RBA may yet have to launch negative rates - Capital Economics
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RBA may yet have to launch negative rates

RBA Watch
Written by Marcel Thieliant
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The recent easing in financial markets suggests that the Reserve Bank of Australia’s (RBA) won’t announce major decisions at the upcoming meeting on 7th April. Looking further ahead though, the Bank may still have to launch negative interest rates to meet its employment and inflation targets.

  • Tensions in interbank and bond market easing
  • Corporate bond spreads remain high but not high enough for RBA to buy private bonds
  • With inflation set to fall short of its target for years to come, negative rates still an option

The recent easing in financial markets suggests that the Reserve Bank of Australia’s (RBA) won’t announce major decisions at the upcoming meeting on 7th April. Looking further ahead though, the Bank may still have to launch negative interest rates to meet its employment and inflation targets.

Tensions in financial markets have eased

The RBA cut rates to 0.25% at its emergency meeting on 19th March, launched a target for three-year government bond yields of 0.25%, and pledged to lend at least $90bn to banks.

Over the last two weeks, the Bank has bought an astonishing $22bn in central government bonds, equivalent to 4% of the outstanding stock. It has also bought $2bn in state government bonds. Those purchases have been successful in lowering yields on 3-year government bonds from 0.50% before its emergency meeting to around 0.25% now. 10-year government bond yields have fallen as well, though they remain a touch higher than in mid-March. (See Chart 1.) That suggests that the Bank won’t introduce a target for longer-dated government bond yields for now.

Chart 1: Government Bond Yields (%)

Source: Refinitiv, Bloomberg

Asset purchases and liquidity provision have resulted in the Reserve Bank’s balance sheet swelling by around $70bn by 25th March. (See Chart 2.) Reserve balances have risen a little further since then, so the overall increase in the Bank’s balance sheet has now dwarfed the one seen during the global financial crisis.

Chart 2: RBA Balance Sheet ($bn)

Source: Refinitiv

The Bank’s large-scale provision of liquidity, including a record $12.7bn in open market operations on 19th March, have contributed to the easing in tensions in money markets. While interbank spreads in the US have shot up well above 100bp, those in Australia have edged down in recent days. (See Chart 3.) That has in turn allowed the Bank to scale back the size of its repo operations to business-as-usual levels.

Chart 3: 3M Interbank Rate to OIS (bp)

Source: Refinitiv

Admittedly, the Bank has had little success in lowering the spreads of corporate and financial bonds, which remain elevated. (See Chart 4.) In November, Governor Lowe noted that the Bank had no appetite to purchase private sector securities. One reason was that there were no signs of dysfunction in private capital markets then. By contrast, the minutes of the last RBA meeting noted that “the market for corporate bond issuance was essentially closed to all but the very highest quality borrowers”.

Chart 4: Bond Spreads over 3-year Government Bonds (bp)

Sources: Refinitiv, Capital Economics

Even so, we don’t expect the Bank to purchase private sector bonds anytime soon. For one thing, spreads aren’t unusually high by past standards. Bonds account for only a quarter of corporate debt and the large firms that issue debt securities may be able to replace them with bank loans. The Bank has already provided $90bn in 3-year loans to commercial banks at an attractive interest rate of 0.25%. That amount will rise further if banks expand their lending to businesses. Lenders will receive an additional $1 for every $1 lent to large firms and $5 for every $1 lent to small and medium enterprises. What’s more, Governor Lowe made it clear previously that the Bank isn’t willing to interfere into resource allocation by interfering in private markets.

Negative interest rates may yet be needed

Meanwhile, the minutes of the Bank’s last meeting showed that the Board considers 0.25% to be the effective floor as members had “no appetite for negative interest rates”. That echoes comments made by Governor Lowe in November, when he argued that negative rates are “extraordinarily unlikely”.

However, that assessment could change as unemployment soars and inflation falls further below target. We’ve pencilled in an unprecedented 15% q/q fall in GDP in Q2 as the social distancing measures restrict a wide range of economic activity. And even though the government has launched a $130bn wage subsidy, we still expect the unemployment rate to jump to 12% in the second half of the year. The upshot is that the RBA will not meet its full employment and inflation targets for years to come.

We think that Australia is particularly well suited for negative interest rates. The average interest rate on owner-occupier interest-only housing loans was a high 3.59% in February, though it will probably fall towards 3.0% as a result of the RBA’s recent interest rate cuts. That’s miles above the interest rate on reserve balances of 0.10%, which is now the de-facto policy rate as reserve balances have surged.

To be sure, the RBA has highlighted a number of drawbacks of negative rates. One of them is that they make life harder for investors who rely on the steady income streams provided by bonds. The RBA has flagged pension funds, but they only hold a fraction of their assets in domestic bonds. Insurance companies would be hit a little harder, but even for them, bonds only account for a rather small share of their assets. (See Chart 5.) Meanwhile, we aren’t convinced that low interest rates are encouraging people to save more. (See here.) And at a time when consumer confidence is already tanking, it’s hard to make the case that negative interest rates will undermine it any further.

Chart 5: Holdings of Domestic Bonds (% of Assets)

Sources: ABS, Capital Economics

If underlying inflation falls below 1% for a sustained basis, we think the RBA will reassess the merits of negative interest rates.

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*

0.75%%

2nd Feb 2021*

0.25%

The Statement on Monetary Policy later that week

3rd Mar 2020

Cut to 0.50%

2nd Mar 2021

0.25%

19th Mar 2020

Cut to 0.25%

7th Apr 2020

0.25%

6th Apr 2021

0.25%

5th May 2020*

0.25%

4th May 2021*

0.25%

2nd June 2020

0.25%

1st June 2021

0.25%

7th July 2020

0.25%

6th July 2021

0.25%

4th Aug 2020*

0.25%

3rd Aug 2021*

0.25%

1st Sep 2020

0.25%

7th Sep 2021

0.25%

6th Oct 2020

0.25%

5th Oct 2021

0.25%

3rd Nov 2020*

0.25%

2nd Nov 2021*

0.25%

1st Dec 2020

0.25%

7th Dec 2021

0.25%

Sources: RBA, Capital Economics


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