RDP 8908: Capital Flows and Exchange Rate Determination III. Monetary Management in the Post-Float Period

The floating of the exchange rate provided the final pre-condition which enabled the Reserve Bank to conduct its monetary policy by orthodox open market operations. Monetary policy is now implemented by buying and selling government securities in a way which has its most immediate impact in a rise or fall in the rate of interest on overnight funds (equivalent to the Federal funds rate). While short-term interest rates are the instrument of monetary policy, its ultimate aim is to influence the movement in a nominal variable, such as inflation or nominal GDP. In this sense, therefore, it is directed primarily towards an internal objective rather than towards an external one, such as the exchange rate or current account.

That being said, there are times when movements in the exchange rate may be an important indicator of the need for monetary action, even within a framework where monetary policy is directed primarily towards an internal objective. For example, a falling exchange rate may provide additional evidence (to that already being provided by economic activity, money supply, etc.) of inflationary pressures, and hence the need for monetary tightening. There may also be other occasions where the exchange rate may fall (or be in danger of falling) so far that it puts unacceptable strains on the capacity of domestic prices and wages to adjust to its impact without generating excessive inflationary pressures. In both of these situations, one would expect to see a central bank responding to a falling exchange rate by raising short-term interest rates.

It is only necessary to point this out because for about half of the post-float period, i.e. between the beginning of 1985 and late 1987, monetary policy has been used in this way. During this period, there were some very large changes in the exchange rate – for example, between January 1985 and July 1986, it fell by 40 per cent on a trade-weighted basis. That is, during this period, the policy reaction function has been such that large falls in the exchange rate have quickly led to rises in short-term interest rates. At other times, for example from late 1987 to the present, monetary policy has generally been adjusted in response to domestic considerations and so rises in interest rates and rises in the exchange rate have tended to occur together.

The earlier period is highlighted in Figure 3, where the shaded bars show large falls in the exchange rate. On each occasion during the period, they were accompanied by rises in interest rates, but for different reasons:

• in the first half of 1985, when the Australian dollar fell sharply, monetary policy was tightened. The tightening was in response to the rapid growth in domestic demand and monetary aggregates during 1984. The fall in the exchange rate early in 1985 was further evidence that the setting of monetary policy had not been tight enough to contain domestic demand and inflationary pressures; it thus brought forward a tightening that was already imminent;
• from about January 1986, the previous year's high level of domestic interest rates slowed the economy and started to attract heavy inflows of capital. The monetary authorities took the opportunity during this period to move interest rates back to a level which was thought to be more appropriate for medium-term developments, given the reduced pressure of domestic demand; and
• this respite was short-lived, and a further sharp fall in the exchange rate starting in May 1986 brought the cumulative fall since the beginning of 1985 to nearly 40 per cent. Concern about the capacity of the economy to absorb a relative price change of this magnitude prompted another tightening of monetary policy at end July 1986. Again, with interest rates at very high levels, capital started to flow into Australia in large volume. Apart from a short-lived episode in January 1987, the exchange rate tended to rise through the remainder of 1987, and interest rates fell.

As a result of these episodes, movements in interest rates and the exchange rate were the mirror image of each other from early 1985 to late 1987.

By late 1987, the situation had changed and there was no longer any tendency for the exchange rate and the interest rate to move in this way. In October 1987, immediately following the share market crash, the Australian dollar fell sharply on market expectations of an impending world recession and a fall in commodity prices. No move was made to tighten monetary policy to resist this fall (although foreign exchange intervention was used). In the event, the exchange rate soon recovered and rose above its pre-October level. During 1988, it became apparent that the economy was growing quickly and progress in reducing inflation was threatened. Monetary policy was tightened on several occasions and the exchange rate rose. Thus, from late 1987 to early 1989, rises in interest rates tended to be accompanied by rises in the exchange rate.

Finally, in February and May 1989, the exchange rate fell again despite the fact that interest rates, which were already high, were raised again. On these occasions, the fall in the exchange rate seems to have been due to a reassessment by the market of the underlying balance of payments and inflation position (helped along by Ministerial statements and official sales of Australian dollars).

In summary, the period since the float has been characterised by diverse behaviour. For a large part of it, the relationship between interest rates and the exchange rate was dominated by an apparent policy reaction function from exchange rate to interest rates. On other occasions, interest rate differentials (with the expected positive sign) seem to have dominated. At other times, fundamental factors have had an influence on short-term adjustments of the exchange rate.