I recall as a junior bond trader new to the desk at Bankers Trust in January 1991, my first brush with extreme volatility was a geopolitical event involving one sovereign nation invading another.
While this could possibly draw some parallels to today’s events, it’s more an observation of how volatility occurs often without warning, and that the fallout can be harsh to the community and economic stability. Around that time there was severe global inflation, credit shocks, and a response from Central Banks to quickly hit the brakes on interest rates to temper demand and credit availability.
In the interim 30 years there were many extreme exogenous events outside of the usual economic cycle. In the 1990s we had an Asian currency crisis, the Long-Term Capital Management collapse and Russian Financial crisis. The 2000s took things up a few notches with the NASDAQ tech collapse, 9/11 terrorist attacks and a long period of easy credit that led to the proliferation of highly leveraged derivatives over equity and property markets. The Global Financial Crisis, however, swept all before it away and paralleled the stresses of the Great Depression.
Central Banks throughout have aimed to moderate inflationary pressures while stimulating employment, currency stability and economic welfare for their people. Such are the policy goals that drive most Central Bank charters.
Yet in recent years, as the pandemic warranted emergency actions, the role of the Central Bank has moved beyond balancing and checking the financial system to something far more substantive and, perhaps, more sinister. The use of “unconventional policy” in whatever-it-takes volumes has become a trademark of the global Central Bank community.
Such actions include the massive expansion of money supply, and balance sheet and yield curve manipulation as the regulator becomes a major player while acquiring government and mortgage bonds. Most Central Bank charters do not explicitly include authority for such actions, which may indeed be a failing of lawmakers to understand the workings of financial markets and the power of such policy. In the past two years alone, it has become clear that sitting as a president or governor of a Central Bank imbues power possibly beyond that which our elected political leaders hold.
There is no better example of unconventional policy becoming mainstream as the European Central Bank has been performing quantitative easing and setting negative official rates since 2014/15.
These variants on money-printing-to-buy-bonds have seen Central Banks quickly crowd out the free market and become the “elephant in the room”, dominating liquidity and pricing. In aiming to squeeze the yield curve lower to set a reference rate for corporate and retail borrowers cheaper than would otherwise occur, Central Banks ended up with extreme balance sheet expansion and enormous bond holdings.
Anchoring yields at such low levels has led to a huge amount of available risk capital searching for investments, and explains why equity and property markets have been propelled to stratospheric heights.
In 2022, with the pandemic largely managed, the world is left with widespread inflation that has grown steadily along the supply chain with a basis from commodity prices, energy and labour. Still, Central Bank behavior has proven recalcitrant, with few pre-emptively raising rates. There exists a belief that Central Bank policy can somehow remove recessions from the business cycle by allowing rates to remain accommodative while inflation builds.
The Central Bank presence remains dominant in all aspects of the financial system long after Government fiscal policy has run its course in cushioning the effects of community hardship. How will balance sheet buildup be run down? How can rates be normalised with asset markets still deep in bubble territory? Is stagflation a clear and present risk in many economies following liftoff?
These are issues that have been debated among commentators for the past year and largely dismissed by Central Banks, calling inflation “transitory”. This often used and maligned descriptor is now evidence of a Central Bank policy miscalculation. In early 2022, we await concerted actions from many Central Banks to finally address runaway inflation.
Yet now, another war rages between two sovereign nations with Russia being effectively struck from the global financial grid through widespread sanctions. Inflation is set to surge further as key energy supply chains are broken. While undoubtedly difficult to administer with unforeseen events and volatility constantly invalidating Central Bank modelling assumptions, policy guidance must be wisely constructed as the community will base investment and borrowing decisions accordingly.
In Australia, the RBA’s charter makes mention of exactly this goal: “economic prosperity and welfare of the people of Australia”.
RBA Governor Philip Lowe stated on February 2, 2021, “The Board will not increase the cash rate until actual inflation is sustainably within the 2 to 3 per cent target range. For this to occur, wages growth will have to be materially higher than it is currently. This will require significant gains in employment and a return to a tight labor market. The Board does not expect these conditions to be met until 2024 at the earliest”.
Mr Lowe reiterated similar guidance for 10 monthly policy statements before abandoning any reference to dates in December 2021. Meanwhile, evidence across other major economies during this period showed an inflation explosion. For example, annual US CPI was 1.7 per cent in February 2021. In December, it hit seven per cent, a 30 year high. Throughout this entire period, Mr Lowe seemed to believe that price pressures from global supply chains, commodities and labour were not relevant to Australia.
This is, of course, three-year policy guidance during perhaps the most difficult forecasting period in history. While the person on the street may not regularly sift through monthly RBA minutes, investment advisors, TV commentators and economists most certainly do. Where was the RBA Board to provide considered restraint before publishing this nonsense?
Such a strong endorsement on the path of interest rates was a key factor in household borrowings growing at record levels in 2021 for real estate and equity purchases. During this period, the property market saw stunning gains of 24 per cent and private indebtedness grew dramatically (7.2 per cent).
Less than two months later, markets had priced four interest rate hikes within 12 months and some fixed term lending rates jumped by 150 basis points.
It is now expected that official rates will move to 2.75 per cent (a rise of 265 basis points) with rates liftoff as early as June 2022.
At a recent National Press Club speech, a journalist asked Mr Lowe: “By saying rates wouldn’t rise until 2024, have you given the wrong signal to people borrowing in the housing market, and do you bear responsibility for these unrealistic expectations?”
Mr Lowe distanced himself from responsibility and said he did not promise rates could not rise. Indeed, in recent weeks he has stated that rates may rise in 2022, some two years earlier than his statement just four months prior.
This standard of governance is unacceptable.
With Australian inflation now running at 1.4 per cent quarter over quarter (more than five per cent annualised) and US inflation at 7.9 per cent, the war in Ukraine could add another two per cent as energy prices spiral and supply chains further break down.
The extent of rate hikes now required to calm widespread inflation may be significant and could threaten recession in many countries. This leads to mortgage stress and lower property and equity prices.
A leading Australian bank economist expects Australian inflation to persist above the RBA’s two to three per cent target range for 12 to 18 months, depending on how soon they decide to lift rates. He believes the household sector is extremely sensitive to higher rates due to the record debt versus income ratio. Property prices appear to have peaked, and higher rates may trigger a fall of 10 to 15 per cent.
Nevertheless, overly accommodative monetary policy and steadily growing inflation deem rate increases necessary soon. Negative real rates (nominal bank deposit rates minus inflation rate) now have a significant wealth erosion effect for Australians. This can only be mitigated by raising rates to fight inflation.
There can be little doubt that it is time for Parliament to review the powers held by the RBA Governor. In the first instance, the RBA Board is there to debate decisions and guidance, but it’s largely comprised of private sector businesspeople with conflicted interests to keep interest rates accommodative. There is no record of dissent by members who surely could not be in total agreement to publish such a reckless long-dated guidance for many months, which has only served to mislead and harm the people of Australia.
Mr Lowe has single-handedly altered the function of Australia’s financial markets in just two years. The RBA held only four per cent of available Government securities in 2020 and now owns 38 per cent. Exchange settlement balances available to banks sit at $440 billion. M1 Money Supply, according to the RBA itself, has risen 60 per cent in three years.
The RBA is now the major financial markets participant and has an ongoing problem to manage inflation through higher interest rates while unwinding a huge balance sheet with billions in nominal losses.
This same institution has been giving unequivocal guarantees to households on the neutral path of rates.
On March 9, Deputy Governor DeBelle announced his resignation to pursue private business interests and represents a huge blow to confidence in Mr Lowe and the RBA.
With a Federal election due in the coming months, the people of Australia will pass judgement on the handling of the economy and pandemic. It is urgent that the Government review and modernise the operations, decision processes and charter of the RBA so that there is greater wisdom and accountability in setting the course of monetary policy.
The role of RBA Governor has become authoritarian and the risk of policy errors too great a burden for an individual. There is too little visibility seen from the RBA Board in attaining balance for the people of Australia.
Neale Muston has worked as Head of Fixed Income, Asia Pacific, for Merrill Lynch Japan, and as Managing Director at Morgan Stanley Australia and senior derivatives trader at JP Morgan Australia. He has previously written for The Sydney Morning Herald.
