Bank to resume bond purchases in earnest - Capital Economics
Australia & New Zealand Economics

Bank to resume bond purchases in earnest

RBA Watch
Written by Marcel Thieliant
Cancel X

The Reserve Bank of Australia isn’t keen on providing more monetary stimulus and instead wants the government to do the heavy lifting. As such, the Bank will certainly keep policy settings unchanged at its upcoming meeting on Tuesday, 1st September. However, we still expect underlying inflation to fall much further than the Bank anticipates and believe that policymakers will eventually expand their bond purchases.

  • Draconian lockdown in Victoria to weigh on recovery and lift unemployment
  • Inflation and wage growth set to soften further
  • We still expect the Bank to start buying-longer dated bonds early next year

The Reserve Bank of Australia isn’t keen on providing more monetary stimulus and instead wants the government to do the heavy lifting. As such, the Bank will certainly keep policy settings unchanged at its upcoming meeting on Tuesday, 1st September. However, we still expect underlying inflation to fall much further than the Bank anticipates and believe that policymakers will eventually expand their bond purchases.

Recovery to remain sluggish

The Bank announced at its July meeting that it would resume its government bond purchases because 3-year yields had climbed above its 0.25% target. It bought just $5bn between 5th August and 13th August, far below the $51bn it bought between March and May. Even so, 3-year yields are once again close to the Bank’s target at around 0.26%. And rather surprisingly given the widening of state bond yields, the Bank hasn’t bought any state bonds.

Meanwhile, the available economic data still point to a rapid recovery in activity following the lockdowns at the start of the year. According to preliminary estimates, retail sales jumped by another 3.3% m/m in July, leaving them up an astonishing 11% m/m from pre-virus levels. Even in Victoria, where similar stay-home orders were issued at the start of July as during the earlier lockdown in March and April, sales only dipped 2% m/m. That meant they were still 2% above pre-virus levels after having slumped 15% below pre-virus levels in April.

What’s more, the labour market continues to recover, with employment rising by another 0.9% m/m in July. That means that around 40% of the jobs lost between February and May have come back. The participation rate continued to rise sharply and has reversed 60% of the drop between March and May. The continued solid gain in employment broadly offset higher participation and the unemployment rate only edged up to 7.5% in July. Even if we include those people who have left the labour force in recent months and those employees who were working zero hours because they were stood down, our broader measure of the unemployment rate has dropped from 15.4% in April to 10% in July. (See Chart 1.)

Chart 1: Broader Measure of Unemployment
(% of Labour Force)

Sources: ABS, Capital Economics

However, the fact that people defied the stay-at-home orders and kept shopping in July eventually forced the Victorian government to impose more draconian measures. We think that those measures will push activity in Victoria 20% below normal levels and will result in a measly 0.5% gain in Q3 GDP following a 6.5% q/q slump in Q2. (See here.)

What’s more, a lot of the recent strength in retail sales was driven by fiscal support measures that will soon have run their course. The extraordinary withdrawals from employees’ superannuation accounts are providing the largest boost to household incomes. While workers can apply for a withdrawal until the end of the year, payouts have tapered off in recent weeks. As such, a sharp fall in disposable incomes towards the end of the year is all but guaranteed. (See Chart 2.)

Chart 2: Contributions to Quarterly Change in Household Income ($bn)

Sources: Refinitiv, ABS, APRA, BIS, ABA, Treasury, CE

Admittedly, the government has eased the criteria for the JobKeeper wage subsidy programme to ensure that firms who were doing fine before the draconian lockdown in Victoria will continue to benefit. (See here.) But casual workers aren’t covered by JobKeeper and they accounted for two-thirds of the job losses in April and May. As such, we still expect the unemployment rate to rise to 8.5%, though that isn’t quite as pessimistic as the 10% forecast by the RBA.

Inflation set to fall further below target

Meanwhile, the recent weakening in price pressures isn’t coming as a complete surprise to the Bank. The 0.3% annual fall in consumer prices in Q2 was in line with the Bank’s forecast from May. So was the 1.8% annual rise in the wage price index last quarter. As such, Governor Lowe clearly isn’t convinced that further monetary stimulus is required.

In a recent parliamentary hearing, Mr Lowe indicated that Bank may buy a given quantity of five or ten year bonds to bring down long-term yields a bit. But when asked whether extending yield curve control to longer maturities would help the Bank in achieving the inflation target, he responded “It may or may not. I don’t know that we would get much more traction at the moment from having the five-year yield curve at 10 or 15 basis points lower than where it currently is.”

What’s more, the Bank is reluctant to launch an actual target for longer-dated yields. Governor Lower argued that “if we’re going to have a target for a five-year yield, I think it needs to be consistent with our expectations for the cash rate.” In other words, the Bank would only launch a target for 5-year yields if it was convinced that short-term interest rates would remain at or below that target for 5-years.

Instead, the Governor is pushing the government to implement additional fiscal stimulus, with the focus increasingly shifting from transfers to households and firms towards measures that provide a direct boost to domestic demand.

However, the Bank’s resistance towards a target for longer-term yields may change if price pressures weaken as sharply as we anticipate. While the RBA expects annual wage growth to bottom out at 1.25% and underlying inflation to reach a trough at 1.0% next year, we expect both to fall to 0.5% in response to the marked increase in spare capacity. Admittedly, growth in the money supply has been rather strong recently, but that’s largely because banks have replaced maturing bonds with funding from the RBA. In fact, bank lending contracted in both May and June, the first consecutive falls since the early 1990s recession.

There are already signs that weak inflation outcomes are weighing on medium-term inflation expectations, with 2-year union officials’ inflation expectations falling to a record low of 1.7% in Q2. (See Chart 3.)

Chart 3: Union Off. Inflation Exp. & Wage Growth

Sources: RBA, Refinitiv

If inflation expectations settle at levels well below the Bank’s 2-3% target, that target will become increasingly elusive. As such, the Bank may come to the conclusion that the cash rate will have to remain close to 0% for many more years, opening the door for a 5-year or even a 10-year yield target. We still expect the Bank to engineer a decline in long-term bond yields by early 2021, probably via a target for 5-year government bond yields.


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

4th Feb 2020*

0.75%

2nd Feb 2021*

0.25%

* Denotes release of The Statement on Monetary Policy later that week

3rd Mar 2020

Cut to 0.50%

2nd Mar 2021

0.25% & Resumption of Bond Buying

19th Mar 2020

Cut to 0.25% and launch of 3-year yield target

6th Apr 2021

0.25%

7th Apr 2020

0.25%

4th May 2021*

0.25%

5th May 2020*

0.25%

1st June 2021

0.25%

2nd June 2020

0.25%

6th July 2021

0.25%

7th July 2020

0.25%

3rd Aug 2021*

0.25%

4th Aug 2020*

0.25%

7th Sep 2021

0.25%

1st Sep 2020

0.25%

5th Oct 2021

0.25%

6th Oct 2020

0.25%

2nd Nov 2021*

0.25%

3rd Nov 2020*

0.25%

7th Dec 2021

0.25%

1st Dec 2020

0.25%

Sources: RBA, Capital Economics


Marcel Thieliant, Senior Australia & New Zealand Economist, marcel.thieliant@capitaleconomics.com