RBA to cut rates to 0.10% and launch QE - Capital Economics
Australia & New Zealand Economics

RBA to cut rates to 0.10% and launch QE

RBA Watch
Written by Marcel Thieliant
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The Reserve Bank of Australia will cut interest rates and launch quantitative easing at its upcoming meeting on Melbourne Cup Day. We suspect that aggressive monetary and fiscal stimulus will pave the way for a strong recovery next year and don’t expect the Bank to follow up with negative interest rates.

  • Cash rate target, three-yield target and TFF interest rate to be lowered to 0.10%
  • Interest rate on Exchange Settlement balances to remain at 0.10%
  • Quantitative easing is coming and the Bank may buy $150bn in government bonds

The Reserve Bank of Australia will cut interest rates and launch quantitative easing at its upcoming meeting on Melbourne Cup Day. We suspect that aggressive monetary and fiscal stimulus will pave the way for a strong recovery next year and don’t expect the Bank to follow up with negative interest rates.

Lowe signals more easing

The Bank kept policy settings unchanged at its October meeting, presumably because it didn’t want to distract from the release of the Federal Budget on the same day. But the minutes of that meeting and a speech by Governor Lowe two weeks ago strongly indicated that the Bank will ease policy at the upcoming meeting. In a parliamentary hearing in August, the Governor argued that it wasn’t clear whether there were material benefits “from having the five-year yield curve at 10 or 15 basis points lower than where it currently is”. But in his recent speech, he argued that as the economy is opening up following the lockdowns earlier this year, “further monetary easing would get more traction than was the case earlier.” And while Mr Lowe argued earlier this year that the benefits of further easing would outweigh the costs by lifting household debt and inflating the housing market, he is now arguing that monetary easing would help to improve private sector balance sheets and reduce non-performing loans. As such, it would improve financial stability.

The financial markets had already priced in additional easing following a dovish speech by Deputy Governor Debelle in late-September, in which he indicated that lowering the Bank’s policy rates and additional asset purchases rather than negative interest rates and foreign exchange intervention are the most likely options for additional easing. Indeed, 3-year government bond yields dropped from just over 0.25% to around 0.15% following that speech. (See Chart 1.) We and most other analysts expect the Bank to cut the cash rate target, the 3-year yield target and the interest rate on the term funding facility to 0.10% next week.

Chart 1: 3-year Government Bond Yields (%)

Source: Refinitiv

Cutting the cash rate target to 0.10% won’t have any impact on short-term money market rates because the rate the Bank is paying on exchange settlement (ES) balances is already at 0.10% and that rate sets the floor for interbank rates. When the Bank cut the cash rate by 0.25bp in March it only lowered the interest rate on ES balances by 15bp to “mitigate the cost to the banking system” associated with the impending surge in reserve balances.

Admittedly, the minutes of the Bank’s October meeting showed that the Bank had discussed cutting the cash rate and the 3-year yield target “towards zero, without going negative”. As such, it’s possible that the Bank will cut the interest rate on ES balances further. But given that ES balances have jumped by 160% since March, the cost of cutting interest rates all the way to zero has soared. We suspect the Bank will keep the interest rate on ES balances at 0.10%.

While Governor Debelle’s speech had resulted in a repricing of short-term interest rates, it still wasn’t clear whether the Bank would launch quantitative easing as we had predicted would happen since May. That uncertainty was resolved by the Governor’s speech, in which he noted that the RBA’s balance sheet had risen less than the balance sheets of other major central banks and that this had an impact on the yield curve and the exchange rate. (See Chart 2.) He noted that the Board is “considering the implications of this as we work through our own options.”

Chart 2: Increase in Central Bank Assets Since Feb. 2020 (% of 2019 GDP)

Sources: Refinitiv, Capital Economics

The markets rightly concluded that quantitative easing is now looking very likely and 10-year government bond yields plunged by 10bp on the day of Mr Lowe’s speech. (See Chart 3.) And while they have rebounded since then as US 10-year Treasury yields have hit a four-month high, we reiterate our year-end forecast of 0.75% for 10-year Australian government bond yields.

Chart 3: 10-year Government Bond Yields (%)

Sources: Refinitiv, Capital Economics

We’ve previously argued that the Bank would opt for a target for five-year yield target but the emphasis on the size of its assets means a target for the volume of bond purchases is more likely. The RBA’s assets are set to increase without additional action. After all, banks have drawn down $83bn under the Term Funding Facility (TFF) but the impact on the RBA’s assets has been broadly offset by a $92bn decline in repo lending. (See Chart 4.) The outstanding amount of repos is now lower than it was before the pandemic so if banks draw down the additional $116bn available under the TFF by the June 2021 deadline, the RBA’s assets should rise by a similar amount. With the cost of 3-year market funding at around 0.40% and the RBA set to slash the interest rate on TFF funding to 0.1%, banks are likely to make full use of their TFF allowance. Meanwhile, the Fed’s assets haven’t risen any further recently.

Chart 4: RBA Assets ($bn)

Sources: Refinitiv, Capital Economics

But other central banks keep expanding their assets and we wouldn’t be surprised if the Fed stepped up the size of its bond purchases, too. If the Bank wanted to get a head start and mimic the expansion in the BoJ’s assets, who is topping the rankings, it would need to buy an additional $150bn in government bonds. (See here.)

The key question is whether that additional easing is enough or whether the RBA will eventually have to cut interest rates into negative territory. The Q3 inflation data were in line with the RBA’s expectations and suggest that price pressures won’t weaken as sharply as we had feared. And with the unemployment rate already having fallen from 7.5% in July to around 7%, Governor Lowe indicated that the Bank’s forecast that the unemployment rate will hit 10% by year-end is too pessimistic. What’s more, we think that Australia’s huge fiscal response covered with its success in containing the virus means that economic activity will rebound faster than most anticipate. As such, we suspect the Bank won’t launch negative interest rates.

The rally in the Australian dollar has stalled a bit recently as markets have started to price in more easing. But we expect it to resume before long as the recovery in risk appetite has further to run. Our end-2021 forecast for the Australian dollar is US$0.78 compared to US$0.71 today.

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

No major policy changes

2nd Nov 2021*

No major policy changes

3rd Nov 2020*

Cash rate target, 3-year yield target & Rate on TFF cut to 0.10%; $150bn 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, +65 6595 1514, marcel.thieliant@capitaleconomics.com