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Financial market cynicism creates difficulties for monetary policy



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P A R L I A M E N T O F A U S T R A L I A

H O U S E O F R E P R E S E N T A T I V E S

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PRESS ■

D R JO H N R. H E W S O N , M .P .

SHADOW M IN IS T E R FO R F IN A N C E M E M B E R FO R W E N T W O R T H

RELEASE ,v>

21 April, 1989

No. 38/89

FINANCIAL MARKET CYNICISM CREATES DIFFICULTIES FOR MONETARY POLICY

Financial markets are now almost entirely driven by cynicism.

Consequently, there is a very real risk that the Reserve Bank will lose control of monetary policy, or , at the very least, be forced into conflict with the Government.

The events of recent days - in particular the so-called "bull run" in bill futures - clearly show just how financial markets now tend to take Keating at his worst. The Treasurer has virtually no credibility in financial markets any more.

The main features of current cynical market sentiment seem to be:

. A belief that an early election is on - irrespective of what Hawke says, the markets know Keating is looking for a "crack of light" on which to run and that as soon as he sees it, they'll go.

. A belief that the Government doesn't want interest rates to go any higher; a belief that the Government wants to avoid any suggestion that their tax cuts will be clawed back by higher interest rates.

This belief seems to be based on a number of things including statements by the Prime Minister that interest rates may not need to go any higher; confirmatory "rumours" apparently from lower levels of both the Reserve Bank and the Treasury; the statement by the Treasurer that he was happy with the reaction of financial markets to the March balance of payments number, which saw the exchange

rate fall with little (net) interest rate reaction; and the opening statement in the latest Reserve Bank Bulletin to the effect that "Information available to the Bank in March suggested that the very strong growth in private demand might be at, or near, its peak".

. A cynical recognition of the willingness of the Treasurer to "fudge" the CPI rather than address the causes of inflation. While the markets will undoubtedly see this as further destroying Keating's personal credibility, they are still nevertheless cynical enough to trade on it.

. A recognition of the fact that on a number of recent occasions when our dollar has recovered to near 80 cents or so, the Reserve Bank has intervened to stem the rise or indeed to try and knock it down a bit.

In developing these cynical views markets seem to have discounted the recent warnings of the Governor of the Reserve Bank, Bob Johnston, as to the magnitude of our current economic difficulties. They also seem to have interpreted the statements by the Secretary to the Treasury, Bernie Fraser, this week as evidence that interest rates have indeed peaked, rather than as another warning that we might "go over the brink".

To summarise, the markets seem to believe that interest rates have peaked and that any further policy adjustment to "bad economic data" will take the form of falls in our exchange rate, rather than increases in interest rates.

However, the last thing the monetary officials can afford now is a sustained "bull run" in money and bond markets before there is clear evidence that the demand for credit has fallen significantly and that activity has slowed. A premature shift to

renewed confidence could see domestic demand sustained, rather than reduced, and our balance of payments and inflation problems compounded accordingly.

So, not surprisingly, the Reserve Bank has been at pains, in recent days, to pull back or negate this "bull run" mentality.

As market rates have been driven down in recent days, the Reserve Bank has been very deliberately raising official cash rates - they now seem to be targetting bill rates at around 17 percent.

Today they backed this up with a very clear signal to the markets. The Reserve Bank announced that although the liquidity of the financial system would be down by about $100 million, they wouldn't deal.

The risks in the current situation are very real. One risk is that the Government continues to foster the "bull run" mentality which could soon bring them into direct conflict with the Reserve Bank.

Another risk is that foreign investors could lose confidence in the Government's economic management, recognise the Government's desire for a lower exchange rate, and start to shift their funds out of Australia, thereby precipitating a substantial fall in the

$A.

A significant fall in the $A would soon be passed on in the form of higher domestic prices, reactivating an early "J curve" adverse effect thereby further deteriorating our current account, and clearly put the wage/tax deal at risk. How long would Mr

Kelty sit quietly by as evidence of significant devaluation induced price increases emerged?

Against this background of competing forces and cynical market sentiment, the Reserve Bank is in danger of losing control of monetary policy.

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