RDP 8812: International Interest Rate Linkages and Monetary Policy: The Case of Australia 4. The Transmission of Monetary Policy

4a. Domestic Credit Markets

The main operational objective for monetary policy in Australia is the overnight interest rate in the professional money market. Daily market operations by the central bank are used to influence this interest rate, with the effects then flowing through to a wide range of interest rates and to the exchange rate.

Once a change in monetary policy is decided on, open market operations are directed to moving short-term interest rates higher or lower. When the market recognises that a new average level of overnight interest rates is being established, it perceives this as a change in monetary policy, and rates on other private short-term securities tend to change quickly.

Yields on instruments such as bills of exchange, bank certificates of deposit and Treasury notes move broadly in line with rates in the overnight cash market. This means that the central bank effectively has quite a strong influence over the whole short-term interest rate structure and, hence, over the rates charged by intermediaries.

The transmission mechanism for monetary policy is seen as working mostly through these short-term rates and rates charged by financial intermediaries. In Australia, most credit is provided through financial intermediaries. If the cost of wholesale funds to intermediaries rises because the whole short-term interest rate structure has moved up, banks and other financial intermediaries soon raise their prime or indicator lending rates. Most loans (including house mortgages) are variable interest rate loans, where the interest rates are changed periodically in line with movements in market rates. Thus, the central bank's influence on very short interest rates soon spreads to most intermediated lending.

Non-intermediated credit in Australia is provided mainly through the commercial bill market – a market for short-term debt. While this is non-intermediated in the sense that intermediaries do not hold large quantities of bills in their portfolios, it is facilitated by banks who act as acceptors for most of the bills on issue, and by a number of intermediaries who make a market in bank-accepted bills. The existence of reserve ratio requirements on banks' deposits encouraged enormous growth in this sort of financing over the past decade, to the point where it represented about one-third of total lending to the private sector by financial intermediaries.

The market for long-term debt has been dominated by the Commonwealth government (and to a lesser extent by semi-government and local government authorities). While this part of the market is well developed and deep, the corporate bond market is quite small. With the Commonwealth government moving into surplus, however, the private market is now beginning to develop, and it may become large in future years. This may be a factor which will increase a degree of integration of Australian and foreign long-term rates in the future.

4b. The Euro-Australian Dollar Market

While there is only a very fledgling on-shore private bond market, there is now a large Euro-Australian dollar bond market. Outstandings in this market now amount to about $30 billion (compared, for example to $40 billion for the domestic government bond market and $60 billion for the bank bill market). More than half of the Euro-Australian dollar raisings have been by non-Australian borrowers, though a fair proportion of these funds represented one leg of a swap transaction where an Australian borrower was the counterparty and ultimate user of the funds.

Has the growth of the Euro-Australian dollar bond market led to a closer integration of Australian interest rates with world rates? At the margin it must have had some effect. The introduction of any new market involving foreign investors will be a factor in increasing the tendency for Australian and foreign rates to move more closely together.

However, just how big this effect has been is another question. The Australian government bond market was already relatively internationalised before the growth of the Euro-Australian dollar market. By 1987, overseas interests held nearly a quarter of the outstanding stock of Australian government bonds, and at times were prepared to trade them heavily. Overseas holders of Australian government bonds can vary their positions according to their views about future movements in interest rates and exchange rates. The bonds are traded in a deep secondary market with low transactions costs and the availability of hedging instruments such as futures and options contracts.

Euro-Australian dollar bonds, on the other hand, do not trade as readily in the secondary market. They are mainly of interest to medium-term holders who are not liable for withholding tax and who are prepared to accept higher credit risk and reduced liquidity in order to gain higher yields. The Euro market is thus not as suited to speculative or arbitrage opportunities as is the government bond market. On the other hand, the capacity of the Euro market to provide fairly large volumes of new funds on short notice will go some way to keeping domestic and foreign yields aligned.

4c. Other Aspects of the Transmission Mechanism

Because most borrowings by the private sector are at the short end does not mean that long-term interest rates are unimportant. From the point of view of investors, of course, there is still a relativity between long-term bonds and alternative assets, including liabilities of intermediaries, commercial bills, equities and so on. Thus a change in bond yields can be important, but as explained in earlier sections, there is no evidence that central bank operations have lost any of their former ability to influence long-term rates. Indeed the evidence from the term structure equation suggests that long-term rates respond more to variations in short-term rates than logically they should.

Under the present approach to implementing monetary policy, there is no deliberate attempt to influence the long end of the official yield curve in Australia. The Reserve Bank's outright dealings in bonds are fairly small, and not designed to affect yields. There is a substantial amount of re-purchase activity in bonds, as part of liquidity-management operations, but those do not affect long-term yields.

Domestic interest rates are only part of the story of the transmission of monetary policy. In a world of capital mobility and floating exchange rates, a change in domestic financial conditions will, of course, affect the exchange rate.

We accept the evidence from a number of countries that much of the work of monetary policy is done by the exchange rate. However, it is difficult to produce evidence in the Australian case of a separate “exchange rate” channel through which monetary policy has worked. This is because in the five years since the float of the Austrtalian dollar, most of the tightening of monetary policy has coincided with periods when the exchange rate was falling (due to external shocks). Thus the tightening of monetary policy has usually co-existed with an improvement in international competitiveness. In time, when we have had the opportunity to see how the system operates under a wider variety of experiences, it is likely that the exchange rate channel will become more evident as in other countries.