Plunge in inflation to eventually trigger more easing - Capital Economics
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Plunge in inflation to eventually trigger more easing

RBA Watch
Written by Marcel Thieliant
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The renewed lockdown in Melbourne is set to undermine the recovery and will push inflation much further below the 2% target than the Reserve Bank of Australia is currently anticipating. We still think that the RBA will respond with additional bond purchases by next year.

  • Initial bounce-back in activity has been stronger than expected
  • But renewed lockdown in Melbourne is weighing on recovery and inflation is slumping
  • We still expect a resumption in asset purchases before long

The renewed lockdown in Melbourne is set to undermine the recovery and will push inflation much further below the 2% target than the Reserve Bank of Australia is currently anticipating. We still think that the RBA will respond with additional bond purchases by next year.

Lockdown in Melbourne undermining recovery

The incoming economic data underline that the recovery from April’s lockdown has been stronger than anticipated. Preliminary retail sales values rose by another 2.4% m/m in June, leaving them up an astonishing 8.2% over the past year.

What’s more, employment bounced back by 211,000 in June, reversing around a quarter of the falls in April and May. And while an even stronger rebound in the labour force lifted the unemployment rate to a fresh high of 7.4%, that’s well below the RBA’s forecast of an average rate of 10% across Q2. The unemployment rate continues to understate the amount of slack in the labour market, but the 8.5% q/q fall in hours worked in Q2 was nowhere near the RBA’s forecast of a 20% plunge. Indeed, Governor Lowe sounded fairly confident in a speech delivered last week and highlighted that hours worked didn’t fall as rapidly as the Bank had anticipated.

However, the worsening virus outbreak and the renewed lockdown in Victoria are undermining the recovery. Transport activity in Melbourne has fallen back sharply in recent weeks and has also started to decline again in New South Wales. (See Chart 1.) It seems likely that the decline in transport activity will translate into weaker consumer spending, too.

What’s more, the rebound in employment seems to have gone into reverse. Since the reference period of the June labour force survey, payroll jobs fell by 0.5%. (See Chart 2.) That decline has been most pronounced in Victoria, but employment has also declined in New South Wales. We now expect the unemployment rate to climb further to 8.5% in Q3. The RBA also seems prepared for a further rise in unemployment: Mr Lowe noted last week that the unemployment rate was still likely to increase as some of those who left the labour force in recent months will start looking for work again.

Chart 1: Apple Maps Routing Requests
(All Transport Modes, Jan. 13th = 100)

Source: Apple

Chart 2: Payroll Jobs (Week Ending 14th March = 100)

Source: ABS

And even if Melbourne’s outbreak is brought under control again, the recent strength in consumption is unlikely to last. After all, households are benefitting from exceptionally strong fiscal support. In addition to the mortgage deferral, the stimulus payments and the JobSeeker supplement, the government has allowed workers to make an exceptional withdrawal of up to $20,000 from their superannuation accounts. As of 19th July, withdrawals had reached $28bn, equivalent to a huge 8.7% of quarterly disposable income. The deadline for applications for early superannuation withdrawals has been extended to 31st December, but we suspect that withdrawals will peter out in Q4. And most of the other support measures are set to expire in Q4, too. (See Chart 3.)

Chart 3: Contributions to Quarterly Change in Household Income ($bn)

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

What’s more, there are mounting signs that the large amount of slack in the labour market is weighing on price pressures. Trimmed mean inflation was -0.1% q/q in Q2, the first fall on record. Even if we strip out those items for which prices were imputed, the measly quarterly rise of 0.1% q/q would have been the weakest on record.

We believe that inflation will remain subdued for a prolonged period. While the RBA expects underlying inflation to bottom out around 1% by early next year, we think it will approach zero. As such, we still think that further stimulus will eventually be required.

More bond purchases most likely option

The Bank’s balance sheet hit a fresh record-high this month. While commercial banks have scaled back borrowing via the RBA’s conventional repo operations, they have stepped up borrowing from the Bank’s Term Auction Facility. As things stand, they can borrow an additional $126bn but that amount is likely to rise further as banks expand their lending to firms. And with the 30th September deadline for drawing down funds approaching, banks will probably make greater use of the facility. As such, banks’ liquidity needs should be met for the next few years.

Meanwhile, the case for buying private bonds has diminished as spreads are nearly back to pre-virus levels. Governor Lowe once again ruled out negative rates in his recent speech. And while the Australian dollar has strengthened in recent months, he argued that foreign exchange intervention is unlikely to be effective when the exchange rate is in line with fundamentals.

That leaves additional government bond purchases as the most likely option. Apart from buying up maturing bonds for liquidity management purposes, the Bank hasn’t bought any government bonds since early May.

The experience from the RBNZ is that even aggressive bond purchases will not necessarily lower bond yields on a sustained basis. After all, 10-year yields in New Zealand are barely lower than in Australia even though the RBNZ has pledged to buy nearly half of outstanding government bonds by March. (See Chart 4.) Indeed, Mr Lowe noted in his latest speech that the Board “recognises that, in the current environment, there are limitations to what more can be achieved through monetary policy.”

Chart 4: 10-year Government Bond Yields (%)

Source: Refinitiv

The main reason is that the RBNZ is targeting a given quantity of purchases rather than a target for bond yields. The experience from the Bank of Japan is that an explicit target for longer-term yields would be effective. (See here.) Admittedly, a yield target for longer-dated bonds can be seen as a stepping stone to helicopter money, which Lowe denounced in his latest speech. But if inflation weakens as sharply as we expect, the Bank may jettison concerns about the blurring between monetary and fiscal policy. Whatever the precise mechanism, we expect the Bank to resume its government bond purchases by the beginning of next year.

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%

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