Westpac: RBA Governor gives “Game Changer” speech

From Westpac chief economist Bill Evans:

I had expected that the events this week would be highlighted by the stunning 11.9% surge in the Westpac-Melbourne Institute Consumer Sentiment Index.

That was not the case.

RBA Governor Lowe delivered a speech on Thursday to a Banking Conference that was, quite simply, a game changer from the perspective of future policy.

Over the years I have learnt that you should always play close attention when Phil Lowe speaks (even before he was Governor).

There are always valuable insights into the economy and sometimes into policy.

Predictably, his insights into the “uneven recession” were refreshingly revealing.

From my perspective he particularly highlighted the strengthening of household and business balance sheets – the key question is “what are people going to do with this extra saving and improved debt situation?”

His key point was that “confidence in the health situation and the future state of the economy” would be the most important determinant.

In that regard the surge in Consumer Sentiment which we reported this week will have given him considerable encouragement.

But in his speech the important insights into the economy – as valuable as they always are – were overshadowed by his announcements around policy.

The comments have a “Jackson Hole” feel about them, coming, not coincidentally, a few months after Chairman Powell signalled a more patient approach to the inflation target – now targeting inflation of 2% “on average” over the cycle.

The conclusion from both speeches is that we can expect policy to remain stimulatory for even longer.

Firstly, he qualified the Bank’s approach to its inflation and full employment targets – “we will now be putting a greater weight on actual, not forecast, inflation in our decision making”.

Certainly, particularly amongst international investors, there has been a degree of cynicism around the strength of the RBA’s commitment to its inflation targeting. The view has been that as long as it is credible to include the attainment of the inflation target at some point in the official forecasts there is limited pressure to address a current underperformance.

A parallel interpretation is to move away from the pre-emptive approach – where policy moves well before the attainment of the goal in anticipation of success.

In the current circumstances such a policy pivot, where inflation is running well below the target, means the immediacy of a policy response is amplified.

We have become used to the policy guidance around employment being “progress towards full employment”.

That was always a somewhat inexact concept with the term “progress” open to multiple interpretations. The approach now seems to be, while not exactly enunciated, that because wage pressures will only emerge with full employment, and wage pressures are necessary to bring inflation back into the 2–3% band, policy will remain on hold until full employment has been achieved.

That thinking is quite clear with respect to the cash rate but raises some issues around the three year bond target. Because maintenance of the bond rate target at the cash rate requires the assumption that the cash rate will not move for three years it will still be necessary to be pre-emptive with the setting of the three year target.

For example, if the forecasts indicated that the RBA expected to be back in the inflation target band and be around full employment in, say, two years it would still be appropriate to hold the cash rate steady but the three year bond target rate would have to be adjusted or, indeed, abandoned.

If that was not enough for one speech he went even further.

The RBA has always been troubled by the interaction of low interest rates and asset prices – in particular house prices. Concepts like “leaning against the bubble” have been regularly considered. Because the central policy objective is emphatically “jobs” the Governor now sees rising asset prices as constructive: “help private sector balance sheets and lessen the number of problem loans… can reduce financial stability risk”.

Unlike the changes around the inflation and unemployment targets this change in approach is likely to be moderated as we move through the recovery phase I expect that the Governor still harbours concerns around the impact of asset bubbles on the real economy. But, for now, and the likely next year or so, concerns monetary policy destabilising asset markets are going to be contained.

Finally, he turns to international comparisons – “in the past, the interest differentials provided a reasonable gauge to the relative stance of monetary policy across countries”. He now notes that balance sheet expansion plays an important role in monetary policy globally – “our balance sheet has increased but larger increases have occurred in other countries”.

For example, despite sharply lifting its balance sheet, from an average of $170 billion between 2016 and early this year to $300 billion, (15.5% of GDP) the RBA is very cautious compared to, say, the Federal Reserve whose balance sheet is 32.7% of GDP. This appears to be a clear signal that the Bank is prepared to use its balance sheet more proactively, including purchasing Australian and semi government bonds right across the yield curve.

The Immediate Outlook

In a very clear signal of his immediate actions he noted “As the economy opens up…. it is reasonable to expect that further monetary easing would get more traction than was the case earlier”.

That signal is about as strong as you can get that he is planning to ease policy at the next Board meeting on November 3.

On September 23, following a speech from the Deputy Governor, Westpac forecast that the RBA would cut the key policy rates (cash rate; three year bond target; and Term Funding Facility) to 0.10% from 0.25% and the Exchange Settlement Account rate from 0.10% to 0.01%. (We originally targeted October 6, Budget Day, but, on September 28, following adverse press coverage around the need to provide the government with clear air to sell its Budget, moved the date to November 3).

The forecasts around the move from 0.25% to 0.10% now look fairly safe.

We also indicated that we expected the Bank to announce its commitment to support the whole yield curve by announcing its intention to further expand its balance sheet by purchasing Australian and semi government bonds in the five to ten year maturity range. That policy now looks consistent with the Governor’s increased emphasis on the need to be “competitive” with other central banks on its use of the balance sheet.

In that regard it is important to note that the increase in the RBA’s balance sheet of around $130 billion represents only around $60 billion of bonds, with the bulk of the remainder being the Term Funding Facility. The Bank’s purchases so far have been modest because markets have accepted its commitment to targeting the three year rate and limited buying has been necessary to defend the target.

In fact in the Q and A that followed the speech the Governor noted that the Australian yield curve was steeper than most other developed countries.

The Rate on Exchange Settlement Balances

When we released our forecasts on September 23 we included a forecast for the rate on the ESA accounts because that rate is playing a very important role in the determination of the short term rates.

Banks are flush with liquidity so the rate (10 basis points) they are paid by the RBA on their ESA balances is an important input into the rate at which they will lend to counterparties. The lending is not, as is usually the case, the rate at which the banks can borrow from the RBA.

Consequently the short term cash rate in the market has settled slightly above the ESA rate at around 13 basis points.

To encourage banks to buy bonds the cash rate needs to be below the bond rate – the gradual unwinding of the CLF will assist in that regard but a yield margin needs to be established immediately.

If the ESA is set at 5 basis points and the cash rate settles at, say, 8 basis points then the funding margin for banks and other investors to support the three year bond target will be extremely tight.

On the other hand, if the ESA rate is set at 1 basis point, cash would settle at around 4 basis points, providing an adequate margin to support the three year bond target.

However, the issue might be around the RBA’s concern with “flirting” with negative rates.

Banks, with excess liquidity, might find it unattractive to borrow from their usual counterparties, such as corporates or other financial institutions, when they can only earn 1 basis point on their excess liquidity. They may even demand a slight negative rate on days when there is ample excessive cash in the system.

Given the Governor’s “extraordinarily unlikely” attitude to negative rates he may choose to adopt the safer 5 basis points model for the ESA rate to keep comfortably clear of negative rates.

On the other hand, particularly in light of his direct comparisons with other central banks, and other significant “game changers” in his policy approach he may be prepared to countenance the possibility of negative rates in the very short term wholesale market.

From the perspective of the negative rate debate it will be very interesting to see the direction which the Board chooses on November 3.

Bill Evans, Chief Economist

Leith van Onselen
Latest posts by Leith van Onselen (see all)

Comments

  1. Blah, blah, Phillips Curve. Blah, blah, blah …

    (Let’s just admit I was dragged kicking and screaming into ever looser policy, my initial conservative policy stance notwithstanding).

    Next up: I never said I was anti MMT!

    • Jumping jack flash

      He’s not anti MMT per se.
      He’s just scared witless about it.

      He needs to get used to the idea and probably wants to know what will happen once he flicks the switch.
      Well, I’m not sure if anyone knows. If he manages to work it out, he’s going to be the first one.

  2. Over the years I have learnt that you should always play close attention when Phil Lowe speaks (even before he was Governor).
    There are always valuable insights into the economy

    Like his forecasts ………….. nice one Bill

    • happy valleyMEMBER

      Economic “orgasm” for Bill as he sees his lifetime dream of NIRP just around the corner and ready to screw his most despised of people – depositors – in the national (aka bankster, more particularly, Westpac interest). Give Bill a pay rise.

      • i keep seeing these comments about how bankers want to screw depositors with nirp
        but the reality is bankers make a margin, and its a lot easier to sneak through a 2% margin when rates are 4% or more, than when rates are 2% or less

        take a look at Europe, nirp for years and banks are in a world of pain

  3. “The RBA has always been troubled by the interaction of low interest rates and asset prices – in particular house prices.”

    Really? Isn’t the whole point of lowering interest rates to stimulate the economy via the “transmission mechanism” of higher house prices?

    • I think they keep hoping that the ‘water’ (new credit) will flow through the small pipe (productive investment) rather than the ‘large’ pipe (housing) – the latter has been artificially enlarged by years and years of government perks and social culture.

      Note to RBA: you need macroprudential (MP), or the credit will flow to speculative/rentier property, and not productive investment.

      Here in the Macrobusiness community we say, ‘MPLOL’ 😀 …but we actually want you to prove us wrong…!

    • Nah, its about reducing the interest rate portion of repayments so people have more dollerydoos to spend in the economy, the fact it keeps leading to higher prices being paid is just a consequence of the human condition.

      People seem to have completely lost sight of the fact that
      a) Dropping interest rates = Economic Stimulation AND
      b) Economic Stimulation means sagging economy….

      Interests rates was the “Accelerator” of the economy,, lower the accelerator makes go faster, raise the accelerator makes go slower…. Its like our economic masters cant work out that t here is no fuel left in the tanks and that’s why its making no real difference anymore…

  4. Its like all the central bankers have had a zoom call and decided to “Let it RIP!!”
    They want inflation, which means they want wage growth.
    The only chance that interest rates are going to rise is when I get a pay increase, and I have not had a pay increase in 10 years.
    The only question is how do you create inflation during a pandemic. Its not like we can all go out and buy bottles of champagne and spray them all over the bar. Nor can we stay at expensive hotels in exotic locations. Its going to accumulate in employed peoples bank account.
    And then all that extra money and liquidity is going to end up in one place. You guess it – Aussie house prices.
    Boom!

    • Jumping jack flash

      You’re right

      If the debt grows fast enough some spills over into the wider economy and isn’t absorbed by the interest and the need for more debt hoarding it all. It’s happened successfully once before and that was around 2006. The place was jumping. Debt was flowing. Wages were rising. Inflation was rising as well.

      When it happened they freaked out at the inflation, and raised interest rates. Ever since then they’ve been trying to get it going again. Over 10 years of back-to-back interest rate cuts have failed miserably. It simply wasn’t enough. They need to go bigger. Maybe they are going to?

      It is a far different time now though. Everyone is more tired, far more gabby and insular, and need a lot more debt than they did back in 2006 to obtain the same results.

  5. Jumping jack flash

    Wow there’s some really good stuff in here!

    “because wage pressures will only emerge with full employment, and wage pressures are necessary to bring inflation back into the 2–3% band, policy will remain on hold until full employment has been achieved.”

    So how can they create employment? Before COVID we had the lowest interest rates ever, but you couldn’t really look at the economy and say that employment was going gangbusters, that jobs were being created and wages rising. Wage theft was rampant and wage indicators were showing falls.

    Wages can’t and won’t go anywhere with all this debt about…
    or while the debt isn’t growing fast enough…

    Which brings me to the next delicious point…

    “Because the central policy objective is emphatically “jobs” the Governor now sees rising asset prices as constructive: “help private sector balance sheets and lessen the number of problem loans… can reduce financial stability risk”.”

    But HOW in the world can they achieve that? What is the connection between rising asset prices and “reduced financial stability risk”? How can “problem loans” be reduced with asset price inflation?

    They are so close to admitting it. Come on! Just say it! “We need a sufficient debt growth rate [to get back to the heady days of 2006], and growing the debt fast enough will help the stability of the debt[‘s risk through the mechanism of debt-inflated capital gains and their effect on LVR]!”

    At this rate the cat will be out of the bag before Christmas, and then we’ll have our -ve cash rate and/or UBI, with or without QE, so everyone can feast on more debt than they ever thought possible. And right on cue, there is pretty much nothing that anyone can do to change the status quo now. Banks have successfully enslaved the world with their debt.

    • Because no macroprudential tools have been used as the RBA lowered the rates borrows have just taken on more debt offsetting any positive effects. Depositors have also taken a hit with rates dropping. As a result its a double fail in trying to free up cash for people to spend. They also talk about improved private sector balance sheets as a positive ignoring the fact the its been propped up by super withdrawals, jobseeker increases, job keeper and loan defferals.

    • “Banks have successfully enslaved the world with their debt.”
      Its the other way around.
      Those who have borrowed the most are the masters. When everyone is levered to the max the central banks cannot increase interest rates as it does too much damage. Which means interest rates can only decline. The borrowers have snookered the central banks.
      The central banks want to unleash inflation so they can get back in control of interest rates.
      Agree, they want to return to 2006. Plenty of young people who weren’t around in 2006 are going to more than happy to party like it is 2006.

  6. Haywood JablomyMEMBER

    They sure aren’t going to create new employment or rising wages if the other clowns achieve their dream outcome of supercharged immigration asap.

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