RDP 8812: International Interest Rate Linkages and Monetary Policy: The Case of Australia 1. Introduction

This paper is about the determination of long-term interest rates in Australia. It examines the role of domestic short-term interest rates and overseas rates in explaining movements in Australia's long-term rates. The main aim is to see whether there has been any change in the relationship over recent years.

In keeping with the BIS outline, the questions and conclusions of the paper can be summarised in four parts:

1. Are long-term interest rates in Australia more volatile than formerly?
2. Are they more closely synchronised with international rates than formerly?
3. Are they less influenced by short-term interest rates than formerly?
4. Are any observed changes in the behaviour of long-term interest rates related to the increased liberalisation of capital movements or to the changed exchange rate orientation of monetary policy?

The work below suggests that the answers to the first three questions should be in the negative, but that the answer to the fourth should be positive. Such results – for example, that long-term interest rates are not more closely synchronised with world interest rates – may seem surprising in view of the experience of other member countries. However, we feel the result is not unusual – the explanation is to be found in recent structural changes to the Australian financial system and policy framework. It is necessary to take these into account before it is possible to make sense of the answers to the four questions above. For this reason, the next section of this paper outlines the major structural changes that have had an important bearing on the behaviour of interest rates and exchange rates.