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