RBA Moves Highlight Risks Around Policy Tightening

I disagree with the widely held view that the bond market selloff forced the RBA to capitulate and give up its 0.1% cap on the 10yr yield. In my view it is the data that changed both RBA and bond market views. Global and Australian data had been signaling either a faster recovery or higher inflation than expected. Markets don’t have the institutional constraints faced by central banks and the former therefore tend to react to news faster.

So, the sentence in the RBA policy statement “Given that other market interest rates have moved in response to the increased likelihood of higher inflation and lower unemployment, the effectiveness of the yield target in holding down the general structure of interest rates in Australia has diminished.” does not mean that the RBA has been dictated to by markets.

Rather it means that the RBA policy outlook has changed and that markets understood that it would make no sense for the RBA to try to maintain a policy that has now been made obsolete by economic developments. The sentence above is the second one in a paragraph that starts with, “The decision to discontinue the yield target reflects the improvement in the economy and the earlier-than-expected progress towards the inflation target.”

That said, it is true that a central bank like the RBA is only one of many players in the bond market. In contrast, in the money markets central banks’ monopoly on the supply of reserves gives them enormous market power.  But in the bond market and in broader financial markets central banks have limited control.  They can nudge markets rather than channel them in the direction of their choice. In that sense, QE is somewhat like FX intervention. It can only be successful if it is consistent with the fundamentals.

So, to me the real lesson from the RBA policy change is that central banks, even the Fed that is now the biggest player in the Treasury market, have much less control over financial conditions than they have over short term rates.  For instance, in the US the recent move in 2yr yields has been accompanied by an easing of financial conditions. Since the Fed believes that its policy stance is transmitted through changes in financial conditions, tightening monetary policy could require more rates than currently priced.

But we don’t know because no one, least of all the Fed, has a reliable model of how rate hikes impact financial conditions.  The risk is that raising the Fed Funds rate to chase tighter financial conditions could backfire; in 2005 Bernanke observed that the Fed Funds hikes were not translating into higher yields.  The Fed kept hiking and the rest is history.

My point here is really that the Fed has kept telling us that bringing down inflation would be much easier than raising it. I don’t think so. Fine tuning policy is always difficult but fine tuning monetary policy after 18 months of unprecedented easing, in the context of the reopening of $22tn economy and of unprecedented fiscal consolidation is nigh impossible.  So, if the Fed is really serious about tightening policy and therefore financial conditions, there is a good risk of a hard landing in 2022.

Dominique Dwor-Frecaut is a macro strategist based in Southern California. She has worked on EM and DMs at hedge funds, on the sell side, the NY Fed , the IMF and the World Bank. She publishes the blog Macro Sis that discusses the drivers of macro returns.

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