Australia - RBA to cut rates and launch more QE - Capital Economics
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Australia – RBA to cut rates and launch more QE

RBA Watch
Written by Marcel Thieliant
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The Reserve Bank of Australia has become more downbeat about the prospects for inflation and wage growth. While it could wait until November, we think it will announce further interest rate cuts and additional asset purchases at the upcoming meeting on Tuesday, 6th October.

  • Bank coming round to our view that wage growth and inflation will remain soft
  • Cash rate target, three-yield target and TFF interest rate to be lowered to 0.10%
  • Additional bond purchases to lower long-term yields also on the cards

The Reserve Bank of Australia has become more downbeat about the prospects for inflation and wage growth. While it could wait until November, we think it will announce further interest rate cuts and additional asset purchases at the upcoming meeting on Tuesday, 6th October.

Markets price in further easing

While the official cash rate currently sits at 0.25%, three-month interbank rates have been closer to the 0.1% the RBA has been paying on commercial bank reserves since March. That reflects the surge in interbank liquidity due to the expansion in the Bank’s balance sheet. But markets now expect interbank rates to fall below the interest rate on reserve balances over the coming months. (See Chart 1.)

Chart 1: Interest Rates (%)

Source: Bloomberg

That reassessment reflects a dovish speech by RBA Deputy Governor Guy Debelle last Tuesday, in which he argued that “the recovery in the labour market is likely to be bumpy and uneven and we still expect the unemployment rate to rise from here”. He reiterated the RBA’s forecast that the unemployment rate will still be at 7% by end-2022. Given that the pre-virus unemployment rate of 5% wasn’t enough to lift inflation towards the Bank’s 2-3% target, that would be inconsistent with meeting the Bank’s inflation and full employment targets. He presented four options for further stimulus, including additional government bond purchases to lower bond yields beyond the Bank’s 3-year target, foreign exchange intervention to weaken the Australian dollar, cutting the interest rate on reserve balances, the three year-yield target and the Term Funding Facility (TFF) and negative interest rates.

The Bank’s cautious tone may seem surprising. To be sure, the 6.3% annual fall in GDP in Q2 was slightly more pronounced than the Bank’s forecast of a 6% decline. But the drop in the unemployment rate from 7.5% in July to 6.8% in August suggests that it won’t surge to 10% by year-end as the Bank is anticipating. And the latest retail sales and hours worked figures indicate that the shutdown of non-essential activity in Victoria wasn’t as damaging as previously anticipated. Our forecast of a 1.5% q/q rise in Q3 GDP is well above the average 0.5% q/q predicted by the RBA across the second half of 2020.

However, the Bank seems to be coming around to our view that the pandemic will result in a sharp slowdown in wage growth and inflation. While the unemployment rate has started to fall again, the underutilisation rate was still a huge 18.0% in August. That’s consistent with falling wages rather than the increases of more than 1% the Bank has been forecasting. (See Chart 2.) Indeed, the minutes of the Bank’s September meeting, when it expanded the size of the TFF, noted that “wage and price pressures more generally were expected to remain subdued for some time”.

Options for additional stimulus

The fact that we’re discussing interest rate movements of a few basis points underlines that monetary policy is now close to its limits. Indeed, cutting the cash rate target would be largely symbolic. But lowering the three-year yield target as well as the TFF interest rate would result in a genuine reduction in borrowing costs across the economy.

Chart 2: Underutilisation Rate & Wage Price Index

Sources: Refinitiv, Capital Economics

Meanwhile, regulatory changes could take some pressure off the RBA to engage in additional bond purchases. According to press reports, the Australian Prudential Regulation Authority (APRA) and the Bank will force banks to increase their holdings of state and federal government bonds from $312bn in Q2 by up to $240bn. The details will be announced after the release of the federal Budget on 6th October.

The RBA previously estimated that commercial banks shouldn’t hold more than 25% of the outstanding stock of government bonds before liquidity in the bond market deteriorates, though that ceiling may be higher now as the stock of government bonds is soaring. Commercial banks already own nearly half of all outstanding state government bonds and we doubt that the regulators would want that share to rise any further. And while banks still have scope to lift holdings of federal bonds (see Chart 3), we suspect they will proceed slowly. As such, those regulatory changes don’t mean that the RBA is off the hook.

Chart 3: Commercial Banks’ Holdings of Federal Government Bonds ($bn)

Sources: ABS, Capital Economics

What’s more, if the RBA cuts shorter-term interest rates further towards 0%, the case for lowering long-term interest rates becomes even more compelling. While 10-year government bond yields have edged down a bit recently, they are stil around 0.8%.

Additional easing is a close call as its next meeting on 6th October coincides with the delayed release of the 2020/21 federal Budget. Many commentators have suggested that the Bank will not want to distract from any additional stimulus measures unveiled in the Budget. What’s more, announcing additional government bond purchases at a time when the government is unveiling record-high budget shortfalls may create the impression that the Bank is monetising the deficit. As such, the Bank may wait until its November meeting before unveiling more stimulus.

By contrast, we think that announcing more support alongside the Budget would send a strong “Team Australia” message and have pencilled in a cut in the cash rate target, the 3-year yield target and the TFF interest rate to 0.10% at the Bank’s October meeting. We also expect the Bank to announce more bond purchases next week.

Governor Lowe had previously indicated that a target for bond yields beyond the current 3-year horizon is unlikely because the Bank would need to be convinced that it won’t hike the cash rate for as long as the target is in place. But Mr Debelle noted last week that it will take more than three years for inflation to return to target. As such, we suspect that the Bank may extend the horizon of its yield target to 5-years. That should contribute to a further decline in 10-year government bond yields from 0.83% today to 0.75% by year-end.

Finally, Mr Debelle’s comments point to a subtle shift in the Bank’s assessment of negative interest rates. Governor Lowe previously argued that negative rates remain “extraordinarily unlikely” and Mr Debelle noted that the Bank’s view hasn’t changed in the Q&A section following his speech. He also noted that the empirical evidence on their effectiveness is mixed. But while we don’t expect the Bank to cut rates into negative territory anytime soon, its previous resistance seems to be softening.

Table 1: RBA Monetary Policy Background Information

Interest Rate Meetings

The Board meets 11 times a year, at 9.00 am on the first Tuesday of the month. There is no meeting in January. Rate decisions are released in a statement at 2.30 pm.

Release of Minutes

Two weeks after each meeting.

Other Publications

The Statement on Monetary Policy sets out the Bank’s assessment of current economic conditions and the outlook. It is published four times a year, on the Friday after the policy meetings in February, May, August and November.

Disclosure of Voting

No, the votes and views of individual members are not identified in either the policy statements or the minutes of the meetings.

Inflation Target

The Board targets CPI inflation of between 2% and 3% over the medium-term. This is an average rather than a rate to be achieved at all times.

Policy Framework

The Reserve Bank Act gives the Board a duty “to maintain price stability, full employment, and the economic prosperity and welfare of the Australian people.”

Membership of Board

The Board comprises the Governor, Deputy Governor, six other non-executive Bank members and the Secretary to the Treasury. The Governor and Deputy Governor serve terms of up to seven years and are eligible for re-appointment. The non-executive members are appointed for terms of up to five years. There is no limit to the number of terms they may serve.

Governor

Philip Lowe

Deputy Governor

Guy Debelle

Other members of the

Mark Barnaba

Carol Schwartz

Reserve Bank Board

Allan Moss

Catherine Tanna

Ian Harper

Steven Kennedy, (Secretary to the Treasury)

Wendy Craik

Meetings

Date

Outcome/Forecast

Date

Outcome/Forecast

* Denotes release of

4th Feb 2020*

Cash rate cut 0.75%

2nd Feb 2021*

No major policy changes

The Statement on Monetary Policy later that week

3rd Mar 2020

Cash rate cut to 0.50%

2nd Mar 2021

No major policy changes

19th Mar 2020

Cash rate cut to 0.25%, launch of 0.25% target for 3-year government bonds & launch of Term Funding Facility (TFF)

6th Apr 2021

No major policy changes

7th Apr 2020

No major policy changes

4th May 2021*

No major policy changes

5th May 2020*

No major policy changes

1st June 2021

No major policy changes

2nd June 2020

No major policy changes

6th July 2021

No major policy changes

7th July 2020

No major policy changes

3rd Aug 2021*

No major policy changes

4th Aug 2020*

No major policy changes

7th Sep 2021

No major policy changes

1st Sep 2020

Increase in size of TFF

5th Oct 2021

No major policy changes

6th Oct 2020

Cut in cash rate target, 3-year yield target & TFF interest rate to 0.10%; launch of 5-year yield target

2nd Nov 2021*

No major policy changes

3rd Nov 2020*

No major policy changes

7th Dec 2021

No major policy changes

1st Dec 2020

No major policy changes

Sources: RBA, Capital Economics


Marcel Thieliant, Senior Australia & New Zealand Economist, +65 6595 1514, marcel.thieliant@capitaleconomics.com