The RBA’s Yield Curve Control Trap

Philip Lowe and the Board have painted themselves into a corner

Between February this year, when the RBA kept its official cash rate on hold, and the end of March, we learned that the Australian economy would face its biggest shock since World War Two. The RBA’s response to that shock was 50 basis points of easing, some modestly stronger forward guidance and a stick to beat the bond market (aka yield curve control) if market participants didn’t view the commitment on the cash rate as fully credible.

Admittedly, we have seen a little more than 50 basis points on the effective as opposed to the target cash rate, but it was still an inadequate response given the magnitude of the shock. The RBA moved 50 basis points in a single month in May 2012, with a follow-up cut of 25 basis points in June 2012. Can you even remember what the RBA was responding to then?

The second wave of COVID-19 in Victoria should put paid to the notion that the recent outperformance of AUD was due to our relative success in suppressing the pandemic rather than the RBA’s lack of policy activism. SEK has also outperformed on the back of the Riksbank’s monetary policy and Sweden is a disaster in terms of pandemic control. AUD-NZD has gone from around parity to 1.07 since 19 March despite New Zealand’s relative success in pandemic control. Yes, this probably reflects the effects of a harder lock-down on the economy, but also a more activist RBNZ that has put negative rates firmly on the table.

Even the AFR’s headline writers give the game away:

Here’s a grab from the story:

The market cheer-leading of foreign capital inflows into Australian debt misses the point that this is entirely unhelpful from a policy perspective and a symptom of overly tight monetary policy and an over-reliance on fiscal policy. The linked story even suggests that negative rates only work for economies running current account surpluses. Leaving aside the fact that Australia is currently running a current account surplus, negative rates would work for Australia precisely because it would make Australian dollar yields unattractive, weakening the exchange rate. Yes, some of the activity that would benefit from a weaker exchange rate is currently shut-down. That’s an argument for policy doing more, not less.

There was speculation that the renewed lock-down in Victoria might spur the RBA into further action today, but no. The RBA will release its latest forecasts at 11:30 on Friday, with Luci Ellis quickly hitting the wires to do spin control from 11:45. But the current policy framework leaves the RBA with few options, despite its stated willingness to do more.

The forward guidance on the cash rate could be extended to five years, with a 0.25% peg on 5-year ACGBs. That would help, but is a poor second cousin to negative rates or QE. Moreover, what would a commitment to keep the cash rate at 0.25% for five years imply about the expected success of that particular policy stance?

Unfortunately, Governor Lowe has spent more time over the last few years telling us what he doesn’t want to do rather than what he is willing to do. Yes, all options are notionally on the table, but the RBA has already said it doesn’t have much conviction in the effectiveness of many of them. If it does choose to turn-up the dial, it will have to work even harder to convince markets of their effectiveness given its previous statements. This raises the reputational cost to a change in the current policy framework, which in turn stands in the way of further timely and aggressive policy action.


ICYMI

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