Sunday, September 26, 2010

Lessons for the RBA on their blunt instrument

RBA Governator Glenn "I''l be back - with higher interest rates" Stevens has been softening up the public for his next interest rate move. He warns that his toolkit contains only a blunt instrument, and we will all be affected. I guess if the only tool you have is a hammer, every problem looks like a nail.

... we only have one set of interest rates for the whole Australian economy; we do not have different interest rates for certain regions or industries. We set policy for the average Australian conditions. A given region or industry may not fully feel the strength or weakness in the overall economy to which the Bank is responding with monetary policy. In fact no region or industry may be having exactly the ‘average’ experience. It is this phenomenon that people presumably have in mind when they refer to monetary policy being a ‘blunt instrument.

I think poor old Glenn is taking his hammer to a screw.

While he wisely notes we have one set of interest rates, not one interest rate, he seems to ignore the fact that differentiation of interest rates on debt should reflect the risk for each particular loan. The problem for the RBA is that those who actually lend in the marketplace are failing to properly price the risk premium associated with their particular loans. Housing is surely a risky investment at the moment, yet interest rates do not reflect the risk premium.

The obvious alternative to shifting the whole set of interest rates is to better manage the risk premium rate for a particular industry of concern, or forcefully adjust risks taken with other measures to suit the rates adopted in that industry.

For example, if banks insist on lending for housing at relatively low interest rates, they can reduce risk by keeping lower LVRs and more conservative income estimates. If they won’t do it voluntarily, because they suffer from extreme moral hazard associated with guaranteed government bail-outs, maybe the RBA can seek to have banks better regulated with regards to housing loan risks, particularly qualifying income and LVRs.

At the moment increasing interest rates will simple increase the interest burden on current debts, high risk or not, decrease take up of borrowing for productive purposes, and fail to curb the mispricing of risk and crude lending criteria of housing loans with the major banks.


  1. Isn't this where BASEL comes in....

  2. These reforms are well intentioned but appear to me (I am not a BASEL III expert by any means) to miss the mark in relation to actually assessing risk itself-
    In Basel III, as in Basel II, the capital requirements are set “in relation to risk-weighted assets (RWAs)” even though it was the risk weights which proved to be most wrong.

  3. His misuse of this "blunt" instrument is also fuelling large inflows of speculative foreign capital buying up our nations assets causing unbalanced currency appreciation, and undercover inflation forces. I'd suggest lower interest rates to relieve interest burden on borrowers and increase lending and foreign capital regulations to prevent over-leverage.

    Free markets arent the answer to everything...

  4. You think "poor old Glenn is taking his hammer to a screw" yet it your blog seems to indicate you have no idea what monetary policy is. Do you ever get tired of being wrong?!?

  5. Anonymous (Oct 4 8.49pm), I'm happy to be enlightened by your views of monetary policy. Obviously, I don't spend a lot of time on the topic in comparison to others, but have my views based on my current knowledge. Obviously that means I am sceptical of text book explanations.

    It is one thing to understand the intention and the action, but another to understand the complete consequences.

    To answer your question. No. How do you learn if you are never wrong to begin with?