Central Banks, Interest Rates and Stock Market Fluctuations

By: Gerard_Jackson

The shortage of capital at the end of the boom period is a sign that the credit system has put its last reserves into the firing lines in order to support the wavering front. (Wilhem Röpke Crises and Cycles , William Hodge and Company Limited, 1936, p. 100)

August this year witnessed a share market meltdown. Come September and the Australian share market takes off and “hits a new record” after the fed cuts the funds rate by 0.5 per cent. In the meantime the Reserve Bank of Australia (RBA) is keeping rates on hold at 6.5 per cent. Clearly the Australian market believes that what's good for the US economy is good for the Aussie economy. Leaving aside the moot point about the fed's interest rate cut let us focus on the domestic economy. The RBA recently stated that though credit has been generous and lending rather casual with respect to financial risks, the recent turmoil in financial markets means that in future greater care will be taken when giving credit:

Some adjustment in risk spreads is to be welcomed, increasing the likely durability of the current global expansion. ( Financial Stability Review , 20 September 2007).

Despite issuing this caution the RBA went on to assure us that the financial system is basically healthy. The Review also claimed that though household debt has jumped

...the value of assets significantly exceeds the value of liabilities means that, despite the latter growing more quickly, household net worth has increased at an average rate of 11 per cent over these two years, slightly above the long-run average rate of increase. Aggregate gearing of the household sector — the ratio of debt to assets — has also continued to rise, to stand at 17.5 per cent at the end of March 2007, an increase of 5.5 percentage points over the past decade. Despite this increase, household gearing remains lower than in many comparable countries.

The Review reported that “the ratio of housing debt to income — from 62 per cent to 138 per cent”, an increase of more than 100 per cent. Combine this with bank bills that still exceed the cash rate and things begin to look rather fuzzy to most people. And that includes our economic commentariat. Terry McCrann, for example, states that

People have been able to borrow extraordinary sums to buy property, at extraordinarily thin margins — the so-called ‘discount' on bank mortgage reference rates. ( Herald-Sun , ‘We' have reason to be nervous , 11 September 2007).

Yet he managed, like the rest of our economic commentariat, to overlook monetary policy. The current economic situation should not surprise anyone considering that the RBA has spent years flooding the Australian economy with credit. From March 1996 to July 2007 the RBA expanded currency by 101.6 per cent, bank deposits by 178 per cent and M1 by 160.7 per cent. These disgraceful figures clearly reveal that the Reserve has subjected Australia to the most reckless monetary policy in its history. A policy that has given us an enormous real estate bubble * that has even sent the price of hovels through the roof and sent the current account deep into the red while accumulating massive foreign borrowings.

Last August the RBA raised interest rates by 25 basis points to 6.50 per cent. Yet we can see that this increase did nothing to curb spending. This is what happened in America in 1929. The fed halted monetary growth in December 1928 and yet real estate and the stock market continued to boom, even though manufacturing started to contract in July of that year. The first thing to note is that the fed had created a huge amount of credit that needed to be drained from the economy. More importantly, though, was that the fed hobbled its own efforts by turning itself into the primary market for acceptances which in turn fuelled the stock market frenzy and encouraged the issuing of even more shares. On top of that huge amounts of loans were being made with very little money. As Fritz Machlup said: “...one dollar is capable of creating many dollars worth of brokers' loans”. ( The Stock Market, Credit and Capital Formation , William Hodge and Company, Limited, 1940, p. 122)

So what does the RBA do? It tells the market that it will broaden the types of assets that it would purchase in its money market operations. This is an obvious attempt to try and relieve upward pressure on money market rates. So what is the difference in principle between the RBA's purchasing policy and the fed's decision to continue to buy acceptances? Absolutely nothing.

Despite its monetary injections and loose purchasing of assets the RBA has so far failed to prevent a squeeze from developing, though things have eased somewhat. The ANZ has complained that tight credit is raising the cost of borrowing that would probably raise interest rates for all types of loans. Naturally, the Reserve's response is to offer to accept bills and certificates of deposit issued domestically by deposit-taking institutions which have an exchange settlement account with the Reserve. Moreover — and there's always more when it comes to monetary policy — it would buy residential mortgage-backed securities supported by prime and fully documented mortgages and rated triple-A. But troubles are still piling up. The National Australia Bank had to move about $6 billion of loans to its balance sheet after a subsidiary failed to refinance them in the short-term debt market.

Some commentators are now taking a more relaxed view of situation, pointing to an easing in short-term rates. Of course there's been an easing. On 20 September the RBA did what it does best — create money: it injected about $544 million into the financial system. However, not everyone thinks money doesn't matter. These massive monetary injections have caused long-term rates to rise in anticipation of a rise in the rate of inflation.

The one question that never gets asked is: why do short-term rates rise after a massive monetary money expansion? Because monetary growth sets loose real factors that increase the demand for short-term loans. Australian capacity utilization rose by 0.2 per cent in August, bring it up to 83.5 per cent. As capacity shrinks one should expect the demand for short term rates to increase as firms find themselves having to make-ever higher bids for factors of production and intermediate goods. This happens when the balance between real savings and investment has been greatly disturbed. As Richard von Strigl put it:

The more credit expansion progresses, the greater will become the share of additional credits in the overall volume of credits within the economy, while savings capital gradually loses its relative importance. ( Capital and Production , Mises Institute, 2000, first published 1934, p. 126).

Allow me to finish on a rather dismal note by Fritz Machlup who stated : that monetary factors cause the [business] cycle but real phenomena constitute it”, Essays on Hayek , Routledge, Kegan Paul 1977, p. 23).

* Those who blame immigrants for rocketing house prices have failed to link the booming real estate market with the Reserve's criminally loose monetary policy.

By Gerard Jackson
BrookesNews.Com

Gerard Jackson is Brookes' economics editor.

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