Policy-at-Risk: The Effects of Financial Conditions on the Conduct of Monetary Policy in Australia

Abstract

The global financial crisis (GFC) of the late 2000s marked an important event in terms of changing attitudes towards prudential and financial regulation. However, it also demonstrated the close connectivity between financial conditions and macroeconomic performance. It is therefore important to understand the influence of changing financial conditions on the conduct of monetary policy by central banks, particularly how central banks respond to these changes. This thesis constructs a financial conditions index (FCI) for Australia to represent the state of financial conditions between 1976 and 2023. I use a two-stage regression model as part of a novel policy-at-risk (PaR) model to assess the effects of financial conditions on monetary policy first at the mean level, and secondly at different quantiles along the distribution of interest rate changes. I also assess the uncertainty associated with monetary policy over time by plotting the conditional distribution of the overnight cash rate (OCR) together with its fitted quantiles. The findings reveal that when the OCR is low relative to systematic policy, the Reserve Bank of Australia (RBA) is less responsive to changes in financial conditions, resulting in smaller interest rate cuts. Conversely, the RBA reacts more strongly to financial conditions when the OCR is relatively high.