Philip Lowe’s Ever Receding North Star

RBA’s inflation forecasts show it is not doing enough

Governor Phil Lowe says that the inflation target is the RBA’s North Star, but the latest Statement on Monetary Policy shows that it is ever receding into the distance.

The Statement included three scenarios for the COVID-19 recession and recovery. It should be recalled that these forecasts are conditioned on current monetary policy settings, which have been largely internalised by the market, as well as a constant exchange rate. The forecasts can be used to benchmark whether the RBA has done enough to meet its inflation target and full employment mandate.

On the RBA’s forecasts, trimmed mean inflation will be running at 1.5% for the year-ended in June 2022, while the unemployment rate will still be at 6.5% over the same period. Even the upside scenario has trimmed mean inflation running at less than 2% by mid-2022. This is a tacit admission that the RBA has not done enough to support the nominal side of the economy. While the RBA has indicated a willingness to do more, it remains of the view that so long as it has locked-down the short-end of the risk-free rate curve for at least three years, monetary policy is already doing as much as it can.

The RBA views its three-year bond yield target of 0.25% as a ceiling which it can easily defend with relatively modest outright purchases of government bonds and semi-government securities. Indeed, were its commitment viewed as fully credible by market participants, the peg could be achieved with little or no outright bond purchases, which is no doubt the RBA’s preference. The RBA might still intervene in the secondary market to maintain liquidity, but interventions for policy purposes might become increasingly rare events. Bond purchases have already started to taper.

This demonstrates that the RBA views monetary policy almost entirely in terms of the short-end risk-free rate structure, rather than growth in monetary aggregates. It is not really QE, because the RBA does not view its asset purchases as operating directly through a quantity channel, only through an interest rate expectations and exchange rate channel. Even the interest rate channel is limited to the short-end of the yield curve. The long-end may benefit from liquidity operations, but long-term interest rates are not themselves a target for policy except in so far as they reflect expectations for short-term interest rates.

It is not hard to imagine a scenario in which the market takes short-end bond yields into negative rate territory. Given the RBA’s apparent aversion to negative rates, this could see the RBA turn the 0.25% peg into more of a floor rather than ceiling, which may require the Bank to sell rather than buy bonds. The RBA would not necessarily view this as contractionary given it is only concerned with the risk-free rate curve and given its long-standing concerns over negative rates. But markets could well take a different view if yield curve control turns into bond selling rather than buying. The Bank of Japan had to deal with similar market ambiguity around whether its target for the 10-year JGB yield was a ceiling or a floor.

Lest one think this is an implausible scenario, US Fed funds futures last week traded at implied rates of between -0.015% and -0.03% for late 2020 and early 2021, while 2- and 5-yr Treasuries fell to new record lows in yield. If US yields continue to fall, it is not hard to see Australian rates coming under similar downward pressure, although Australian bonds may underperform to the extent that Australia outperforms on pandemic control.

The AUD exchange rate is actually above the level prevailing ahead of its announcement of yield curve control on 19 March and higher than when the RBA cut rates on 3 March. A charitable interpretation of the level of the exchange rate is that it reflects Australia’s outperformance in suppressing the pandemic. But it also suggests that the RBA has little to show for the policy measures taken last month in terms of easing overall monetary conditions. The RBA has validated market expectations that it would take the cash rate to what it views as the effective lower bound and keep it there for an extended period of time. If the RBA does more, it is likely to be in terms of liquidity operations and lending facilities rather than the policy rate. From its perspective, the only other option would be to extend the cash rate commitment and peg beyond three years. The RBA’s inflation forecasts show that what it has done to date is not enough. More could be done through outright purchases of government bonds and other assets that sought to exploit quantitative channels of monetary policy transmission, but the RBA does not see it that way because it does not believe monetary policy can be made to work other than through its effects on expectations for the risk-free rate structure.

Thursday sees the release of the April labour force report, the first to fully capture the effects of the lockdowns implemented from mid-March. The market is expecting job losses in the order 550,000, with a range of -125,000 to -1 million. The unemployment rate is expected to rise from 5.2% in March to 8.3%, with a range of 5.6% to 10%. Month to month movements in the unemployment rate are hard to forecast at the best of times. However, the headline unemployment rate will almost certainly understate the loss of jobs. Those on Jobkeeper will still be classified as employed, while many will exit the labour market altogether given that job search will be precluded for many by lockdown restrictions. The new ABS payrolls data are more consistent with job losses in the order of one million rather than the number we are likely to see reported on Thursday. The underemployment rate, the participation rate and hours worked should instead be watched as better indicators of the labour market. Friday’s US employment report saw the U6 measure of unemployment surge to 22.6%.

On Wednesday, the first quarter wage price index is released and has the market expecting a 0.5% q/q rise, the same as for the final quarter of 2019, with a range of forecasts from 0.3% to 0.6%. Wages will be slow to reflect the collapse in the labour market, but were already weak at 2.2% y/y in the final quarter of last year, well below the 3% annual growth that has prevailed over the life of this series. A combination of slow productivity growth and low inflation and inflation expectations has weighed on wages. There are downside risks relative to market expectations for both employment and wages.

Wednesday will also see the release of the WMI Consumer Sentiment Index for May. The collapse in April was the biggest in the nearly 50 year history of the survey, with the index now at recessionary levels. A pick-up in May can be expected, but will still leave sentiment thoroughly depressed.


ICYMI

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