Joye: RBA will do MOAR not less

Via Chris Joye at Coolabah Capital:

While we are very bullish on Antipodean growth over the next 12 months, there is certainly a lot to be anxious about at present.

We have a 50 per cent probability that China tries to take Taiwan in the next few years, triggering an immediate conflict with the US and the spectre of World War Three. That would almost certainly activate Australia’s ANZUS treaty with the US, and prevent us from selling iron ore, coal or natural gas to our biggest trading partner.

Why now, you ask? Simply because there is game-changing US military kit coming down the pike in the next five years that will make it hard for China to unify Taiwan, which is a defining objective of the one-person political state. And the most powerful leader in the Middle Kingdom’s history knows it.

Underestimating Xi’s determination to win in what he perceives to be an inevitable and existential conflict with capitalism, and its defender in chief in the form of the ailing US hegemon, is a mistake almost every politician and analyst has made over the last decade with few exceptions.

So that is issue number one and our biggest left-tail risk. In a new paper co-authored with my chief macro strategist, Kieran Davies, who was formerly Director of Forecasting at the Commonwealth Treasury, we outline a range of other crucial problems that the Reserve Bank of Australia is grappling with right now.

While there has been much talk about the ebullient labour market (we were massive outliers forecasting a 6 to 7 per cent unemployment rate in April last year when consensus was at 10 to 12 per cent), the RBA’s bigger worry is its long-term failure to resuscitate wages growth.

Wages are currently expanding at a record-low pace of just 1.4 per cent annually, miles below the 3.5 to 4 per cent range required to sustainably lift core inflation back into the RBA’s target band.

To get this pay growth the RBA needs to encourage the economy to exhaust its excess labour supply by pushing down the jobless rate to “the 4-point-something” bogey that Governor Phil Lowe has in his cross-hairs.

One thing that is missed in this narrative is that the RBA is not trying to just get to the so-called non-accelerating inflation rate of unemployment (aka the NAIRU), but rather push right through it.

After a decade of flirting with a 5 per cent jobless rate and failing to deliver decent wages outcomes, the RBA needs the Aussie economy to overheat. Janet Yellen made exactly the same argument in respect of the world’s largest economy when she was chairing the US Federal Reserve. That is, Yellen was directing the labour market through the Fed’s estimate of the NAIRU, which at the time was in the high 4 per cent band.

The Fed succeeded, with the US jobless rate falling to as low as 3.5 per cent, which restored wages growth to its pre-GFC zone around 3.5 to 4.0 per cent. It is somewhat ironic that notwithstanding Australia’s extraordinary performance during the COVID-19 crisis, our jobless rate of 6.6 per cent is almost identical to the current US rate.

This sheds light on why, for example, the RBA’s Deputy Governor Guy Debelle recently asserted that, “I think in the situation we’re in at the moment, I would certainly think the right decision is to err on too much support rather than too little support”. The RBA is learning from the lessons of the post-GFC period when it arguably under-clubbed its stimulus.

The contemporary wrinkle is that most of the RBA’s monetary policy tools are tapped out: the overnight cash rate is sitting at its effective lower bound of 0.1 per cent, as is the RBA’s 3-year government bond yield target. Since October 2020, banks flush with liquidity have not drawn materially down on the RBA’s Term Funding Facility, which has $100 billion in spare capacity.

A key question is what would Martin Place be doing in the absence of such constraints. To try to address this, my co-author Kieran Davies forecast the RBA’s cash rate using the so-called “Taylor rule” from the RBA’s MARTIN macroeconomic model. This rule sets the cash rate as a function of the real neutral cash rate, forecast underlying inflation relative to the RBA’s target, and forecast unemployment relative to the NAIRU.

Davies assumed that the real neutral cash rate has declined from the RBA’s estimate of about 0.75 per cent at the end of 2019 to 0.5 per cent in 2020 given the wider spread between lending rates and the cash rate. He took the NAIRU as equivalent to 4.5 per cent, which is consistent with Lowe’s characterisation of “4-point something”. Finally, he used a forecast outlook for unemployment based on the consensus of economists, which has a lower profile than the RBA’s estimates, and an inflation forecast based on the RBA’s November estimates, much the same as the market’s profile.

On this basis, the Taylor Rule points to a significantly negative cash rate of about minus 3.25 to minus 3.75 per cent in 2021 and minus 2 to minus 3 per cent in 2022. Given that the RBA regards 0.1 per cent as the effective lower bound for the cash rate and the 3-year government bond yield, this emphasises the need for very significant unconventional monetary policy to be maintained in 2021, with some winding back in 2022.

This is accentuated by the fact that Australia’s unprecedented fiscal stimulus, which saw the largest peacetime budget deficits on record, is largely temporary by design. The private sector has saved some of this stimulus, but fiscal policy will be sharply contractionary over the course of 2021 as labour market subsidies, temporary welfare payments and housing grants roll off.

So what can the RBA do? The RBA’s current QE program, which launched in November and expires in April, was an experiment of sorts insofar as it was the first time the RBA has bought 5- to 10-year Commonwealth and state government bonds to put downward pressure on long-term Australian interest rates, and even more importantly, our trade-weighted exchange rate. The RBA had theoretical modelling on the relationships between these variables, but no hard Australian data.

As my talented stablemate, Karen Maley, recently highlighted, there is zero doubt that the program has been immensely important in slowing the ascent of our exchange rate. Applying some impressive quantitative research, Maley reveals that based on the historical nexus between commodity prices and the Aussie dollar, one would have expected its appreciation to be “about twice as much” as what we have actually experienced since the RBA launched its November QE program. That is to say, the RBA’s QE has saved local exporters and import-competing businesses from much harsher conditions. Our research confirms this, implying that the Aussie dollar would be trading north of US80 cents were it not for the RBA’s interventions.

Another stablemate, Matthew Cranston, noted this week that the RBA buying 5-year to 10-year government bonds has virtually no impact on housing market dynamics given most Aussie home loan borrowers use variable or short-term fixed-rate products. It does not, therefore, trigger the financial stability concerns associated with other, more conventional tools.

Furthermore, housing credit growth remains weak while there has been no net aggregate house price growth since 2017. Home values in Sydney and Melbourne are actually 3.88 per cent and 1.76 per cent lower today than they were three years ago. (Unsurprisingly, one week earlier Maley argued that Lowe does not see housing as a constraint on policy right now.)

A final tell that the RBA has more QE to do is the fact that our government bond yields are attracting enormous foreign demand. In the last two weeks Victoria and Queensland have launched bond issues that set records for total book demand, which hit $6 to $7 billion individually, partly fuelled by overseas buyers attracted to Australia’s world-beating AA and AAA rated interest rates, which would ideally be a lot lower. This foreign capital is putting upward pressure on the Aussie dollar to the detriment of domestic growth at a time when all central banks are doing everything they can to debase their own currencies.

I agree with all of that except the odds of the CCP invading Taiwan in the next five years. My base case for slowing Chinese growth, and the concurrent need for the CCP to shift to nationalism from economic management as the key driver of its legitimacy does not become critical until the 2030s.

Moreover, it will take years to bed down the vicious Hong Kong suppression such that Beijing can be satisfied that it will not have to fight a war on two fronts.

David Llewellyn-Smith

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