is cutting interest rates...

Throughout the world central banks have been “injecting liquidity into the system” and the US Federal Reserve has cut one of its key interest rates. This means that Australia is now most unlikely to push up rates, right?

Wrong. If anything it means our Reserve Bank is more likely than before to push up Australian rates.

Sorry Mr Costello. And if you have any say over it, pencil in the election for the Saturday before the Reserve Bank’s crucial meeting on Melbourne cup Tuesday.

I’ll get back to what it means to “inject liquidity” and what it means to push rates up and down in a moment. Many of us don’t really know, and I suspect the wizards who control our central banks quite like it that way. It gives them mystique...

But first - if you want to get an idea of what Australia’s Reserve Bank is likely to do on Melbourne Cup Tuesday, you only need to ask it.

That’s what ten government and opposition members of the parliament’s economics committee did on Friday when the Governor of the Bank, Glenn Stevens appeared before them.

He told them his chief concern was Australia’s climbing rate of inflation. As he put it: “We are clearly very fully employed, and we are getting a stimulus from the rest of the world which is quite powerful… we are at a point where we are certainly more worried about inflation being too high than we would be about inflation being too low.”

Inflation is climbing towards the very top of the Reserve Bank’s 2 to 3 per cent target band and (we can’t be certain of this yet because the official figures are historical) may have already climbed beyond it.

The next official figures are out in nine weeks’ time on October 24, almost certainly right in the middle of the election campaign.

Should Australia’s underlying rate of inflation be continuing to head toward 3 per cent – notwithstanding the last rate hike – or have moved beyond it the Bank will consider pushing up rates at its Melbourne Cup day board meeting, and make the announcement at 9.30am the next day, Wednesday November 7.

It’s a fair bet that by itself the August interest rate hike won’t have done enough to stop the inflation rate climbing. There’s a saying in financial markets: interest rate hikes are like cockroaches – there’s never just one of them.

Might the Governor and the board hold their fire because an election campaign was underway?

Extremely unlikely. As Governor Stevens himself put it to the committee: “I don’t think there is any case for the Reserve Bank board to cease doing its work for a month in the month that an election is going to be. I doubt very much that members of the public would regard that as appropriate.”

“Should the inflation data or other data make that case I feel we would have no choice, nor should we have any choice.”

But what about the perilously weak state of financial institutions in the United States – a weakness now spreading to institutions as far flung as France’s BNP Paribas and Australia’s Macquarie Bank.

That doesn’t much concern Australia’s Glenn Stevens, unless it means there is some sort of worldwide economic slowdown which brings down Australia’s rate of inflation anyway.

He told the committee that it was “true that the United States is weak, but other areas of the world have been accelerating over recent times, particularly China which is very important to Australia.”

Earlier this month he pushed up rates even though he could see the US crisis coming. “We could see that there were tensions in global markets to some extent. We did not think at that time that those things were likely to make a difference to the macroeconomic outlook sufficiently to outweigh what we thought was a pretty clear case for a modest adjustment to interest rates. I still think that.”

But would he push up rates again, at a time when the US Fed was actually cutting rates? He answered this question firmly (if indirectly) by pointing to what financial markets expected.

As he put it: “The markets are pricing in cuts by the US Federal Reserve, which doesn’t mean the Fed will do it, but they are pricing that in and they are still I think pricing in an increase by us within the next year. That doesn’t mean we have to do that either, but current expectations are quite different between the two countries - not without reason, I would say.”

Stripped of any vestige of ambiguity, the Governor’s words mean that he believes financial markets are right to expect him to push up rates even if US is cutting them. If needed, he won’t hesitate to do it.

Indeed, to the extent that a cut in US interest rates makes a worldwide slowdown less likely it’ll make him more likely to push up Australian rates, not less.

Powerful, isn’t he?

It’s time to let in on a fairly well kept secret. The Reserve Bank can’t really push up interest rates (or push them down, for that matter). It can only try.

When the Reserve Bank announced two weeks ago that it had “decided to increase the cash rate by 25 basis points to 6.5 per cent” it wasn’t telling the complete truth.

Until Glenn Stevens took over as Governor late last year the wording was more modest. It said the Bank “will be operating in the money market this morning to increase the cash rate by 25 basis points”.

The hidden truth is that Glenn Stevens and the Reserve have little more power than anyone else attempting to influence the price of anything.

If you wanted to push up the price of oranges at the Kingston markets you could do it buy buying a lot of them. So could the authority that runs the markets. In this case, the authority, the Reserve Bank, succeeds because it’s more determined, and other traders know it. It will keep buying cash (issuing pieces of paper called bonds in return) until it has pushed up the price of cash – called the interest rate - as far as it wants.

If it wants to cut the price of money, it lends it freely (the equivalent of flooding the fruit market with oranges) until it has pushed down the price, known as the interest rate.

That’s what it and other central banks do when they want to “inject liquidity into the system”. They lend until there’s enough money around to make sure no-one goes under.