Policy to remain looser for longer - Capital Economics
Australia & New Zealand Economics

Policy to remain looser for longer

RBA Watch
Written by Marcel Thieliant
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The Reserve Bank of Australia will keep policy settings unchanged at the meeting on 2nd March and will probably push back against mounting expectations of policy tightening.

  • The financial markets have started to price in a rate hike as soon as early-2023
  • Labour market tightening but wage growth and inflation set to fall short of RBA’s targets
  • We expect the first rate hike to be delayed until early-2024 and bond yields to fall back

The Reserve Bank of Australia will keep policy settings unchanged at the meeting on 2nd March and will probably push back against mounting expectations of policy tightening.

RBA playing the long game

The RBA decided to expand its quantitative easing programme by another $100bn at its February meeting while keeping the weekly pace of purchases unchanged at $5bn. With the first round of purchases not scheduled to end until April, that decision came earlier than most had anticipated. As things stand, purchases will have run their course by end-August. The Bank could wait for the release of updated forecasts in the Statement on Monetary Policy due at the August meeting to decide whether to extend the programme. But we suspect it will again make a decision well before that, perhaps in June.

We have pencilled in another $100bn extension to $300bn, which could be unveiled at the June meeting and which would take until January 2022 to complete. While we think that the unemployment rate will have fallen from 6.4% in January to 6.0% by June rather than remain stuck at 6.5% as predicted by the Bank, that alone won’t move the needle much. The latest Statement on Monetary Policy contained an upside scenario, which foresees the unemployment rate falling to around 4.75% by mid-2023 instead of the Bank’s base case that it will only fall to 5.25%. That would be well below its pre-virus trough of 5.2% and fairly close to the Bank’s estimate of the natural rate of around 4.5%. But even in that optimistic scenario, inflation “would still be below 2 per cent by end of the forecast period in mid 2023”.

Another reason to think that the Bank won’t taper its asset purchases is that other central banks will keep theirs broadly unchanged this year. (See Chart 1.) RBA Governor Lowe indicated in a recent speech that if the Bank were to end quantitative easing prematurely, the Australian dollar would strengthen even further.

Chart 1: Monthly Change in Central Bank Assets ($bn)

Sources: Refinitiv, Bank of England, Capital Economics

But as the labour market continues to recover faster than the RBA anticipates and other central banks announce the tapering of their purchases, we think the Bank will pull the plug on asset purchases by the end of the year.

Even if we are wrong and the Bank decides to extend them further, it will probably scale down their size. We estimate that once the Bank has acquired $300bn in government bonds, it will own just under 30% of the outstanding amount of federal and state bonds. But because the Bank’s purchases are split 4/1 between federal and state bonds, higher than the 3/1 ratio among outstanding bonds, the Bank will own around one-third of outstanding federal bonds by the end of the year. (See Chart 2.)

A fourth $100bn extension with an unchanged composition of purchases would result in the Bank soon owning nearly 40% of outstanding federal bonds. The Bank has been arguing that its purchases haven’t impaired the functioning of the bond market yet but both the Reserve Bank of New Zealand and the Bank of Japan have slowed their purchases when they reached similar proportions.

Chart 2: Central Bank Holdings of Government Bonds (% of total)

Sources: Refinitiv, Bank of England, Capital Economics

Rate hike expectations premature

The RBA indicated at the last meeting that economic conditions won’t allow a rate hike before 2024. But the financial markets aren’t buying it as they are pricing in a rate hike as soon as early-2023. (See Chart 3.) That explains why the Australian 10-year government bond yield has surged from 1.1% at the Bank’s February meeting to 1.59% today.

Chart 3: RBA Cash Rate Target (%)

Sources: Bloomberg, Capital Economics

We have some sympathy with this upbeat outlook, not least because we expect the unemployment rate to fall to around 4.75% by mid-2023. And the labour market is probably tighter than the unemployment rate suggests. (See our Focus.) As such, we think that wage growth will recover faster than the Bank anticipates.

And with the economic recovery continuing apace, loose monetary policy may soon start to undermine rather than support financial stability. The surge in housing loan commitments points to housing loan growth of nearly 10% by the middle of this year. That surge is partly driven by the HomeBuilder Grant, but even if we strip out loans for new dwelling construction, lending commitments have risen sharply. Any renewed surge in housing debt would happen at a time when household debt is still at record-highs relative to income

Even so, we expect the first rate to be delayed until early-2024 and 10-year government bond yields to drop back to 1.25% by the end of the year. For one thing, it would be bold to assume that the structural forces that kept wage growth subdued before the pandemic will have disappeared once virus restrictions are removed and immigration resumes. While the 0.6% q/q rise in the wage price index in Q4 was the largest since mid-2019, it was partly driven by temporary wage freezes unwinding. Underlying wage growth is just 1.5% annualised and we only expect it to rebound to 2.5% next year, whereas the RBA has made it clear that wage growth needs to hit 3% to meet its inflation target.

And while financial stability concerns may encourage the RBA to phase out quantitative easing, we doubt they will trigger rate hikes. RBA Governor Lowe has rightly pointed out that house prices aren’t any higher than they were four years ago. What’s more, the erosion of lending standards that encouraged the Australian Prudential Regulation Authority to impose restrictions during the last housing boom isn’t happening.

Indeed, the Bank is already pushing back against any expectations of policy tightening. With 3-year government bond yields creeping above its 0.10% target, the Bank this week bought 3-year bonds for the first time in two months.

The Bank indicated in February that it will have to make a decision later this year about whether or not the Bank will shift from the April 2024 to the November 2024 bond for its 3-year yield target. Sticking to the April 2024 bond beyond July would be a hawkish signal as it would imply that the Bank isn’t confident that the cash rate will remain at its current level beyond mid-2024.

We still believe that the Bank will instead roll over its target to the November 2024 bond. We suspect it will then stick to this bond for the foreseeable future, which means that the 3-year yield target becomes shorter as time passes on. But it’s possible that it will ditch the yield target altogether by the time it ends QE later in the 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

* Denotes release of

4th Feb 2020*

Cash rate cut 0.75%

2nd Feb 2021*

Additional $100bn in government bond purchases

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

Bank to announce $100bn extension of QE programme

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

No major policy changes

2nd Nov 2021*

Bank to confirm end of QE

3rd Nov 2020*

Cash rate target, 3-year yield target & Rate on TFF cut to 0.10%; $100bn in government bond purchases.

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, marcel.thieliant@capitaleconomics.com