The policy was to tie the three-year bond yield to the overnight rate target, with the aim of lowering the cost of lending up to that term.
The goal was also a de facto commitment not to raise interest rates during that period, to give borrowers more confidence to take on debt.
But the policy met an unworthy end last November as early evidence of rising inflation led the market to test the RBA’s ability to maintain its target. As selling pressure mounted, the central bank chose to differentiate itself from the market and concluded that the policy no longer served its purpose.
Reputational damage an open question
The RBA admitted that many financial market participants were 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 future commitments of this nature by the bank,” the review said. The extent of the reputational damage caused by the withdrawal 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 reputation costs and large movements in market prices, as forecasts and forward guidance based thereon have not been met,” the review said.
The RBA said there were also financial costs associated with defending the target, as the bonds it bought declined in value as interest rates rose. But it said those costs were modest compared to the costs of the bond purchase program (or quantitative easing) and term financing policies.
QE future favorite
Going forward, the RBA said it would be more likely to opt for quantitative easing, which is to focus on a quantity of bonds rather than a price or yield. This allowed for greater flexibility and avoided the exit issues associated with the return target, it said, adding that QE was not without risks; later this year, the bank will evaluate that policy.
Despite the fateful end, the bank said the policy has worked for most of its existence as it led to a record draw of cheap, fixed-rate loans that boosted the economy.
The establishment of a three-year low borrowing rate “led to historically low fixed and variable borrowing rates for borrowers. In response, housing and corporate credit growth accelerated at the fastest pace in more than a decade.”
These low borrowing costs worked by “freeing up cash flows to support the financial position of households”.
“The unusually strong response to house price growth by the standards of past spot rate cuts has provided a significant boost to the achievement of employment and inflation targets through the usual channels of housing investment and consumption,” the review said.
Frank and transparent
Economists and RBA watchers said the report was more self-critical than they expected.
RBC Capital Markets economist Su-Lin Ong described the review as “detailed, candid and quite transparent”.
She said of interest was the board’s agreement to “strengthen the way it considers a full range of scenarios when making policy decisions”.
“Perhaps this will provide more scenario analysis and policy options with a clearer response function as a key outcome of this assessment,” said Ms. Ong.
Economist Saul Eslake said the Reserve Bank’s mistake was setting a date for how long interest rates would remain at record lows “which to my knowledge no other central bank did”.
“It’s not often that people in high office admit they’ve done something wrong, or recognize that their reputation has taken a ‘hit’, so it’s to the credit of the Reserve Bank and the Governor for having that on this occasion. and have indicated that they have learned something from the experience,” said Mr Eslake.
Meanwhile, ANZ economist David Plank said the bank was “honest about the issues”.
“Let’s not be too hard on them, in hindsight 2020 is when things were happening at a breakneck pace,” he said, although the exit was always going to be a “messy” affair.
“The market thinks there’s a chance it will exit, either you have to own all the bonds, or you have to give up the target. Either way, you end up in a difficult position.”
Richard Quin, the head of Bentham fixed-income fund, which actively shorted bonds during the first half of the year, said it was “bizarre” that the central bank stuck to its moderate prediction that cash interest rates would not rise before 2024 .
“They were so wrong and had a chance to be a bit more normal about things earlier in the year, and they didn’t take it,” he said.
The review is not the first study into the effectiveness of the policy.
In May, a New York Federal Reserve Report Completed that yield curve control policies have boosted the Australian economy, but their effectiveness has crumbled as the bond market lost confidence in the central bank’s hold on monetary institutions.
The Fed’s investigation found that yield curve management tended to be through a “super narrow” channel, impacting only specific Australian government bonds affected by the RBA’s purchase transactions, but there were no spillovers elsewhere.
“The RBA bought up the target bond, but accomplished little else,” it said. In other words, the policy has failed to achieve its main goal: easing financial conditions.
The forced removal of the link, at the hands of the market, sparked 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 reprimanded the bank for not engaging in quantitative easing, which it eventually did.
In May, Governor Philip Lowe admitted his erroneous prediction that rate hikes wouldn’t happen until 2024 was an “embarrassing” mistake when he raised the benchmark.
The Reserve Bank will also face an independent, bipartisan investigation, the most detailed examination of its capabilities since the 1997 Wallis investigation.
The Australian Financial Review reported this week that Treasurer Jim Chalmers plans to appoint a panel of independent experts to conduct the review.
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