Phil Lowe’s ‘dangerous path’ revisited

The RBA's road not taken

This week, the Reserve Bank laid out the options to be considered at the July Board meeting in relation to its target for the three-year bond yield and its outright purchases of longer-term government bonds.

The decision in relation to the three-year bond yield target is whether to roll the target forward from the April to the November 2024 bond. Governor Lowe tied this decision to the outlook for the cash rate, so the RBA’s decision can be taken as a signal as to when it expects its conditions for an increase in the cash rate to be satisfied. Even without this explicit linkage, the market would likely interpret any decision on the three-year target in this way.

Given the RBA probably doesn’t want the market making free judgements about the credibility of its commitment on the cash rate via the three-year bond, it makes sense to roll the commitment forward to the November bond. But at some point, the market will get ahead of the RBA on the timing of an increase in the cash rate. At that point, the RBA will have to decide whether it wants to own a lot of three-year bonds or abandon the target. Allowing the target on the three-year to fade in duration now might be preferable to a more abrupt transition later, but that’s not what I am expecting in July.

On the bond purchase program, the options laid out by the Governor are:

1.    ceasing purchasing bonds in September;

2.    repeating the current $100 billion purchase program over a similar time frame;

3.    scaling back the amount purchased or spreading the purchases out over a longer period; or

4.    moving to an approach where the pace of the bond purchases is reviewed more frequently, based on the flow of data and the economic outlook.

The Governor has ruled out the first option. The approach that maximises the RBA’s future discretion is the fourth option and so it is a reasonably safe bet that’s where the Board lands. Unfortunately, the fourth option is also ambiguous in its implications for the stance of monetary policy.

If the RBA were to then maintain the current run rate on bond purchases on an open-ended basis, it could be viewed as expansionary relative to the current fixed program size, making it a preferable option. But it also means that a decision to then taper the current run rate could potentially be on the table at every Board meeting. Again, markets could quickly get ahead of where the RBA is at, leading to an effective tightening in monetary conditions. Taking the fourth option is therefore probably also an argument for rolling forward the three-year bond target to provide some discipline on the market getting ahead of itself, at least from the RBA’s perspective.

Note that the Governor did not put on the table the option to expand bond purchases. Strictly speaking, option four would not preclude an expansion via an increased run rate or longer time frame for bond purchases, but it would seem unlikely that such an expansion would be announced in July or subsequently. It should still be an option put to the Board.

WIB has rather helpfully updated their normalised measure of central bank balance sheet expansion, showing that the RBA still lags most of its G10 peers, with some of the convergence a function of tapering by other central banks such as the Bank of Canada. Recall also that much of the early balance sheet expansion on the part of the RBA was due to bond market liquidity operations and not QE, which did not begin until November last year, although you could argue they have similar effects.

The exchange rate implications are readily apparent in this chart showing the outperformance of the Australian dollar since the end of March last year relative to its peers. The results roughly map on to the chart of central bank balance sheet expansion, most notably with respect to AUD-JPY.

In this context, it is worth recalling Governor Lowe’s pre-pandemic ‘dangerous path’ remarks to the Crawford School in 2019:

If everyone is easing then there is no exchange rate channel. We trade with one another, not with Mars. So if everyone is easing the effect you get from exchange rate depreciation isn't there so you don't get the stimulus you normally get from monetary easing…It might be possible if you ease a bit more than others – you might get a bit extra growth – but that is a dangerous path to go down.

What these remarks did not canvass is what happens when you do, not just a bit less, but a lot less, than others. We now have the exchange rate to show for it. Recall that this exchange rate outperformance has taken place against the backdrop of Australia’s net external financing position shifting by seven percentage points of GDP to become a net lender internationally.

Australia’s fiscal expansion is in line with the advanced economy average based on the IMF’s Fiscal Monitor, second only to the US, NZ and the UK relative to GDP. But as we have noted previously, there is an asymmetry in the exchange rate response to monetary and fiscal stimulus. While the exchange rate will reward relative monetary expansion with a depreciation, it will penalise relative fiscal expansion with an appreciation. The RBA’s reluctance to embrace QE and its subsequent catch-up gave Australia a sub-optimal macro policy mix. To be clear, this is an argument for monetary policy to have done more, not fiscal policy to do less.

In today’s speech, Governor Lowe implicitly fingered the business community for low wages growth, a line which has naturally dominated media coverage of the speech, although his comments about rationing output and hiring sit uneasily alongside today’s 115,000 gain in employment. The RBA will be punting on a tighter labour market to lift wages, although it might also spur increased capital for labour substitution. Lowe’s remarks echo an earlier, pre-pandemic narrative that blamed business for having excessively high hurdle rates of return on investment spending. Business investment got another outing in today’s speech.

The Governor went on to say:

The underlying point here is that there are a range of factors that are contributing to limited upward pressure on wages, even in tight labour markets. I have previously talked about the effects of globalisation, technology and industrial relations arrangements.

What is missing from this list, of course, is the role of monetary policy in holding back inflation, inflation expectations and nominal wages growth. Governor Lowe’s message is always, ‘Look! Over There!’

The business community won’t bite back, but they could be forgiven for arguing that they are just responding to incentives and policymakers heavily condition those incentives. When it comes to wage setting, they almost certainly look to the RBA’s own forecasts of inflation. Workers do the same. As argued here many times before, the RBA is the author of its own nominal expectations doom-loop. Pointing to real factors that are conveniently outside the RBA’s remit does not let it off the hook for meeting its own mandate. The business community could mention that too. But won’t.