Deflation Phil argues furiously to do nothing

Via Bill Evans at Westpac:

Today Reserve Bank Governor Lowe made his biannual address to the House of Representatives Standing Committee on Economics.

His dominant theme is the need to support the economy through job creation.

Every policy should be judged on its capacity to boost jobs.

His position on borrowing and budget deficits is quite clear: “By borrowing today to support the economy we are avoiding an even bigger loss of output and jobs that would damage our economy and society for years to come, which would put ongoing strain on the budget”.

He supported the argument noting that Australia’s public finances are in strong shape; public debt is low; the balance sheet strong due to decades of good economic performance; and financing costs have never been lower”.

Expansionary fiscal policy has adequate scope to boost demand while governments need to free up supply through structural reform.

Opportunities for reform exist in the industrial relations system; lifting skills; promoting innovation; addressing over regulation; and taxation (including states’ stamp duty).

In response to a question contrasting Federal support ($314bn) with State support ($44bn) he noted that the states have considerable influence on job creation, particularly in the infrastructure space, and should be focussed on that objective rather than protecting a credit rating.

It has always been refreshing and insightful to listen to the Governor’s observations around policy and the economy.

But this event, with its penetrating question time, also provides some opportunities to examine the Governor’s own policy positions.

That opportunity came with one line of questions around the Bank’s current forecasts which envisage the inflation rate still at 1.5% (having dipped to 1%) by the end of the forecast horizon – December 2022 and the unemployment rate at 7%.

Recall that the Bank’s objectives are: full employment (generally assessed at 4.5–5.0%) and inflation sustainably in the 2–3% range.

With such discouraging (but entirely realistic) forecasts a Committee member opined as to whether the Bank should be doing more on its own policy front.

The Governor pointed out that the Board could reduce the cash rate by 0.1–0.2% but doubted whether that would make any worthwhile difference.

Another possibility was to move the bond rate target out along the curve from the current three year maturity to five years.

He pointed out that the decision to target the rate (Japan is the only other country exercising yield curve control) was based on two considerations.

• It is a more direct way of achieving a low funding cost. Targeting the volume of bond purchases would also have lowered the rate but would come with the difficulties of calibrating the volume to achieve the required rate.
• It reinforces forward guidance. The Governor is entirely confident that the cash rate will not be increased for three years given the requirement for the Board to be confident that inflation would be sustainably within the 2–3 % band.

He noted however that he could not be confident that the cash rate would remain unchanged for five years making the extension of the target to a five year maturity unhelpful (my wording) from a forward guidance perspective.

Looking forward it therefore seems likely that the Bank is most likely expecting to raise or abandon the target for the three year rate some time in 2022. That lift in the three year bond rate figures in our own rate forecast for 2022, implying that markets would be factoring in a rate hike some time beyond 2023.

The Governor was also questioned on negative interest rates.

The Committee member quoted me as a proponent of negative rates – potentially making me a member of a select ‘rogues gallery’.

I was pleased that the Governor responded with some more detail around his view that negative rates are “extraordinary unlikely” without entirely ruling them out.

He recognises that the major benefit would be on the exchange rate. I agree that a small open economy with large foreign liabilities is likely to benefit through negative rates with a lower exchange rate.

I have no doubt that the key benefit seen by the RBNZ, which is still holding open the possibility of negative rates, is the prospective boost to competitiveness (especially if the RBA and Fed continue to eschew this policy path).

As I have argued before, the major proponents of negative rates – Europe; Japan; and Switzerland – have large net foreign assets limiting the benefit to the exchange rate of a negative rate approach.

While the Governor acknowledged the benefit from a lower exchange rate, he continues to argue that the costs would outweigh those benefits.

He highlighted the costs in terms of the credit creation mechanism pointing out that European banks’ lending had been impacted.

There is always the demand/supply issue when assessing slow lending growth just as the Governor himself explained the slow take up in his own very generous TFF facility.

Issues around bank profitability through negative returns on exchange settlement balances can be managed through a threshold system.

But the big issue seems to be around negative retail rates. He noted that if the deposit rate was negative people would save more than spend on the basis that expected income growth would be negative.

The net stimulus argument supporting rate cuts seems to be contradicted when rates go negative. I agree that the potential non linear impact of negative rates on overall confidence is a key area of uncertainty.

But the basis of the Australian banking system, where retail deposits only represent around 60% of assets (generally compared to near 100% in Asian; Japanese and European banking systems) would allow Australian banks to avoid negative retail deposit and mortgage rates, confining negative rates to the wholesale market.

A large corporate or institution when confronted with a negative cash rate might be motivated to invest in a higher yielding risky asset or invest offshore potentially boosting activity either through a more competitive exchange rate or more funding for real assets.

His factual observation is that those countries with negative rates have not gone ‘more negative’ in the COVID period nor has any central bank gone from positive to negative. If the global recovery expected post COVID disappoints then more pressure might come on to central banks, including the RBA, to be more aggressive in their policy options.

The Governor was asked about other ways to lower the AUD.

His point here was that intervention (which would be done by selling AUD and buying foreign assets such as US Treasuries or gold) would only work if the AUD was overvalued relative to fundamentals – trying to move a currency away from fair value would be extraordinarily difficult given the depth of the currency markets.

Some issues come to mind here.

Firstly, of course, negative rates would lower the fair value.

Secondly, fair value models differ with their choice of the risk component. Fair value at a time of high risk would, using such models, be much lower for the same commodity price/yield differential than without a risk component.

I think that commodity prices are overstated as a source of demand stimulus in Australia. Lifting profits for mining companies which are typically targeting margins and not volumes will not necessarily boost demand in Australia.

It is our view that AUD has entered a long upswing period – at least out to end 2021 and most likely beyond.

The figure above shows the history of the AUD’s long cyclical movements. With the current downswing having ended in March, a two year plus upswing is now most likely. But supply issues could easily derail fair value in 2021, potentially opening up a considerable overvaluation of the AUD.

Perhaps, under such circumstances, and given our view that the Australian economy will be growing around 3%, compared to RBA’s 5%, in 2021 the negative interest rate/intervention debate might get a wider hearing.

How absurd. A central bank that has’t forecast a single thing right since 2011, now won’t move policy for fear of being wrong five years out.

Sack Phil Lowe. He’s paralysed by fear. We need an Operation Twist now and negative rates as soon as possible to smash the currency.

Prepare macroprudential as well to control any spillovers into credit.

David Llewellyn-Smith
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  1. karlflowersMEMBER

    What a shame the anti-investment RBA strategy is set to push us deeper into recession. Why invest in import-competing or exporting industries in Australia – when the RBA runs policies to keep the A$ artificially high? What a shame that only in Australia do monetary policy experts have so little idea about industry economics. The only industry competitiveness issue valued by the RBA seems to be the banking cartel’s profits. Recalling the recent RBA policies that gave us US$1.10 to the A$ means that the RBA would need to be utterly convincing in the unexpected situation of them seeing sense and emphasising how they can turn to positively influencing demand for investment.


    I dont think they are going to go negative nominal rates if they can help it. Will just bind it to current levels and let negative real yields do the dirty work. Manage the fallout of the debt deleveraging with bouts of fiscal.

    Lyn Alden sums it up nicely:

    As bad as the pandemic is affecting the global economy, the bigger story is how the pandemic is just a large catalyst that is triggering the later stages of a long-term debt cycle that has been building for decades.

    I also marked on that CBO chart the period where Treasuries consistently failed to keep up with CPI purchasing power, or in essence, the United States inflated away part of its national debt. In the 1940’s, it was through formal yield curve control. In the later 1960’s and into the 1970’s, it was by raising interest rates at a slower pace than inflation, and the Treasury market failing to keep up with inflation.

    That is historically how long-term sovereign debt supercycles are paid down when they are denominated in one’s own currency and hit 100% of GDP or more: currency devaluation, and a soft default through purchasing power of that sovereign debt, rather than a nominal default.

    They are going to use messaging (perpetual hope speak) to manage the bond market where possible, and failing that, directly intervene in any problem areas of the curve to peg yields.

    • Jumping jack flash

      They don’t need negative cash rate if they use a UBI correctly.
      The two are basically equivalent, especially with the economy so dependent on debt to obtain the things that are essential. A UBI would basically be used to obtain debt in the vast majority of cases, and given that assumption, a UBI would work in a similar way to an interest rate cut for improving debt eligibility and getting the debt growing again. That’s also assuming the banks would lend money to people taking their UBI into account. Don’t see why they wouldn’t.

      At the moment the UBI is restricted to a subset of the economy. They need to broaden it to give everyone access to the free money.

      Deficits don’t matter. They could use QE or another kind of trickery to hide the inflation that would cause, but it is probably more likely that the extra debt’s extra interest would cancel out any actual inflation.

      • UBI is just debt monetization.

        The UBI (JobSeeker) would be funded by the CB printing money and purchasing the issued debt – QE.
        That printed money has no basis in new production and will inflate pricing by a commiserate amount; ie direct fiscal injections, as opposed to being trapped in financial asset inflation (old QE).
        If the CB has pegged yields via YCC, inflation will run over yields and create a negative real yield environment. Yields need to be maintained at the lows so as to prevent mass defaults, which is the other form of debt deleveraging.

        In effect, the CB has monetized the debt by debasing the currency (printing), as the debt is a fixed nominal figure maintained by low rates. In other words the debt figure doesn’t change, but there are now more dollars in the hands of the people with which to pay those debts down.

  3. “Paralysed by fear”, pot calling the kettle black from the “lock us down” mob, no?
    What happened to embracing creative destruction?

    We are living in a time where capitalism isn’t working in favour of those that make the rules; so we suspend it. It reminds me a little of something else we have suspended, democracy, that’s it. Why ask the people what they want or even have a sitting parliament or even a voice of opposition when we can just declare rolling states of emergency and disaster.

    Now we have those 2 pesky issues dealt with let me refer to my George Orwell collection for what comes next.

    By continually changing The rules of the game whilst the game is in play you don’t get better results for everyone, you merely allow the powers that be to chose who will be the winners and who will be the losers. And so many people believe they will be on the favoured list!?!

  4. Jumping jack flash

    The only slightly obscure thing they were confident at doing was manipulating interest rates – something that was completely taboo for years prior to 1999/2000 mind you.

    Prior to that the performance of the economy set the interest rate. For 20 years they ran the economy backwards and inside out and whenever things got a bit hairy they simply manipulated interest rates downwards. Again and again and again it was done. And apparently nothing about that was strange or weird or concerning.

    Now that they’ve reached zero rates and need to step into the wild and woolly world of MMT (other than the whole interest rate manipulation period of course) they’ve all gone to water.

    Come on Phil. Like a bandaid, mate.

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