Westpac: RBA Governor casts more light on policy options

From Westpac chief economist, Bill Evans:

Today Reserve Bank Governor Lowe made his bi-annual address to the House of Representatives Standing Committee, 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; 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 ($314 billion) with State support ($44 billion) 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 word) 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 sees the boost to competitiveness as the key advantage, (specifically if RBA and FED eschew the policy).

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 compartmentalising the 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 a aggressive in their policy options.

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

His point was that intervention (which would be done by selling AUD and buying foreign assets such as US Treasuries or gold) would only work if AUD was over valued 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 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.

Bill Evans, Chief Economist

Leith van Onselen
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Comments

  1. >> Every policy should be judged on its capacity to boost jobs.
    This must suck for every other leech that judges policies on how it boosts their bottom line or house prices.

  2. Sunlord BCNMEMBER

    The RBA can say and wish for what ever they’d like, what matters to people is what interest rate they pay on their home loan and banks will be forced to raise home loan interest rates. I believe int rates are going to rise out of cycle into this crash

    Re AUD, I tend to agree but because I believe DLS’s AUDSPX correlation holds.. I think we are going to have one more big sell off in DOW, S&P500 and ASX200, that’ll drag AUD to 50s again and then AUD up
    Think we will get a chance to buy AUD and ASX much lower in next 6 months
    This isn’t over ….,,

      • Sunlord BCNMEMBER

        GB
        I’ve written extensively over the last 12 months about many of my views
        One was holding cash
        But as the year has gone on I’ve adjusted my view based on what’s actually played out
        I misunderstood the extent RBA AND GOV would bail out banks, extension on loan repayments etc
        I don’t trust the GOV re cash, it wouldn’t surprise me if they cancelled cash one day…
        It’s still good but I’m not as phased about less cash, banks will get in trouble but they’ll keep the electronic payment system going somehow
        Either way I don’t trust the GOV
        I like equities gold silver short dated bonds etc..
        Also since this virus people seem a little scared of cash notes re virus
        Let’s see

        • I agree , increment by 10 billion in broad money in few months is a sign that even with corona people still want cash and less trust banks. it would be imaginable disaster if the cancel cash

      • “While some of these notes might be used for “shadow-economy transactions”, which includes everything from drug deals to cash-in-hand wages, the RBA estimates this contributes modestly to the overall figure”.

        So why the Cashless imperative if Shadow Money is modest?

        • It will facilitate NIRP.

          But with tried & true LNP ‘bait-n-switch’ politics they will highlight the black economy considerations as justification.

    • if you turnout to be right then RE will crash over 80%. Not many can pay any IR hike let alone hikes. I’d say if rates go up 75 basis points will see about 35-50% of all home loans defaulting. People are drowning in debt.

      • Sunlord BCNMEMBER

        Niko
        I don’t care what anyone says, as these arrears and defaults start piling up, banks are going to increase their margin through higher interest rates. I’m sorry I’m not interested in any made up concoction MMTQEYIELDCONTROL of what ever. Rates are going up in next 6 to 12 months

        • I am not saying you are wrong.. I too lean towards IRs going up and catching everyone by surprise. All I am saying is what will ensue if (or when) they do go up.

    • Anybody who thinks the RBA policy settings can ‘create jobs’ is brain dead. Literally as dumb as dog-sh#t.

    • Monetary policy cannot boost jobs. What a load of nonsense.

      More quackery from the Keynes cargo cult

  3. boosting jobs for current residents or just just increasing the amount of jobs? Either way they will probably take the short term route and just build more roads and bridges to nowhere rather than the slow build up of proper industry.

    • Jumping jack flash

      This

      Infrastructure jobs are the most useless.
      They add nothing except the money paid to build it, and then when the building is complete they stop contributing anything.

      And in the case of [increased] tolls, fares, fees, etc, for the use of the completed work, it just redirects existing money in the economy to their payment which just leaves less to spend on everything else.

      But they look pretty i guess.

      • Haywood JablomyMEMBER

        There’d be less need for it at all if we gave up our spinning the wheels immigration fed economic ‘growth’ model.

        • Jumping jack flash

          Immigration is just a symptom of their infinite debt growth model. Works great up until the point where you hit the zero bound on interest rates. I suppose they never thought that far ahead.

          But fear not, Bill has the answer.

      • >but they look pretty I guess

        1 And we have six planets worth of resources to burn through so what are we waiting for 🙂

      • It’s worse than doing nothing however JJF. I really do believe projects are selected by their ability to benefit my mates effectively non-transparent bribery (call my cynical).

        – The money I can siphon to my “mates” who got me here and are doing my PR, giving me donations often through construction work, labour hire firms owned by people I know and highly paid contracting/contractors. (Short Term)

        – Opportunity to sell the project for less than I spent developing it giving long term money to my “mates”. (e.g spend $50 billion on infra and supporting context, sell for $3 million NPV to private entity afterwards).

        It explains why these things often get built where other community wants often go lacking (e.g. hospital capacity) or they wouldn’t stand up in their own right under normal economic terms (e.g. West Syd Airport post COVID). I sadly believe projects are judged on their ability to produce a long term cash flow and generate back handed payments vs their benefit to the community.

  4. Jumping jack flash

    NIRP ftw!
    But if they give you NiRP Bill will you lower the eligibility standards to allow the debt-steeped people to actually borrow more?
    Keep in mind that wage theft is ending.

  5. happy valleyMEMBER

    Captain Phil can now do a Scotty from Marketing and shove off to Hawaii for 5 years and collect his $1m a year while sitting on his hands.

  6. Arthur Schopenhauer

    Just been mulling the NAB Chief’s words. It translates to me as, NAB is looking to offload as many low performing/high risk mortgages as possible, but there are some that are just too poor to move. As a consequence, the mortgagees holding unmovable trash loans will just have to do the Bank a favor and sell up ASAP.

    (The Mortgagees are probably doing themselves a favor too.)