RDP 8702: Open Market Operations in Australia: A U.S. Perspective 2. Interest Rate Volatility and Open Market Operations

This section provides an examination of the scope of open market operations and of the daily volatility of the interest rates that serve as the short-run focus of monetary policy, namely the official market rate in Australia and the federal funds rate in the United States. Specifically, the averages of squared first differences for both selected sample periods and by month are used to examine interest rate volatility. The data are depicted in Tables 1 and 2. The selected sample periods were chosen in an attempt to isolate periods over which policy was unchanging (ie there was not an intentional tightening or loosening of policy). This was done so that policy engineered changes in interest rates do not contaminate the variability measure that is associated with operating procedures. This procedure is admittedly ad hoc and therefore monthly averages have also been included.

The sample periods over which monetary policy in the two countries corresponds most closely is the post float period in Australia and the 8 October 1979 – 30 January 1983 period for the United States. Both of these periods involve an overall tightening of monetary policy as well as the use of lagged reserve requirements. As indicated in tables 1 and 2, the volatility of daily rates over these periods are roughly equivalent in the two countries. For most months these measures indicate daily rates movements on the order of 50–90 basis points. If one looks at the volatility measure over selected sample periods the implication is that daily rates are somewhat less volatile with changes on the order of 30–80 basis points. This type of volatility is inconsistent with an interest rate peg, but it does not rule out a close focus on interest rates in implementing monetary policy.

Another indication that both central banks look closely at interest rates as a guide to policy is the degree of turnover in their portfolio. For example, in 1985/86 the Reserve Bank of Australia's portfolio of $A assets showed only a small net increase, while gross sales were $28.4 billion and gross purchases were $29.7 billion (of course, part of the gross transactions reflected the Bank's foreign exchange transactions). This is similar to the 1980 US experience documented by Friedman (1982) and by Levin and Meulendyke (1982), where the Federal Reserve made gross transactions on its own account of $393 billion while only adding $4.5 billion to its portfolio. A high level of portfolio turnover is more consistent with a focus on interest rates than it is with a policy of direct control of some reserve measure.

While the evidence presented does not conclusively support the hypothesis that both central banks focus exclusively on interest rates there is a strong implication that interest rates play a large role in implementing monetary policy. The analysis now proceeds to investigate in detail the operating procedures and institutional setting in which monetary policy takes place in Australia. Where relevant, comparisons are made with the United States.