The author has been described by News Ltd as an "iconoclast", "Svengali", a pollie's "economist muse", and "pungently accurate". Fairfax says he is a "Renaissance man" and "one of Australia’s most respected analysts." Stephen Koukoulas concludes that he is "85% right", and "would make a great Opposition leader." Terry McCrann claims the author thinks "‘nuance’ is a trendy village in the south of France", but can be "scintillating" when he thinks "clearly". The ACTU reckons he’s "an enigma wrapped in a Bloomberg terminal, wrapped in some apparently well-honed abs."

Wednesday, November 23, 2011

Will the RBA give financial markets a "Stevens' Put"?

It is fascinating sitting back and watching the tug-of-war over monetary policy between the RBA staff, financial markets, vested industry lobbies, politicians, and the RBA's private-sector Board. Every single one of these constituencies wants lower interest rates with the exception, perhaps, of the RBA staff.

The CEOs of the two biggest banks in the country, CBA and Westpac, have both come out post the RBA's November cut calling for another one. But of course they would: they know that another reduction in rates would be a huge fillip for the housing market, which is where they have 60% of their balance-sheet invested (especially in the case of CBA and Westpac).

The industry lobbies all want lower rates and a lower currency because they are profit maximisers, and know that economic growth will be higher the lower the RBA cash rate goes.

Think about the counter-factual: when was the last time you heard an industry representative, or a bank CEO, call for higher interest rates?

You can put politicians in the same camp. Intimating to (as Gillard/Swan have done), or outright calling for (the line Robb/Hockey have taken), the need for an easing in RBA policy is a no-brainer as an electoral strategy. No politician in their right mind is ever going to really argue for higher rates, even though there are, numerically, more net savers than net borrowers.

Finally, we have the investment banks and financial markets. For the last two decades Australia's financial and superannuation systems have been built around the performance of the domestic share market. It is vital for the revenues generated by investment banks from their stockbroking, corporate finance, and equity capital market businesses. The decline in share prices, M+A activity, and IPOs since 2007 has been devastating for the finance industry, and tangential sectors, such as financial news media, that service them. The same is true of the corporate, retail, government and industry super fund domain, which has yielded members dismal returns as a consequence of being massively, and irrationally, overweight equities.

So the drums are beating from all the major retail and investment banks for the Glenn Stevens' "put". They don't even attempt to hide this in their language. Economists and finance leaders are increasingly calling for "insurance" from the RBA against something going wrong (a "put option" is a form of insurance). We need another rate cut just in case things turn out worse than the RBA is expecting. It would be the RBA's "policy of least regret" to provide a cushion for the economy.

They can smell blood: they already forced the RBA's reluctant hand after just one quarter of low inflation data, which the RBA itself argued could prove, after future revisions, to be a "noisy" anomaly. The markets are currently pricing in a near-100% probability of another cut in December, and they know, correctly, that the RBA has an institutional aversion to setting policy in striking conflict to market expectations. In the RBA's own words, it likes to "smooth volatility", which is why you are seeing its media proxies, like Alan Mitchell in the AFR, try to convince us all that a December cut is unlikely.

The RBA demonstrated with its November decision that this weight of community opinion--the tidal wave of public pressure--has a real impact. As I have noted before, the RBA is genuinely concerned about its "political independence" and about not disenfranchising popular support for its typically unpopular price stability objective (if meeting that objective ever means higher interest rates).

In the AFR this week we had a highly-regarded former Deputy Governor of the RBA, Stephen Grenville, argue that in crises central banks sometimes have to bail-out insolvent banks (a point I have raised repeatedly, and which the RBA's Guy Debelle will tip-toe around in a speech today), accepting, as I have maintained, that "in practice it's difficult to distinguish between illiquidity and insolvency in real time." You bet it is. Amazingly, some people criticised me when I first raised this argument (see here).

But Grenville goes further. He asserts that the US Federal Reserve's funding of the US Government's budget deficit--via the process of printing money to purchase US Government bonds--is sound policy. He does not see this as compromising the Fed's political independence. He also finds no fault with similar initiatives by the Bank of England (noting, however, that politicians may end up crimping the UK central bank). And he implores the ECB to go to its own policy extremes to "save" the Euro.

Grenville argues that central banks acting unilaterally (ie, without a direct electoral mandate) in such a fashion can "compensate for the dithering of the democratic process." He believes that history seems to be judging these measures relatively well and concludes that "there will be time, after the crisis, to return to the narrow task of price stability."

I hold a less sanguine view. I don't think history has judged anything yet. And I don't think central banks have been really tested. That test will come, as Grenville concedes in another article, when sovereign states likely decide that the least costly way to staunch the socio-economic problems they face is through a sustained period of inflation (remember this is more or less the explicit goal of the Fed). It will be then that we learn whether central banks have the political fortitude to raise rates again to achieve their tough price stability objectives. I reckon there's a chance we discover that the public appetite for independent central banks has well and truly waned...