Lessons from past financial crises for the RBA’s monetary policy

Echoing the US experience, the American regional bank failures have triggered a sharp market reassessment of the path for the RBA’s cash rate, with the market pricing out rate hikes and factoring in the risk of lower rates. This large shift in market pricing implicitly assumes further bouts of instability morph into a global financial crisis, which seems an overreaction at this point given the initial international policy response has been both quick and aggressive and where the ways for global volatility to spill over to Australia are more limited nowadays, with the strongly regulated Australian financial system is in much better shape than its peers. That said, history shows that the RBA has reacted to broad financial crises by cutting rates, temporarily if the economic fall-out is limited, with deeper/longer-lasting cuts if the crisis proves more serious.

1. Financial stability concerns can trump the RBA’s inflation objective.

As is the case for any central bank, a bout of financial stability that evolves into a broad financial crisis will take precedence for the RBA over dealing with high inflation because financial crises can lead to longer recessions, deeper downturns if a credit crunch is involved, and potentially weaker economic recoveries.

2. US and European market volatility will likely lead to tighter global financial conditions having some impact on Australia ...

In this context, the current market instability in the US and Europe can affect Australia’s economy via the potential impact on:

• world growth, where the implicit initial Fed estimate equates the problems with the regional banks with a roughly 50 to 75bp increase in the funds rate (this is broadly the difference between the market/economist expectations of the peak in the funds rate prior to the market disruptions and the median FOMC estimate of the funds rate);
• bank funding costs;
• confidence;
• stock prices; and 
• the lending practices of the local subsidiaries of global banks, which account for about 4% of residential property debt and 2% of commercial property debt.

3. ... where history suggests that the RBA could end up cutting rates, at least temporarily, if further international instability ended in an outright financial crisis.

Depending on their size and persistence, these factors could take the place of at least some RBA tightening of monetary policy, allowing for a likely partial offset from a lower exchange rate. 

Moreover, if further instability evolved into a global financial crisis, the RBA could actually cut interest rates, quickly reversing course if the economic fall-out was limited or keeping rates low for an extended period if there was a substantial impact on unemployment and underlying inflation.

4. The 1987 and 1998 financial crises led to temporary rate cuts, while the more serious 1990-92 and 2007-09 crises involved larger/more lasting cuts.

Categorising the monetary policy response to past financial crises:

(1) The 1987 stock-market crash and 1998 Long Term Capital Management (LTCM) crisis led to temporary rate cuts.

• The RBA had been cutting rates ahead of the October 1987 crash, lowering rates once more at the end of that year, partly to provide liquidity, but also because the bank thought the crash would slow the economy. The bank later admitted this “assessment proved to be wrong” and started to hike four months later;
• In 1998, the bank cut the cash rate once after the Asian and Russian debt crises culminated in the collapse of LTCM. This cut followed a long period of stability in the cash rate and was reversed ten months later when the RBA started to raise rates given the limited fall-out from the crisis; and
  

(2) The 1990-92 domestic bank/non-bank failures and the 2007-09 global financial crisis led to deeper/more lasting rate cuts.

• The 1990-92 crisis involved the failure of two state government banks and a number of local non-banks, which, along with the bursting of a bubble in commercial real estate and falling house prices, saw the RBA cut rates sharply over almost the entire period as underlying inflation fell and unemployment rose to the highest level outside a depression, holding rates steady for a year before hiking.
• The global financial crisis was the largest shock to the world economy and world financial system since the 1930s. Spillovers included sharply lower stock prices, particularly bank share prices, while wholesale mortgage lenders and structured investment vehicles, which were bank off-balance-sheet vehicles, fell over as cheap overseas funding dried up. The RBA was still raising rates early in the crisis given high and rising inflation, but cut rates aggressively as the crisis deepened and the economy deteriorated, also taking unconventional monetary policy steps for the first time in years. The RBA started hiking six months after the last rate cut.

5. The recent large shift in market pricing of the future cash rate indicates the market anticipates a worse outcome.

Echoing the US experience, market pricing is behaving as if the shock to the US regional banks will evolve into a broader financial crisis, pricing out further rate hikes and factoring in a reduction in interest rates. 

While further volatility seems likely as the poor financial decisions based on near-zero interest rates are brought to light, the large shift in market pricing seems an overreaction at this point given:

1. the initial international policy response has been quick and aggressive, involving innovative measures that were shaped by the experience of the global financial crisis; and
2. the local, strongly regulated financial system seems in a much better position than other advanced economies, which limits the ways in which overseas instability can spill over to Australia.

That said, history suggests that if further instability does evolve into a global crisis, the RBA could temporarily cut rates, resuming raising rates relatively quickly if there is no material economic fall-out.