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Wednesday, October 6, 2010

RBA will not bail out failing banks

A couple of weeks ago I wrote that Terry McCrann had called an October rate hike with the consequence that financial markets had favourably shifted the probabilities of this event coming to pass. I argued that, “I would love to see the RBA pause in October to prove the ‘Shadow Governor’ wrong…it is silly that he still moves markets based on pure speculation, which has its legacy in the RBA historically wording him up.” Regular readers will recall that I’ve pressured the Bank to cease this practice for over a year.

A few days later I argued that HSBC’s newly appointed chief economist, Paul Bloxham, was “probably the best current guide to the trajectory of rates over time.” This claim was, rather ruefully, contested by McCrann in a subsequent article. As is now well known, Bloxham was calling a non-consensus October pause followed by a total of five hikes before the end of next year.

A final element of my thinking in the lead up to yesterday’s Board meeting was the logic that the RBA was more likely to hike in October than November for the reasons I outlined here.

I was proved wrong on latter call but right on the others. I should have known something was up. I shot an email to a friend yesterday morning noting that it was odd that none of the other RBA voice-pieces—Alan Mitchell, Ross Gittens, or Michael Stutchbury—had written their standard pre-meeting briefings anticipating the result.

So it turned out that Australia’s central bank sensationally wrong-footed Terry McCrann—the ‘former Shadow Governor’, as one economist described him last night—for the first time ever within a week of a Board meeting. In what is a major governance win for the Bank, McCrann, who remains our best rates commentator, will never hold the same sway with markets again.

The somewhat ironic downside to all of this is that we have been subject to much higher financial market volatility as a direct result of the unprecedented confusion surrounding the RBA’s intentions. Many hundreds of millions—if not billions—of dollars were lost by banks yesterday investing on the basis that an October hike was a done-deal.

The RBA’s executive used to think that it needed to ‘word up’ commentators before Board meetings precisely to ‘smooth-out’ these interest rate expectations. As I have argued countless times before, the problem with this approach is that it undermines the Board’s ability to second-guess the executive’s recommendations when the world has been deliberately guided to focus on a specific outcome. And the Board is the only check taxpayers and politicians have on the non-democratically elected executive.

The current volatility is thus the short-term pain the RBA has to wear as it migrates to a new, and much improved, governance and communications regime under its excellent Governor, Glenn Stevens. In this respect, most of the economics community is scratching its head today trying to work out how they got it wrong. The RBA would be well-advised to facilitate this process by shedding light on what factors influenced its thinking in the Minutes and speeches that are scheduled in coming weeks.

For what it is worth, Bloxham’s October call was a triumph. After more than a decade at the RBA, he had just been appointed HSBC’s chief economist. His prediction of an October pause was courageous since it: (a) would have been far safer to hedge by saying that October was an even-money bet with November more probable (instead he stuck to the line that October was no-go); (b) recent RBA rhetoric had convinced 80 per cent of his peers that rates would rise with the market pricing in a similar probability in the hours before the decision; and (c) if Bloxham had got his first, very high profile call wrong, his credibility as a rates seer would have been shattered.

Indeed, Bloxham ‘doubled-up’ his position by reaffirming the prediction in an ‘updated’ research note issued less than 40 minutes before the 2.30pm announcement. Some might say this was ethereal prescience. Either way, it looks like he will temporarily succeed McCrann as the market-mover de jour.

The final chapter in what was an exciting day was the scuttlebutt that the decision had been vigorously debated at Board level, and may have even run against the grain of the executive’s recommendation.

The risk to the RBA’s October inaction is that the third quarter inflation pulse is weak, which is entirely possible given we’ve had the unusual conjunction of a destabilising federal election leading to a hung parliament, the apparently unfounded spectre of a double-dip recession in the US, and sovereign debt hysteria in Europe. Applying Bloxham’s logic that the RBA is ultimately dictated to by the inflation data, a low print potentially pushes the Bank to the sidelines until the first quarter of 2011. And if the RBA does hike in the face of very benign inflation outcome, it will look rather silly for pausing in October.

By delaying today the RBA is focusing a great deal of attention on past information instead of taking the opportunity of breaking this pattern and demonstrating that it is setting policy with its future, through-the-cycle forecasts in mind.

This is particularly hazardous given that under Glenn Stevens’ four-year term ‘core inflation’ has averaged between 3.4 and 3.5 per cent per annum, which is significantly above the RBA’s mandated 2-3 per cent target. And esteemed commentators like McCrann and Stutchbury are highlighting this failure for the first time. The concern is that if this performance persists it will surely eat-away at the RBA’s credibility and inevitably start raising long-term inflation expectations. The case for going in October was that you were erring on the side of policy conservatism even if that meant rates would have been a little higher than you might otherwise have liked. One wonders what more hawkish central banks like the ECB or Bundesbank would have done in the same situation…

In closing, I want to offer some further thoughts on the new ‘Statement on the Conduct of Monetary Policy’ that the RBA has struck with the Treasurer. Last week I showed how this gives the Bank latitude to irregularly lean against asset price and credit growth innovations in the short-term even when its inflation-targeting framework counsels inertia.

There was a second important modification to the Statement that has gone largely unnoticed by the commentariat. While acknowledging its role as a lender of last resort to institutions in crisis, the RBA has added this ostensibly curious rider to its financial stability responsibilities:

“The Reserve Bank's mandate to uphold financial stability does not equate to a guarantee of solvency for financial institutions, and the Bank does not see its balance sheet as being available to support insolvent institutions.”

At first, I thought this was just jaw-boning. After all, it is contradictory. The fact is that if any retail bank is subject to a sustained liquidity shock, they risk immediate insolvency given the asset-liability mismatches that underpin their business models. The RBA showed during the GFC that it would vouchsafe the banks’ liquidity during such circumstances. So when I read this paragraph I had thought that it was just RBA rhetoric seeking to insure against moral hazard by declaring that ‘there are no guarantees that we will bail you guys out.’ Given all the major banks are too-big-to-fail this appeared like an empty threat.

But my friend Matt Johnson at UBS offered a more nuanced insight. We had previously discussed how we thought the Governor was concerned about the ‘politicisation’ of monetary policy in the US and UK as central banks engaged in quantitative easing and effectively encroached on traditional fiscal policy territory.

In this context, Matt’s view, which I agree with, is that the new text in the Statement is the RBA effectively telling government, If you want to recapitalise failed institutions, that is your prerogative. But it is not the RBA’s job. So use Treasury. In short, by including this new caveat the RBA is quarantining its balance-sheet against the vagaries of political decision-making. A non-trivial development.