In this new paper, Coolabah’s Chief Macro Strategist, Kieran Davies, and its Chief Investment Officer, Christopher Joye, examine the case for the RBA launching QE 2.0 after the current $100 billion QE program, which has helped slow the ascent of both long-term interest rates and Australia’s trade-weighted exchange rate, expires. They focus, in particular, on the challenges the RBA faces trying to stoke incredibly weak wages growth at a time when the labour market is a long way from being fully employed, the RBA’s other monetary policy tools appear to have exhausted their available stimulus, and fiscal policy is about to start detracting from growth as the government’s spending programs unwind. Martin Policy’s decision-making is being further complicated by lockdowns and double-dip recessions overseas, and the spectre of a one-sided trade war with Australia’s largest export partner.
Summary
The Reserve Bank of Australia (RBA) board meets on 2 February to decide policy based on updated staff economic analysis and forecasts, which will show that domestic activity and the labour market have recovered more rapidly and robustly than the RBA expected, consistent with Coolabah Capital Investments’ (CCI’s) priors. While this will be welcomed by Governor Philip Lowe when he speaks on the economy and policy the next day, CCI believes he will remain cautious about the medium-term outlook given his ambitious aim of achieving full employment, which the RBA says is equivalent to reducing the unemployment rate to “4-point something” per cent, juxtaposed against a patchy global outlook ridden with second and third waves and harsh lockdowns in key developed economies.
Full employment is crucial to lifting wages above 4% to return core inflation to the RBA’s target 2% to 3% band. The last time Australia experienced full employment was prior to the global financial crisis (GFC), which explains why the RBA has consistently undershot its inflation target in the years leading up to the pandemic. Lowe will also be mindful that Australia still confronts many important challenges: the global economy is experiencing a fresh setback from COVID-19, with lockdowns in Europe, the UK and US, amongst others; a serious, albeit one-sided, trade war has erupted with China; much of the federal government’s massive fiscal stimulus is unwound this year; and the international border likely won’t open until 2022/2023 given Australia’s tough and highly successful approach to managing the pandemic.
With the RBA a long way from its economic objectives, the Taylor rule from the RBA’s MARTIN macroeconomic model points to the need for a strongly negative cash rate: as much as -3¾% in 2021. Since Lowe has all but ruled out negative rates, the RBA will have little choice but to furnish additional unconventional monetary stimulus in 2021 and, to a lesser extent, in 2022. Quantifying how much extra support is required is difficult, but CCI expects that the RBA will extend its existing quantitative easing (QE) program, which is due to expire in April, for another six months with a similar, c.$100bn commitment to relieving upward pressure on Australia’s high long-term bond yields and the trade-weighted exchange rate.
Although we don’t have high conviction on the size of QE 2.0 (there are credible arguments in favour of a significantly bigger commitment), we agree with Deputy Governor Debelle when he remarked last year, “I think in the situation we’re in at the moment, I would certainly think the right decision is to err on too much support rather than too little support”.
If anything, market participants may be underestimating the possibility of a larger program given that the key learning from QE 1.0 is that the RBA has not done enough to achieve its macro aims, as reflected in a higher Australian dollar. This is reinforced by the fact that both the cash rate and the 3-year government bond yield are at their effective lower bound (the 3-year rate is being managed under the RBA’s yield curve control policy). A final consideration is that banks have not materially drawn on the RBA’s c. $180 billion term funding facility (TFF) since October 2020 because they are awash with excess liquidity in a world where balance-sheet growth remains very weak. The last remaining policy tool with substantial untapped potential is QE targeting long-dated bonds, which also has the very attractive benefit of having little impact on housing market dynamics given most Australian home loan borrowers use variable or short-term fixed-rate products. It does not, therefore, trigger the financial stability concerns associated with other more conventional monetary policy tools.
There is also a case for the RBA to take this opportunity to fine-tune the mix of its purchases of Commonwealth and state government bonds to 70%/30%, more in line with the relative weights in the stock of outstanding debt. The RBA had previously underweighted its purchases of state bonds (or “semis”) over concerns about liquidity in the market, which proved unfounded even following the announcement of much larger state budget deficits and the rating downgrades of NSW and Victoria. In fact, all the evidence suggests that the RBA has uncovered enormous offer-side liquidity in the semis market, buying most of its bonds very cheaply at or wide of the mid credit spread (i.e. not at the offer as would normally be the case).
The market consensus is for an extension of QE in April with most expecting another $100bn round of purchases, while some banks look for a smaller extension. There are also some early indications that the RBA’s favoured media proxies are validating the concept of QE 2.0. Surprisingly, no economists are currently canvassing a larger package, although Westpac is factoring in additional purchases next year. Some banks believe that the RBA might soon modify its 3-year yield target, but CCI thinks it will probably remain in place for a while longer, assuming QE is extended. Over time the RBA might have to rethink its options if its bond purchases fail to keep pace with the monetary stimulus from other central banks and the real exchange rate continues to appreciate. One cannot rule-out direct currency interventions, as was more common in the 1990s, although this raises the spectre of the RBA being criticised globally as a currency manipulator.