Strengths and Weaknesses of Monetary Policy
Short Decision and Implementation Lags
Monetary policy decisions are made on the first Tuesday of each month and react shortly to changes in the economic climate, thus having a short decision lag. The change in the cash rate is usually immediate with Australian banks responding to changes to the interest rates on their financial products on the same day, hence short implementation lags.
Effective During Booms
Increasing the cost of borrowing is an effective method of combating high levels of economic activity. Increases in cash rates have an immediate effect on household and firms cash flow and an immediate increase in investment risk.
No Political Influence
While the RBA is considered Government policy, it is not influenced by the political spectrum of government. The Reserve Bank is an independent authority where all decisions made by the bank are solely based on economic reasons to achieve the Reserve Bank's three economic objectives. - Strong Links to the Exchange Rate Changes in the cash rate often have an immediate effect on the exchange rate. In most cases, changes to the cash rate are followed by expected market movements in the floated exchange rate of the Australian Dollar.
Monetary policy is often viewed as a blunt instrument as it is applied to all industries, sectors and states equally, regardless of the different levels of growth. This was notably seen during the mining boom where the high cash rate peaked at 4.75% which fuelled a high exchange rate of $1.10 AUD in order to counteract high levels of mining investment growth. However, non-mining sectors were punished with high costs of borrowing and uncompetitive exchange rates. We also see it now, in the mining downturn, where all states share the same low cash rate despite the high levels of growth in the Eastern States and low levels of growth in the mining states of WA and QLD.
Long Effect Lag
Monetary policy has a long effect lag as it works indirectly through the transmission mechanism to reduce or increase aggregate demand. To combat this, the RBA often makes cash rate decisions based on the mid-term economic outlook rather than a short-term outlook.
Ineffective During a Trough
During a trough, low levels of economic activity create a lack of confidence in the economy that outweighs the benefits of low cash rates. During a trough, households will still save despite low deposit rates due to the prospect of economic uncertainty. Households will be reluctant to spend despite the low cost of credit. In addition, businesses will be unlikely to invest as future demand for a business's goods and services will be low.
Emergence of a Housing Bubble & Household Debt
During periods of low economic activity, low cash rates can encourage over-investment in the housing market. Low cash rates may make it easier for households to purchase a home, but once the economy strengthens, higher cash rates could see households having difficulty in meeting their mortgage repayments. A housing bubble could also emerge where over-investment into housing construction. Once those housing projects are finished, we could see an oversupply of property, causing property prices to fall. Low cash rates could also see the overuse of credit with household debt rising to unsustainable levels. While households making purchases on credit may create a short term benefit with increased economic activity, in the long term there is an increasing chance of households defaulting on their credit obligations.
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Acknowledgements to the Reserve Bank of Australia for the use of the Credit Chart. (Taken from the Chart Pack last updated on 7 December 2016). Notice how the level of credit has grown above 1.5 times GDP to a similar level of that was only once experienced in the mining boom. This high level of credit has been encouraged by low cash rates and could be a sign of dangerous implications of aggressive expansionary monetary policy.