The yield curve control trap is sprung
RBA would rather add market frictions than buy bonds
The RBA has been struggling to maintain its target yield on the April 2024 bond as the market prices an increasingly aggressive tightening profile that is at odds with the RBA’s forward guidance that tightening is unlikely before 2024. The RBA has even resorted to throwing sand into the gears of the repo market to make it more difficult to short the bond in order to avoid having to increase its outright bond purchases.
As I argued in previous posts, the danger with yield curve targeting (YCT) was always that the market would one day take a different view to the Bank’s forward guidance, requiring even heavier intervention in the bond market than under QE to support the target. One of the reasons the US Fed has shied away from YCT is its concern it could end up holding even more bonds than under QE. The RBA’s YCT was always motivated by a desire not to aggressively expand its balance sheet, a battle it ultimately lost in November last year under pressure from other central banks and the exchange rate.
But the RBA remains a reluctant bond-buyer. The fact that it is prepared to add frictions to the market to avoid buying bonds underscores the point that both the size and scope of the RBA’s QE program at longer maturities likely reflects self-imposed constraints on the Bank’s willingness to expand its balance sheet and to take ownership of specific bond lines. If you are pulling your punches because your policy instrument is constrained, that’s an argument for adapting the policy instrument. The RBA could expand the scope of QE to include longer dated maturities or corporate bonds. Arguably, these should have been on the table back in March last year.
The RBA has form when it comes to repo market frictions. A few years ago, repo spreads blew out due to frictions in the cash market which the RBA was reluctant to address. I remember sitting in meetings with repo market participants and the RBA where the RBA would say that all they cared about was the unsecured cash market, since repo had no role in monetary policy transmission. This is true in so far as repo is not a net source of funding in the system, but easier monetary policy is not much help if cash doesn’t get to where it’s needed, when it’s needed. The RBA said the secured cash market would just have to fend for itself, putting it back on market participants to address the frictions. One market participant pointedly made the observation that Guy Debelle would be the one taking the phone call from the Treasurer when a hedge fund blew-up because it couldn’t get funding at the end of a given day.
As Matt Johnson points out, Australia is in an anomalous position with respect to its dollar bloc and other peers in meeting its inflation target and short-end pricing. Matt argues there is value in the Australian short-end accordingly. My interpretation is that markets just don’t believe the RBA’s forward guidance. It is not hard to imagine a scenario in which the forward guidance is changed, with Governor Lowe invoking financial stability risks, reinstating leaning against the wind with inflation below target.
Matt also highlights the fact that New Zealand inflation is no longer forecasting Australian inflation in the way it once did. This former correlation was useful for forecasting Australian inflation given the NZ inflation data come out before Australia’s. The break-down in the relationship is just one of many indications that there is something not right with Australian monetary policy (not that the RBNZ has covered itself in glory in recent years).
Bloomberg belatedly got on to the story of a likely review of Australian monetary policy this week, noting Phi Lowe’s argument that other central banks had converged on the RBA’s approach. In fact, the Fed’s long-term strategy review not only repudiated the RBA’s let bygones-be-bygones approach to inflation targeting in theory, the Fed is now increasingly doing so in practice, as illustrated by Zac Gross:
This stands in contrast to the Lowe Gap. While other central banks have acted, we are left with Governor Lowe’s shaggy dog stories about the non-monetary causes of low inflation.
The minutes of the October Board meeting were notable for observing that ‘there were few indications from disaggregated wages data or from the Bank's liaison program to suggest that aggregate wages growth was likely to accelerate sharply in the period ahead.’ So much for closed borders contributing to stronger wages growth. Here is Governor Lowe keeping some interesting company on immigration and wages:
To be fair to Phil, he also acknowledged that labour market shortages would hold back output. Labour shortages are in fact a contractionary supply shock. Even if they put upward pressure on wages, this would only serve to serve to induce stronger temporary migration inflows when the border re-opens, not to mention running the risk of permanent capital for labour substitution. Policy-induced labour shortages are not a sustainable way of lifting wages.
Fortunately, we now have a seemingly pro-immigration Premier in NSW and the federal government is looking to review post-pandemic immigration policy settings. In a report for USSC last year, I warned that the pre-pandemic population planning framework risked state government capture of federal immigration policy, but if the same machinery of government delivers capture by a pro-immigration Premier, that may not be such a bad outcome.
With a review of immigration and monetary policy in the works and a parliamentary inquiry focused housing supply underway, there are some reasons to be optimistic about progress on these related issues. As you might have noticed, I have been engaged in advocacy on these three areas of public policy for many years because they offer the potential for huge welfare gains, especially if addressed jointly. I am struck by how much alignment there is among diverse think-tanks not just on the importance of these issues, but also on the way forward.
ICYMI
I had a piece in Australian Outlook on my Geoeconomic Alliance report for USSC.
In sad news, the Cato Journal is no more.
The industry super fund presiding over 100% pass through of SG increases to some of its workers. Not that there’s anything wrong with that.
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