The minutes of the RBA’s July Board meeting summarise the discussion around the decision to taper its bond purchases and allow the yield curve target to fade in duration. On the former, the minutes note ‘members acknowledged that an argument could be made to retain the pace of bond purchases at $5 billion per week, given that economic outcomes were still well short of the Bank's goals for inflation and employment.’
This was widely interpreted as suggesting the decision went to the wire, which is not unusual at turning points in the cycle, although tapering was clearly the Bank’s recommendation. With much of Australia now in lock-down, it has already been suggested the RBA has regrets. Fortunately, the decision to taper does not take effect until September. In the interim, we have the August Statement on Monetary Policy, which will see a new set of forecasts that will incorporate the expected effects of the extended lockdowns. This gives the RBA every opportunity to walk-back its decision to taper. Some have suggested this is only ‘an in case of emergency break-glass’ option, but this is an emergency. Ricardian Ambivalence has resurfaced to suggest there is a 75% chance of a reversal on tapering and a 50% chance of a reversal on the yield curve target given the prospective damage to the RBA’s forecasts. That sounds right to me.
A little too much has been made of the idea that the rapid recovery from previous lockdowns means that less stimulatory policy settings may be required. But as we have argued previously, the better-than-expected recovery only serves to underscore how underbaked the RBA’s pandemic response has been. The RBA has come up short on its goals even in the presence of a better-than-expected recovery on the back of near-zero community transmission of COVID. Now that the delta variant has broken free amidst a still largely unvaccinated population, there is every reason to expect a contraction in Q3, possibly extending into Q4. The RBA needs to not only reverse its tapering decision, but to do more. Governor Lowe indicated after the July Board meeting that the outlook for bond purchases was symmetrical, notwithstanding the decision to taper, so a decision in August to accelerate bond purchases from September onwards would be perfectly in keeping with this overall guidance.
The July minutes repeated Lowe’s attempt to distinguish between the stock and flow of QE, maintaining the effect came from the stock, but the flow is obviously important for expectations as to the future stock. Market participants certainly think the flow matters. Many evaluate the effect of QE on yields in terms of the net of AOFM issuance and RBA purchases. I think that is mistaken, in that AOFM issuance still increases the stock of gross debt, even if it is purchased by the RBA. I also think markets focus too heavily on bond issuance as a determinant of yields. But the market focus on the outcome of AOFM bond tenders strongly suggests they think flows matter even aside from QE. Lowe’s stock-flow distinction strikes me as a rationalisation for tapering when you don’t have stronger arguments for doing it.
The experience of central banks around the world in the wake of the global financial crisis is mostly that they wish they had done more not less, and taken more time to tighten. In the case of the Fed, those lessons have been internalised in its long-term strategy review and now inform its approach to average inflation targeting, which approximates flexible price level targeting.
The signal from bond markets, however, is that central banks are set to make the same mistake. The head-scratching around the decline in nominal and real yields is perfectly explicable when viewed in those terms, especially against the backdrop of the rapidly spreading delta variant. While lower yields are partly a reflection of an expectation central banks will do more in response to delta, they also imply that it will not be enough.
The recent inflation scare also has precedents. It has all the hallmarks of a transitory supply shock similar to those that have led monetary policy astray on previous occasions. Scott Granis sees the increase in M2 in the US as inflationary, arguing that inflation will increase the price level and the level of incomes by enough to return people's desired cash balances (e.g., the ratio M2 to annual incomes) to lower levels. My own view is that money demand will remain elevated in the wake of the pandemic, just as it took a permanent step higher in the wake of the GFC. A widespread return to lockdowns will only reinforce this dynamic. Relative price increases on the back of supply constraints and bottlenecks will generate strong medium to long-run supply responses that are ultimately disinflationary.
It is perhaps also worth noting the effect of the latest lock-down in NSW on the building and construction industry. While these restrictions will only last until the end of the month at this point, that is long enough to add to existing bottlenecks and put a dent in the short-term outlook for housing supply, putting further upward pressure on prices. This in turn might be mistaken for a demand rather than supply shock, leading to perverse responses from policymakers.
The fading of the yield curve target, the decision to taper and the end of the TFF in July marked the beginning of a new monetary tightening cycle, exploiting a loophole in the RBA’s forward guidance which frames tightening exclusively in terms of an increase in the cash rate target. The July meeting confirmed the RBA Board has an itchy trigger finger, as we have long feared. The August meeting will be an important test of whether it has learned from past mistakes and those of is overseas peers. James Glynn says ‘Keeping bond purchases at A$5 billion a week in September would also demonstrate the RBA’s willingness to be flexible in times of renewed uncertainty.’ But the current situation calls for more than that.
ICYMI
The NBER Business Cycle Dating Committee has determined that April 2020 was the most recent trough in the US business cycle after the previous peak in February 2020, making it the shortest US recession on record. The expansion might also end up being one of the shortest.
In the US, net worth gains in 2020 were the largest for the least wealthy. So much for QE increasing inequality.
US pension funds know politically-secure economic rents when they seem them.
Brisbane right now:
Excellent write up Stephen. One has to empathise with the RBA, as signalling strategic policy shifts amid constantly shifting Covid winds was never going to be easy. QE is also unnaturally suited to the Australian economy where risk appetite, use of leverage and cyclical elements don't match the deflationary, defensive, frugal-minded countries like Japan and Germany. The only true consensus on QE post-GFC is that it works well to signal and unfreeze capital markets. No country or Central Bank has high conviction on how to use it as a fine-tuning monetary policy tool. Without high conviction, RBA is right to minimise its protracted use and to taper according to a 'phasing out' playbook, rather than timing a cyclical outlook, badly aggregated by Covid case volatility.