RBA to stay the course - Capital Economics
Australia & New Zealand Economics

RBA to stay the course

RBA Watch
Written by Marcel Thieliant
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The continued easing in financial market tensions suggests that the Reserve Bank of Australia won’t announce any major new measures at its meeting on Tuesday, 5th May. And with unemployment set to remain above the natural rate for years to come, the Bank won’t tighten policy at least until end-2022.

  • Bank has started to roll back liquidity provision and bond purchases as tensions ease
  • Unemployment set to remain above levels consistent with full employment for years
  • Interest rates will have to remain low for longer than markets anticipate

The continued easing in financial market tensions suggests that the Reserve Bank of Australia won’t announce any major new measures at its meeting on Tuesday, 5th May. And with unemployment set to remain above the natural rate for years to come, the Bank won’t tighten policy at least until end-2022.

RBA scaling back its liquidity provision

After shooting up to a record $281bn in early-April, the RBA’s balance sheet has started to shrink again. (See Chart 1.) The main reason is that the RBA has scaled back the amount of liquidity available through its repo operations from $95bn at the end of March to around $85bn now. However, that’s still well above the $40-$60bn that were the norm before the virus outbreak. What’s more, banks have already borrowed $7.8bn out of the $90bn available under the RBA’s Term Funding Facility, lowering their funding needs. That explains why the spread between the 3-month Bank Bill rate and 3-month overnight rates has now turned negative. Tensions on US-dollar interbank markets have also started to subside, which matters because many Australian banks rely on short-term US-dollar funding.

Chart 1: RBA Balance Sheet ($bn)

Source: Refinitiv

Meanwhile, conditions on government bond markets have continued to improve as the spread between bid and ask yields has declined gradually since mid-March and is now almost back to normal levels. The minutes of the last RBA meeting noted that “if conditions continued to improve, it was likely that smaller and less frequent purchases of government bonds would be required.” Indeed, the Bank has already curtailed its purchases of Australian government securities drastically and may soon stop them altogether. (See Chart 2.)

Chart 2: RBA Government Bond Purchases ($bn)

Sources: RBA, Capital Economics

Admittedly, spreads on longer-term bank debt remain high by past standards even after some modest falls in recent weeks. If that remains the case, the RBA may eventually have to expand its Term Funding Facility further.

A case could also still be made for corporate bond purchases by the RBA as spreads have barely fallen after shooting up around 100bp in March. However, the RBA doesn’t seem overly concerned about the fact that corporate bond markets remained “strained”. While it noted at its April meeting that issuance of high-yield debt had largely ceased, it described overall conditions in funding markets as “mixed”. It also emphasised that the level of borrowing costs was low as government bond yields had declined. And its latest Financial Stability Report only made a passing mention of corporate bond markets.

At the upcoming meeting, the RBA is likely to take stock of the measures announced so far. We don’t expect the Bank to launch any new measures next week.

Interest rate hikes still years away

Looking further ahead, the financial markets aren’t pricing in any rate hikes for the next three years or so. That makes sense because the virus outbreak will keep underlying inflation below target for years to come. The RBA expects GDP to fall by around 10% in the first half of the year and the unemployment rate to hit 10% in Q2. We are a little more pessimistic as we expect GDP to fall by 12.5% from its peak and think the unemployment rate will hit 12%. What’s more, many employees will be working shorter hours than usual, so the underemployment rate will climb, too. The upshot is that the underutilisation rate may reach a record-high of 22% in Q2. (See Chart 3.)

Chart 3: Underutilisation Rate & Wage Price Index (%)

Sources: Refinitiv, Capital Economics

On past form, an underutilisation rate of 22% would be consistent with wages falling by 3% per annum. Indeed, we think that the consensus forecast that inflation will average 1.5% this year and 1.9% next is too optimistic. We expect underlying inflation to average around 1% both this year and next.

However, the hurdle to negative rates in Australia is high as Governor Lowe noted they are “extraordinarily unlikely”. What’s more, the RBA is already factoring in a pronounced weakening in price pressures: it expects consumer prices to fall in the year to June due to the provision of free childcare and the slump in oil prices.

A longer-lasting period of deflation remains unlikely. For one thing, the surge in the unemployment rate should unwind fairly quickly. The restrictions imposed to prevent the virus from spreading have hit some of the most labour-intensive industries, with accommodation & food services accounting for 7.6% of employment and wholesale & retail trade accounting for an even larger 12.6%. Employment in retail trade had fallen by a relatively modest 2.5% between mid-March and 4th April as supermarkets have hired more staff to meet soaring grocery demand. But employment in accommodation and food services plunged by a massive 25.6%. Once restaurants are no longer limited to takeaway and delivery, there will be a strong rebound in employment in that sector. Indeed, we expect the unemployment rate to fall to 7% by end-2022.

What’s more, the flattening of the Phillips curve means that wage growth is less likely to surge when the labour market is tightening. But it also means that cost pressures won’t weaken sharply when there’s additional slack in the labour market. (See Chart 4.)

Chart 4: Unemployment Rate & Wages

Sources: One Hundred Years of Economic Statistics, Refinitiv, CE

The way wages are determined in Australia should also prevent widespread pay cuts. The wages of more than a fifth of employees are directly set by Australia’s Fair Work Commission, which is very unlikely to propose wage cuts. For another 40% of employees, wages are determined by enterprise bargaining agreements, where workers’ representatives will oppose falling pay, too.

The key point though is that the unemployment rate will remain above the RBA’s estimate of the natural rate of 4.5% for year to come. The upshot is that rates may remain close to zero even for even longer than financial markets anticipate.

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%

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