De-mystifying RBA Setting of Interest Rates

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My pre­vi­ous blog post on the RBA not­ed their ten­den­cy to fol­low a Tay­lor Rule pri­or to the GFC. A col­league points out anoth­er sta­tis­ti­cal reg­u­lar­i­ty that holds either side of the GFC, and right back to 1990: the RBA’s deci­sions fol­low the 90-day bank bill. Below are Phil Williams’ obser­va­tions on this issue.

In the days run­ning up to the first Tues­day of each month, the Aus­tralian pop­u­lace is sub­ject­ed to the excru­ci­at­ing pageantry of whether the RBA Board will increase or decrease inter­est rates, or whether they will keep them on hold for anoth­er month.

Econ­o­mists take a break from their rou­tine of por­ing over moun­tains of sta­tis­tics and econo­met­ric mod­els to come forth and give their solemn prog­nos­ti­ca­tions to an ador­ing pub­lic. Finan­cial com­men­ta­tors spring to life like wildlife awak­en­ing from the first rains of the wet sea­son, wait­ing with bat­ed breath on what those extra­or­di­nary men and women of the RBA Board might decide.

And then the press state­ment is released, trad­ing floors spring to life and news­pa­pers splash forth on what it may mean to the lives of the heav­i­ly indebt­ed peas­antry. This month­ly cha­rade also gives politi­cians an oppor­tu­ni­ty to spruik their wares. And then we wait for the process to start again next month.

As a human­i­tar­i­an, I would like to save us from this dread­ful spec­ta­cle and give each of us the oppor­tu­ni­ty to track what the RBA might, or might not do in real time. In so doing I hope to de-mys­ti­fy the process, by stat­ing that the RBA does­n’t lead the way in set­ting rates, the mar­ket does. The RBA is a fol­low­er, not a leader.

The fol­low­ing graph plots the 90-day bank-accept­ed bill rate (red line) and the RBA tar­get cash rate (black line) from Jan­u­ary 1990 to 28 July 2011. The blue line at the bot­tom shows the per­cent­age dif­fer­ence between the two rates. The data is sourced from the RBA’s own web-site, Table F1, “Dai­ly Inter­est Rates and Yields – Mon­ey Mar­ket”.

The graph shows an almost 100% cor­re­la­tion between the cash rate and the 90-day bank bill rates. How­ev­er the data also shows that in almost every instance the RBA cash rate FOLLOWS the 90-day bank bill rate, rather than leads it. The data also shows that the RBA will gen­er­al­ly increase rates once the 90-day bank bill rate gets 50 basis points or more above the RBA cash rate. The actions on the down­side are not as tight, with decreas­es in cash rates occur­ring when the bank bill rate is any­where from 0 to 100 basis points below the 90-day bank bill rate. How­ev­er as a rule of thumb the RBA tends to decrease the cash rate when the 90-day bank bill rate is 50+ basis points low­er than the cash rate.

This analy­sis rais­es a num­ber of inter­est­ing ques­tions:

1. Why do we have the RBA as an inter­est-rate set­ting body at all when all they do is fol­low the mar­ket?
2. Why does the RBA shroud itself in such mys­ti­cism when their actions are so trans­par­ent to all?
3. What is the qual­i­ty of our econ­o­mists, politi­cians and finan­cial com­men­ta­tors that we have to go through the “Will They or Won’t They” pan­tomime each month?
4. How could any econ­o­mist get their fore­casts wrong, par­tic­u­lar­ly on the up-side?

I can only say one thing in defence of the RBA. They are not as destruc­tive as the Bank of Eng­land, the ECB or the activist US Fed­er­al Reserve.

Phil Williams