Reserve Bank of Australia Annual Report – 1985 The Bank's Market Operations[1]
The Bank implements monetary policy primarily through operations in domestic money and securities markets. In 1984/85, those operations were conducted in a rapidly changing market environment. It was the first full year with a floating exchange rate; remaining controls on bank deposit interest rates were abolished in August 1984; and the interest rate ceiling on bank loans under $100,000 was removed at the end of April 1985 for all purposes other than owner-occupied housing. Some important changes were also made in the market instruments used by the Bank, its operating techniques and its broader relationships with the markets.
In August 1984, the Bank commenced trading with authorised money market dealers in repurchase agreements based on Commonwealth Government securities. This facility has now become a normal part of the Bank's operations, providing extra flexibility in coping with patterns of cash flows. Also in August, loans by banks to authorised dealers, where secured by Commonwealth Government securities, were included respectively as savings banks' prescribed assets and trading banks' LGS assets; these loans are included in the trading banks' prime assets ratio (PAR) which replaced the LGS Convention requirements at the end of May 1985.
From the beginning of January 1985, the Bank changed its arrangements for dealing with the market in Commonwealth Government securities. It now deals primarily with authorised money market dealers in securities within a year of maturity. The major exception is the special arrangement under which the Bank sometimes buys very-short-dated bonds from banks for liquidity management purposes. The Bank's purchases and sales of bonds with more than a year to maturity are now conducted with a group of dealers selected on the basis of their trading volume in the bond market. The initial list of 21 reporting dealers includes banks, authorised money market dealers, merchant banks, stockbrokers and specialised securities dealers. The list will be reviewed from time to time.
1 Monetary Aggregates and Yields
In May 1985, the Bank extended the range of published information on its market operations. The additional information includes an indication each morning of the Bank's dealing intentions for the day and a weekly summary of its market operations and of market conditions generally.
The Bank's market operations are co-ordinated with the Commonwealth Government's debt management operations. During 1984/85, the Government financed its net domestic spending wholly through primary sales of securities to the public, mainly through bond tenders. The bond tender programme was concentrated in the first half of the year (see panel) to accord with the seasonal pattern of the Government's net spending. In the March quarter, heavy volumes of Treasury notes were issued to provide cover for the tax collections in April and May.
As 1984/85 opened, domestic financial markets were relatively calm and interest rates generally were tending to fall. Many commentators, on the basis of patterns of previous years, were looking for further falls during the September and December quarters. The Australian dollar had weakened over the final months of 1983/84 both against the U.S. dollar and on a trade-weighted basis.
| Tender Number |
Date Held |
Amount Offered and Allotted ($m) |
|---|---|---|
| 17 | 10 July 1984 | 1,200 |
| 18 | 28 August | 1,200 |
| 19 | 25 September | 1,100 |
| 20 | 23 October | 1,000 |
| 21 | 4 December | 1,000 |
| 22 | 22 January 1985 | 850 |
| 23 | 28 May | 1,200 |
July to September
Late in July, good news about inflation and money growth over 1983/84 engendered bullishness in money and securities markets. With interest rates falling overseas, particularly in the United States, domestic interest rates also began to decline. The market's optimism was reinforced by the announcement in early August of the Commonwealth's Budget for 1984/85. The projected deficit of $6.7 billion was smaller than many in the market had expected.
Interest rates continued to decline into the early part of September. By this time, however, financial data were pointing to stronger growth of money and credit than had appeared likely a month earlier, and stronger also than could be readily accounted for by the effects of deregulation. The Bank's market operations were designed to tighten financial conditions. The Bank pressed sales of securities when cash was in surplus and was sparing in providing accommodation on days when the market experienced cash deficits.
Part of the market's earlier optimism had stemmed from a slight weakening in the U.S. dollar from early August, raising the possibility that the long upward climb of that currency might be at an end. This boosted the demand for Australian securities in August. It also helped to strengthen the Australian dollar, in trade-weighted terms as well as against the U.S. dollar, despite the decline in domestic interest rates. Conversely, the sharp recovery in the U.S. dollar in September helped dissipate the Australian market's optimism on interest rates. By the end of the month, rates had risen by up to a percentage point from their low points earlier in the month. Longer-term interest rates also rose, though less strongly.
The Bank's operations in the foreign exchange market during the September quarter were very small.
October to January
Borrowing and lending by financial intermediaries continued to grow strongly between October and January. On the other hand, there were signs, including National Accounts data for the September quarter, of a weakening economy. The conflicting pictures presented by the various indicators posed something of a dilemma for the monetary authorities.
2 Interest Rates
By the end of October, preliminary figures put growth in deposits of all financial intermediaries over the September quarter at about 4½ per cent. Growth in lending was slightly higher at 5 per cent. Demand for credit by business looked stronger than had earlier been suspected. Also unexpected was the evidence that non-banks as a group were growing more rapidly than banks.
The overall pace of financial intermediation was too rapid for comfort. However, there were doubts about the strength of economic activity. There were also qualifications to the raw financial data. New statistical collections, commenced only in July, indicated that the figures for non-banks were being inflated by transactions between financial intermediaries (‘double counting’). The removal of interest rate controls from bank deposits from 1 August had set in train competitive factors which were not fully understood at that stage but which seemed to have boosted aggregate figures for both deposits and lending. Banks were clearly competing more aggressively for lending business with greater confidence of being able to raise the necessary deposit funds in whatever mix of maturities best suited the market at the time.
3 Growth in Credit
The strong growth of non-bank financial institutions as well as banks was, in the circumstances, a cause for some concern. The increase in bank bills on issue, a substantial proportion of which went into non-bank portfolios, offered a partial explanation. Money market corporations and other intermediaries were also actively promoting new lending products to meet the added competition from banks. To some extent this appeared to be attracting business previously handled on a direct financing basis. However, data were not available to confirm or test the extent of this latter factor.
In its market operations, the Bank took account of the tendency already in train for markets to tighten as a result of earlier actions. Interest rates on marketable securities had not yet responded fully to firming of policy from mid September. Despite the change in policy, market expectations that yields on short-term securities would fall during the December quarter were quite persistent. A number of institutions held bill portfolios that were yielding less than the cost of funding them. The Bank expected that as these institutions became less optimistic about interest rate falls they would seek to reduce their portfolios, putting upward pressure on market yields in the process.
Also in the ‘pipeline’ were probable adjustments to interest rates paid and charged by banks. Banks had lowered their lending rates on large overdrafts in August, and this had probably been a factor in their high volume of lending in September and October. With the cost of funds rising, and expected to rise further over coming months, banks were facing pressure to reverse earlier rate cuts.
In the event, financial conditions tightened steadily but perceptibly over the final months of 1984. Short-term interest rates rose almost 2 percentage points during November and December; longer-term yields rose by between a ½ and 1 percentage point. Towards the end of 1984, nervousness about funding conditions in the coming June quarter seemed to add to upward pressure on interest rates. This factor assumed less importance in early January after the Bank issued a statement on the likely shape of the seasonal run-down.
Banks were slow to raise their lending rates, with the result that overdraft lending grew at the expense of the use of bill facilities. Bank balance sheets continued to expand rapidly but there were signs of moderation in the growth of non-bank financing.
The Bank's market operations were complicated in the early part of 1985 by industrial action by some public servants which delayed the collection of taxes and other items of Government revenue. One effect was a substantial unforeseen boost to deposits held with banks and other intermediaries from funds that would normally have been withdrawn to meet tax obligations. The impact was not great in December and January. Most taxes due in that period had been collected before the work bans took effect. The major impact was felt in February.
Market rates on overnight and call money were relatively steady in January, but yields on longer-term bonds declined from around mid month. Initially, this seemed to be a minor correction of rises that had occurred in nervous trading through December and early January. The Government's announcement on 15 January that foreign commercial banks and some foreign government agencies could henceforth invest in Australian Government securities may also have been a factor in the markets' greater bullishness.
February to April
The February-April period was marked by considerable volatility in the foreign exchange market and a substantial fall in the value of the Australian dollar. Some of the nervousness affecting foreign exchange trading spread to domestic money and securities markets. Early in the period, Commonwealth public service bans on revenue collections added to uncertainties.
The Australian dollar had been relatively strong in the first half of 1984/85 and market conditions had been fairly stable. The picture changed abruptly from the end of January. Against a background of wide fluctuations in major currency relationships on overseas markets, the Australian dollar depreciated over the first three weeks of February by around 15½ per cent against the U.S. dollar and around 13½ per cent against the trade-weighted index. The Bank's operations in the foreign exchange market were much heavier in February than in other recent months.
The reasons for the change in market sentiment are not entirely clear. The strength of the U.S. dollar was undoubtedly an important factor. A range of economic and political factors also seemed to contribute, including, importantly, the growing deficit in the current account of the balance of payments. The suspension of the monetary projection no doubt played a part.
The effects of the public service work bans again disrupted domestic financial markets in February. The volume of funds uncollected was very large at times, adding to public liquidity and complicating the task of monetary management. Despite substantial market operations by the Bank, it took some time to bring things under control, and financial conditions were less firm than desired in the early days of the month.
As the delayed tax collections were processed in the second half of February, the opportunity was taken to allow financial conditions to tighten. Overnight and call money rates and yields on marketable securities all rose sharply. By the end of the month, yields on longer-term paper had also risen.
The Bank maintained its generally firmer approach to market operations through March and April. Overnight and call rates continued to rise from their end-February levels. Yields on market securities also increased in a lagged response to the tightening of policy in the second half of February. Responding to the higher cost of funds and the general trend in market rates, banks and other financial institutions raised many of their interest rates.
Despite some nervousness, the foreign exchange market was relatively settled during March. The Australian dollar weakened a little in trade-weighted terms but was fairly steady against the U.S. dollar. The Bank's foreign exchange operations in March were modest in amount.
April saw another period of severe disturbance in the foreign exchange market and a further sharp depreciation of the Australian dollar. It weakened by over 11 per cent against the trade-weighted index in the first three weeks of the month, bringing the net depreciation since late 1984 to over 25 per cent.
As in February, the Bank was again a heavy net seller of foreign currency in the market. Coincidentally, the volume of net sales was much the same in the two months.
The firming of financial conditions, the foreshadowing of a May economic package from the Government and a growing view in the market that the fall in the Australian dollar had been excessive, contributed to a small rally in the currency at the end of April.
4 Markets For Foreign Exchange
May and June
The exchange rate fluctuated in early May, then levelled off at around 6 per cent above its April low against the trade-weighted index. It remained relatively stable throughout the final weeks of the financial year. At the end of June, the trade-weighted index was 65.0, almost 18 per cent below its level at the end of June 1984 and over 22 per cent below its peak in November 1984.
The Bank's transactions in the foreign exchange market over the final two months of the financial year were relatively small and less frequent than in April.
Domestic financial conditions in May and June were not greatly influenced by economic developments abroad. They were, however, subject to a range of locally-generated influences. A delay in the company tax instalment in May caused it to coincide with monthly PAYE tax collections, producing a tendency for money market conditions to tighten and short-term interest rates to rise. Intermediaries were preparing for the final bond tender of the year and for the effects of large end-year transfers of funds from the private sector to Government.
The higher interest rates on overnight and call money led to slower-than-normal settlements for bonds issued in the tender. As the end of the settlement period overlapped with June PAYE tax collections, this again put upward pressure on interest rates.
During this period, the Bank was very active in domestic markets and fully offset the withdrawal of cash from the system as a result of the Government's transactions, including the bond tender. Nonetheless, cash rates rose further in the first half of June, reaching very high levels in the unofficial market on a few days. The competition for deposits by intermediaries seeking to fund overdrafts or to replenish deposits lost as a result of tax payments and bond settlements was the major factor. Banks made substantial calls on short term money markets for funds, reflecting the lower-than-usual levels of available liquid assets they carried into the seasonal run-down period.
Money market rates declined later in June and were affected to only a minor extent by end-of-financial-year pressures. Similarly, bill yields, which had risen sharply for a few days in the first half of the month, returned subsequently to levels prevailing at the end of May. Persistently high costs of funds led to further rises in rates paid and charged by banks and some other intermediaries in May and June.
The Bank judged it appropriate, in the conditions applying in late June, to take a small step in the transition to full operation of the Prime Assets Ratio (described in the following Chapter). The minimum level of prime assets which trading banks were required to hold under the transitional arrangements was reduced by $140 million.
At the end of the year, financial conditions were generally firm. Interest rates, other than in particular areas like loans for owner-occupied housing and some personal loans, were much higher than a year earlier. Borrowing and lending by financial intermediaries were still growing strongly but less rapidly than in the earlier part of the year.
Footnote
*Detailed quarterly surveys of the Bank's market operations during 1984/85 appeared in the October 1984, February, May and August (forthcoming) 1985 issues of the Bank's Bulletin. [1]