Via Bill Evans at Westpac:
Over the last two weeks, I have been visiting institutional investors, real money managers, and hedge funds in Europe and London.
There has been extraordinary interest in the Australian story on this visit. Westpac has received considerable credit for its views over the last eighteen months. A year ago, when market pricing and most commentators, including the central bank, signalled higher rates, Westpac took a strong stand that rates would remain on hold. Customers also recognised that Westpac was the first of their advisers to predict rate cuts – a forecast made back in February this year.
Whilst it is understandable that Australia is of interest at the moment due to the RBA being “in-play”, it is also important to note that many institutional investors see the Australian dollar as an integral part of their investment portfolios. Investors support Australia because it still provides relatively high yields, deeply liquid markets, competitive pricing, and reliable research.
In my discussions, I highlighted the evolution of the approach to policy from the RBA. This started with the RBA Governor’s view late last year that household debt was a bigger threat to the Australian economy than a long period of low inflation. His approach to policy was that while rates were on hold for the time being, the next move in rates was likely to be up.
Around the end of last year, when the housing market deteriorated more rapidly than expected and GDP growth slowed abruptly, there were clearly second thoughts emerging in the RBA. That culminated in a speech in February in which the Governor indicated that rates could either rise or fall. This was an important signal for Westpac, since for some time we had suspected that the RBA did not think rate cuts would be particularly effective. Clearly that approach had changed. Shortly after the speech, Westpac shifted to forecasting two rate cuts, in August and November 2019.
RBA rhetoric then switched to highlighting the ‘tension’ between the labour market data and the GDP (and other spending partials) data. Westpac pointed out that this tension could be resolved by noting that employment in cyclical parts of the labour market was indeed in decline, and the overall employment figures were holding up due to government spending driven sectors including health and education. In late May, the Governor finally switched his target towards stimulating the labour market, indicating more could be done to drive the unemployment rate down from its current 5.2% with the NAIRU also being seen as lower than the previously assessed 5% (later confirmed as being closer to 4.5%).
That switch in policy objectives was confirmation of our view that rates were about to fall, and given that the RBA’s current forecasts, which incorporate two rate cuts, were for a 5% unemployment rate this year and next, only ticking down to 4.75% by mid 2021, we expected that more than two cuts were going to be required. Today our view holds that two more cuts will be delivered in August and November – a total of three cuts for 2019.
By far the most interesting discussions with those customers who closely follow the RBA rate cycle is what action is likely to follow the move to a 0.75% cash rate target. Westpac’s view has been that the risks to that forecast are to the downside, although we do anticipate a more constructive economic environment in 2020 as the housing market stabilises; fiscal policy plays a more stimulatory role; and the global economy improves following two FOMC rate cuts in 2019, the impending US election also motivating the US President to play a less disruptive role.
We also speculated that if the RBA saw a continuing need to stimulate the economy, it would embrace some form of quantitative easing (QE) rather than drive the cash rate below that 0.5-0.75% range seen as the likely floor beyond which the transmission to lending rates becomes ineffective.
There were a range of opinions from customers about the appropriateness of QE for Australia. Coming from a European base, these customers held that the challenges facing Australia were totally different to those faced by the ECB and the BoE, where credit conditions and liquidity were the major constraints on the economy.
One view was that Australia’s flexible exchange rate could be expected to play the constructive role, unlike say a country like Italy where the necessary exchange rate flexibility was not possible. This argument pointed to the preferable policy being to drive interest rates down to 0% and rely on the currency reaction to deliver the bulk of the stimulus. In fact, the general view in Europe was that negative interest rates were mainly beneficial through the currency rather than any response from the banking system.
A second view questioned the process of moving from interest rate cuts to quantitative easing. The most likely form of quantitative easing, as we have discussed, is for the RBA to provide cheap long-term funding to banks secured by mortgages registered with the RBA under the Committed Liquidity Facility. This policy was questioned since, as we have discussed, the signal that the transmission from lower rates was not working would come through the banks’ muted response to interest rate cuts. Customers questioned whether it would be a politically viable policy to switch to QE, which would effectively be supporting the banks with low cost funding. Naturally, as we have seen in the UK and Europe, these facilities would be tied to new lending, but with around 80% of mortgages in Australia linked to a variable rate, the real transmission effect should come from lower rates on existing mortgages rather than new loans. This policy approach was assessed by these customers as being overly ambitious.
Finally, there was a view that QE has a range of unintended and unpredictable costs. Such a policy should only be adopted when a credit crisis has emerged. It should not be adopted as a form of stimulus, particularly when the stimulus is aimed at chasing a NAIRU that cannot be known in advance. Evidence around the world indicates that NAIRUs are much lower than anticipated, with the US unemployment rate of 3.6% still not generating clear wage pressure. This criticism is questioning the link between unemployment, wages and inflation. For Australia, perhaps, the better lead indicator for policy should be the response of the housing market. Ironically, that implies RBA policy would be reverting back to where we were a year ago, when the most important aspect of economic welfare related to household debt and housing markets.
Clearly, we find ourselves at a very interesting stage of policy. While we are aware that the RBA has done considerable work on quantitative easing, certainly during the GFC period, sensible people are warning that the practicality and the unknown costs of quantitative easing policies do not justify their use when the target is not credit and liquidity but instead chasing an uncertain NAIRU.
I also addressed the European Securitisation Conference and noted that a further dimension to QE would be the RBA buying asset backed securities issued by non-banks. The response of a number of issuers was surprising. They claim that unnecessarily driving down the rates on these assets would disadvantage them with other investors and therefore not be welcomed. That theme is a clear example of the so-called hidden costs of quantitative easing.
Secondly, banks receiving extensive low cost funding from the RBA would therefore restrict their support for their traditional funding markets, be they wholesale or retail depositors. Temporarily moving away from traditional funding sources, which still remain available, may be an appropriate example of the costs that QE creates in a well-functioning financial system.
Conclusion
Westpac remains comfortable with its forecast that there will be two more rate cuts in August and November. In 2020, the risks are to the downside for another cut. We see that 0.5–0.75% as the effective policy floor. The issue of whether the RBA moves into a ‘QE-mode’ beyond that floor will be a very difficult one for them to consider. It is not our central view that QE will be adopted, and certainly, some of the arguments discussed above are significant themes that the RBA will be considering should it see the need for further stimulus next year.
