The Reserve Bank Board meets next week and policy is certain to remain unchanged.
The three year bond rate target of 0.25% is set to remain in place “until progress is made towards the Bank’s goals of full employment and the inflation target”. And the Bank would not increase the cash rate target “until progress is made towards full employment and it is confident that inflation will be sustainably within the 2–3% target band”.
These guidelines have been decidedly imprecise, allowing the Board considerable scope. For example what does “progress” mean? Does it need to be a reduction in the unemployment rate at a faster pace than the Bank’s current forecast for the unemployment rate to fall from 10% in December 2020 to 8.5% by end 2021 and 7% by end 2022?
What is progress on inflation?
Is it a better performance than the RBA’s current forecast that the trimmed mean measure will increase from 1% in December 2020 to 1.25% in December 2021 and 1.5% in December 2022?
If it has moved from 1% in December 2020 to 1.5% in December 2022, does that provide adequate confidence that inflation “will be sustainably within the 2–3% target band”?
The answer to this last question is almost certainly ‘no’ given that the Bank is prepared to purchase three year bonds at 0.25%, indicating that the cash rate is expected to stay at 0.25% at least out to August 2023.
But does “confident that inflation will be sustainably within the 2–3% target band” mean that inflation needs to SETTLE within the band for a period of time or does it only require the Bank to see a need to be pre-emptive? i.e. inflation is lifting sufficiently quickly for the RBA to be confident that it WILL SETTLE within the band over the policy horizon.
The US Federal Reserve has a significant influence on the thinking of other central banks.
Overnight Chair Powell delivered an important speech to the symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming.
From my perspective he made three key points:
1. Policy decisions will be informed by “assessments of the shortfalls of employment from its maximum level” whereas the previous approach considered “deviations from its maximum level” – i.e. a robust job market can be sustained without causing an outbreak in inflation, so policy should be targeted at achieving full employment and should be patient once full employment has been reached.
2. Policy towards inflation will change: “following periods when inflation has been running below 2%, appropriate monetary policy will likely aim to achieve inflation moderately above 2% for some time” – i.e. it is important to maintain 2% inflationary expectations after a long period of below 2% outcomes.
3. “Monetary policy interest rates are more likely to be constrained by their effective lower bound than in the past”.
The key economic developments which Chair Powell identified as relevant for the policy approach are:
• A fall in potential growth from 2.5% to 1.8%, reflecting lower population growth; the ageing population; and a slowdown in productivity growth.
• A fall in the neutral interest rate (the rate consistent with full employment and stable inflation).
• Extraordinary progress in lowering the unemployment rate – before the pandemic, the US experienced two years of the unemployment rate at 50yr lows.
• Inflation did not respond to low unemployment rate, lowering estimates of full employment.
• Persistent low inflation was lowering inflationary expectations which further lowered actual inflation – low inflation was feeding into lower interest rates which limited policy scope to lift rates in good times and cut
rates in times of an economic downturn. Chair Powell’s concern is that by reducing scope to support the economy by cutting interest rates due to the effective lower bound, downside risks to employment and inflation increase. To counter these risks the Fed is prepared to use the full range of tools to support the economy.
Implications for policy
The obvious interpretation of this approach is that policy will remain expansionary for longer than under the previous approach where the inflation target was more closely aligned with a specific 2%. Any further deterioration in the economy will be met with more aggressive easing.
There seems to be a rebalancing of priorities with the labour market transcending inflation as the key policy objective.
Being less pre-emptive and pushing the economy harder will eventually allow higher rates during a period of full employment so that greater flexibility can be allowed when the economy requires stimulus.
From my perspective there are two complications to this revised approach.
The Chairman noted that ”Prior to the current pandemic induced downturn a series of historically long expansions had been more likely to end with episodes of financial instability”.
This ‘new’ approach gives no attention as to the likely constraint on policy from asset markets, instead only focussing on the experiences of forty years ago when expansions ended with high inflation.
It is more than reasonable to expect that the policy constraint to ongoing aggressive stimulus will be asset markets rather than inflation.
A key to the new approach is to establish some interest rate flexibility above the zero lower bound (ZLB). But he does not explain why policy could not go into negative rates where the ZLB constraint would no longer hold.
It is also somewhat disappointing that Chair Powell does not outline any new policies that might assist in his objectives.
How might this affect the RBA?
If we consider some of the key observations about the US itemised by Chair Powell there are certainly some similarities.
The RBA is facing a falling potential growth rate due, partly, to low productivity growth.
Its performance on its inflation target has been disappointing – inflation has not been in the 2–3% range for six years.
However, Australia has not been able to replicate the US performance on the unemployment rate with the low point since the GFC being 4.8% compared to a 4% low prior to the GFC. We assess that the RBA sees the full employment rate as 4.5%.
We have not been able to replicate that two year period in the US where 50yr lows for the unemployment rate failed to spark inflation pressures.
Nevertheless, like the US, we have very low inflationary expectations as measured by the indexed bond market.
I believe the risk/reward trade-off for negative rates is much more attractive for Australia than in the US, due to the currency effect on a small open economy with large foreign debt.
So, are there any lessons from the Fed’s policy pivot for the outlook for Australian monetary policy?
The RBA has given itself maximum flexibility around the policy outlook. It’s only real commitment has been setting the three year bond rate at 0.25%, indicating a steady cash rate for the next three years.
Using the term “progress” around its unemployment target, and not identifying the full employment rate, it provides maximum flexibility.
I agree with the Fed that it is unlikely that the inflation constraint will be a factor limiting policy’s central objective – a return to full employment.
For Australia, and most likely the US as well, the constraint to extended aggressive policy stimulus will be the “financial instability” that Chair Powell so astutely identified as being the cause of the curtailment of recent “historically long expansions”.
The RBA is in a good space at the moment, providing fairly vague guidance with respect to future policy.
Over the next three years that is much more likely to change with a need to provide further stimulus than any need to tighten policy.
As with the US when the need to tighten does arrive it is more likely to be due to asset market imbalances than inflation.