The policy was to peg the three-year bond rate to the target overnight rate, with the aim of reducing the cost of borrowing to that maturity.
The aim was also a de facto commitment that interest rates would not be increased during this period, to give borrowers more confidence to take on debt.
But the policy came to an undignified end last November as the first evidence of rising inflation led the market to test the RBA’s ability to hold the target. As selling pressure mounted, the central bank opted to distance itself from the market, concluding that the policy was no longer relevant.
Reputational damage an open question
The RBA admitted that many in the financial markets had been burned by its decision to drop the target, including those who expected it to be retained.
“As such, this experience could reduce the effectiveness of any future engagement of this nature by the bank,” the review said. The extent of reputational damage caused by his removal was an “open question” but could only be assessed in the long term.
“Many other central banks have also been surprised by the strength of the economic recovery and inflation, with associated reputational costs and large market price movements, as forecasts and forward guidance based on these have not been complied with,” the review said.
The RBA said defending the target also had a financial cost, as the bonds it bought had lost value as yields rose. But he said those costs were modest compared to the costs of his bond-buying (or quantitative easing) program and term funding facility policy.
Preferred EQ in the future
Going forward, the RBA said it would be more likely to opt for quantitative easing, which involves targeting a bond quantum rather than a price or yield. This provided greater flexibility and avoided the exit problems associated with the yield target, he said, adding that QE was not without risks; the bank will conduct a review of this policy later this year.
Despite its unfortunate end, the bank said the policy worked for most of its existence as it led to record underwriting of cheap fixed-rate loans that boosted the economy.
Setting a low three-year borrowing rate “has led to historically low fixed and variable lending rates for borrowers. In response, housing and business credit growth accelerated at the fastest pace in more than a decade.”
These low borrowing costs have worked by “freeing up cash flow to support household finances”.
“The unusually strong response in house price growth by the norm of previous cash rate cuts has been a major boost in progress towards employment and inflation targets through the usual channels of investment and of consumption in housing”, indicates the review.
Frank and transparent
Economists and RBA watchers said the report was more self-critical than they had expected.
Su-Lin Ong, an economist at RBC Capital Markets, called the review “detailed, candid and quite transparent.” She said the interest was the council’s agreement to ‘reinforce how it considers a full range of scenarios when making policy decisions’. Ms Ong said: “Perhaps this will provide better analysis of scenarios and policy options with a clearer reaction function as a key outcome of this review.”
Economist Saul Eslake said the Reserve Bank’s mistake was to set a date on how long rates would stay at record highs “which, to my knowledge, no other central bank has done” .
“It’s not often that people in high office admit they’ve been wrong or acknowledge that their reputation has taken a ‘hit’, so it’s to the credit of the Reserve Bank and the Governor that they did on that occasion, and indicated that they learned something from the experience,” Mr. Eslake said.
Meanwhile, ANZ economist David Plank said the bank was “honest about the issues”.
“Let’s not be too hard on them, the hindsight is 2020, back then things were happening at a blistering pace,” he said. “The market thinks there’s a chance it will come out, either you have to own all the bonds or you have to give up the target. Either way, you’re in a tough spot.
Richard Quin, the head of the Bentham bond fund, which had been actively shorting bonds throughout the first half of the year, said it was “weird” that the central bank stuck to its dovish prediction that the cash rate would not increase until 2024.
“They got so wrong and had the opportunity to be a little more normal about things earlier in the year, and they didn’t take it,” he said.
Previous Reviews
The review is not the first review of the policy’s effectiveness.
In May, a End of New York Federal Reserve Report that the yield curve control policy helped stimulate the Australian economy, but its effectiveness collapsed once the bond market lost confidence in the central bank’s grip on monetary parameters.
The Fed study found that yield curve control operated primarily through a “super narrow” channel where only specific Australian government bonds targeted in RBA buys were affected, but it did not. There were no fallouts elsewhere.
“The RBA redeemed the targeted bond, but did nothing else,” he said. In other words, the policy has not achieved its main objective: to ease financial conditions.
The forced removal of the peg, at the hands of the market, has led to criticism of the central bank, including by former treasurer Peter Costello who said his credibility had suffered.
The RBA has been constantly criticized for not doing enough. In November 2020, former Prime Minister Paul Keating chastised the bank for not engaging in quantitative easing, which it eventually did.
In May, Governor Philip Lowe acknowledged his mistaken forecast that interest rate hikes would not occur until 2024 was an “embarrassing” mistake as it raised the benchmark rate.
The Reserve Bank will also be subject to an independent review, which has garnered bipartisan support, marking the most detailed examination of its capabilities since the 1997 Wallis inquiry.
The Australian Financial Review reported this week that Treasurer Jim Chalmers intends to appoint a panel of independent experts to conduct the review.
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