Recent data not enough for the RBA to shift course - Capital Economics
Australia & New Zealand Economics

Recent data not enough for the RBA to shift course

RBA Watch
Written by Ben Udy
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In recent weeks, the Reserve Bank of Australia has continued to push back against expectations of monetary tightening. We think the RBA will keep policy settings unchanged at the meeting on 6th April. And later this year we expect the Bank to announce a further extension to its asset purchase programme. What’s more, we think the market is overzealous in pricing in rate hikes as early as next year. We think rates will be on hold at least for a couple more years and probably until 2024.

  • RBA will remain committed to its bond yield target
  • And should extend QE once more in June
  • Market too bullish on rate hikes

In recent weeks, the Reserve Bank of Australia has continued to push back against expectations of monetary tightening. We think the RBA will keep policy settings unchanged at the meeting on 6th April. And later this year we expect the Bank to announce a further extension to its asset purchase programme. What’s more, we think the market is overzealous in pricing in rate hikes as early as next year. We think rates will be on hold at least for a couple more years and probably until 2024.

RBA playing the long game

The RBA this month demonstrated that it is willing to be flexible in defending its yield curve target when liquidity conditions deteriorate. Bid-ask spreads spiked to the highest level since early 2020 at the start of March month prompting the RBA to briefly double the pace of asset purchases. (See Chart 1.) Aside from that occasion, the Bank has remained consistent, buying $5bn in bonds per week.

Chart 1: Bid-Ask spread

Sources: Refinitiv, Capital Economics

It also took steps in early March to defend its three-year yield target against short-sellers by lifting the cost of borrowing from its own facility from the usual 20bp to 100bp. Those moves should help the Bank maintain loose monetary conditions for some time to come.

Data better than expected

Admittedly, recent data have surpassed the RBA’s expectations. In February the RBA forecast Q4 GDP to have remained 2% below pre-virus levels. In fact, strong growth in consumption and investment meant that GDP rose to just 1.1% below pre-virus levels. And while the brief localised lockdowns in Q1 will have disrupted activity somewhat, we still think GDP rose further at the start of 2021.

More importantly for the RBA, a burst of hiring in February caused the unemployment rate to drop from 6.4% to 5.8%. The RBA had expected unemployment to remain above 6% until the end of this year. And it forecast that it would only drop to 5.5% by the end of 2022. The improvement in February was therefore clearly an upside surprise.

Even so, the economy still has a long way to go before the RBA will be satisfied.

Governor Lowe gave a speech last month which revealed that the Bank has lowered its estimate of the natural unemployment rate which would be consistent with full employment, to around 4.0%, bringing it in line with our own view.

Chart 2: Unemployment Rate (%)

Sources: Refinitiv, RBA, Capital Economics

While we are more upbeat about the outlook for the labour market than the RBA, our forecast that the unemployment rate will decline to around 5% by the end of 2022 means that full employment is still a long way off. (See Chart 2.)

And while our forecast for wage growth to reach around 2.5% by the end of 2022 is more optimistic than the consensus or the Bank’s forecast that would still fall short of the Bank’s desired rate of wage growth of 3% or above.

The upshot is that we don’t think recent data will have changed the RBA’s dovish stance. We agree with the consensus view that the Bank will keep policy settings unchanged at next week’s meeting.

More QE to come

In fact, we think the RBA will maintain its dovish stance for a while yet. While inflation may rise in the months ahead the Bank is likely to look through this. Inflation may reach 3.3% y/y in Q2, above the ceiling of the RBA’s 2-3% target band. But that’s largely due to temporary price reductions during the initial lockdown in Q2 last year becoming the base for the annual comparison. Those price reductions were largely unwound in Q3 last year so annual inflation will ease again in the second half of the year. We expect headline inflation to drop back to just 1.7% y/y by the end of this year.

And while we do expect a further improvement in the labour market, employment growth is likely to slow in the coming months as the JobKeeper wage subsidy comes to an end. We think strong labour demand and the low underemployment rate mean that the schemes end will not result in job losses in most sectors, but some sectors such as tourism may still need to reduce staff. We therefore doubt the surge in employment in February will be repeated.

It would take a significant upside surprise in the coming data to cause the RBA to change course. On that basis we still expect the RBA to announce one final $100bn extension to its QE programme at its June meeting which would take until January 2022 to complete.

By the end of the year, it should be clear that the labour market is continuing to recover which, alongside the vaccine rollout may convince the Bank to end its purchases.

Rate hikes still a long way off

But we don’t expect the unemployment rate to fall below 4.5% until 2024, and, beyond the upcoming spike, we think that inflation won’t rise much above the bottom of the RBA’s target band before then either.

As such, we don’t expect the Bank to raise interest rates anytime soon. By contrast, market expectations are still consistent with rate hikes as early as next year. (See Chart 3.)

Chart 3: Market Rate Expectations

Sources: Bloomberg, Capital Economics

Admittedly, we have recently revised our forecast for the Australian dollar and now only expect it to rise to US$0.78 by the end of this year before easing to US$0.75 by the end of 2022. That should take a little bit of the pressure off the RBA to keep policy loose for the sake of the exchange rate. And with the stronger recent data, the risks to our policy rate view have shifted towards a somewhat earlier hike – perhaps late in 2023.

But we continue to think that the chances of rate hikes before then are lower than generally anticipated.

The RBA is due to make a decision in the next few months on whether to switch the focus of its yield target from the April 2024 bond to the November 2024 bond. One possibility is that the unexpected strength of the labour market convinces the Bank not to shift and to allow the maturity of the yield target gradually to decrease in the years to come. It wouldn’t be binding, but that could provide a form of forward guidance for the path of short-term rates out to 2024.

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

Alison Watkins

Carolyn Hewson

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


Ben Udy, Australia & New Zealand Economist, ben.udy@capitaleconomics.com