Authored by Kieran Davies and Christopher Joye, Coolabah Capital Investments.
In this flash note, we forecast a very high probability of a $100 billion QE3 program succeeding the $100 billion QE2 commitment the RBA sensationally announced this week, which we had previously forecast in late January (the consensus economist expectation was for a tapering of QE down to $63 billion).
With the RBA committing to another six-month, $100bn round of bond purchases – aka “QE2” – once the current round finishes in April, CCI has updated its forecast outlook to formally include “QE3” with a six-month, $100bn extension into 2022 followed by additional purchases likely next year with the size depending on the path of the virus and the state of the economy.
In forecasting QE2 in January, we argued that more stimulus, not less, was needed for the RBA to achieve its ambitious economic objectives of lowering unemployment enough to secure the strong 3.5-4%-plus wage growth needed to finally return core inflation to the 2-3% target. All this points to near-zero interest rates for the foreseeable future, with QE an ongoing feature of Australia’s fixed-income markets.
This is an important distinction that means QE is no longer considered a temporary COVID-19 mitigant in the manner of the Federal government’s fiscal stimulus, the RBA’s repo liquidity injections, or its Term Funding Facility (TFF), the latter of which is due to expire in June this year. For so long as the overnight cash rate and the 3-year government bond yield are stuck at their 0.1% effective lower bound, the RBA’s QE program is now the most active and dynamic part of its ongoing monetary policy apparatus, which can be calibrated up or down according to economic requirements.
As Governor Lowe has testified, inflation will probably undershoot the target for the whole of his term, which ends in late 2023, stressing that even when inflation is finally back in the band the RBA would probably hold off for a few quarters before raising rates to make sure higher inflation would be sustained. In the meantime, Lowe advised parliament that the RBA “[hasn’t] ruled out further bond purchases”, laying the foundations for QE3 and QE4.
We have high conviction in a $100 billion QE3 call given the formidable challenge faced by the RBA in achieving full employment, where:
- The economy is a long way from full employment and, by definition, therefore a significant distance from finally returning inflation to the 2-3% target band. Unemployment has likely peaked at a less disastrous level than feared, but Governor Lowe has previously characterised full employment as an unemployment rate in the 4s, which history suggests will be very difficult to achieve. Indeed, we have not seen it since the pre-GFC era. Governor Lowe’s parliamentary testimony implied that it may take 5-6 years to return inflation to target, rating the chances of meeting this goal over the remainder of his term – which ends in late 2023 – as “not very high”, even though the “board is doing everything it can to achieve it”.
- QE is the obvious option left to the RBA given it is reluctant to adopt negative rates. The cash rate is at the RBA’s effective lower bound of 0.1% and Governor Lowe continues to strongly push back on the negative policy rates adopted in Europe and Japan, arguing they could cause problems in the banking sector and prove ineffective.
- The RBA’s analysis implies QE1 has worked, but its influence has been offset by stronger global forces. The RBA argues that QE has helped “lower interest rates and meant that the Australian dollar is lower than it otherwise would have been”, reducing long-term Commonwealth bond yields by around 30bp, contributing to lower semi spreads, and adding to market liquidity. This latter point is interesting because some banks and issuers had asserted that QE would reduce market liquidity, which has not been our experience as one of the more active participants in the space. Our peers at bank balance-sheets also advise that they believe that the RBA’s QE program has actually enhanced liquidity in the semi-government bond market.
- The RBA has emphatically pushed back on market speculation of tapering of policy support. The RBA sought to nip this speculation in the bud by the early announcement of QE2 at its first meeting in 2021, with Lowe warning that “it is premature to be considering withdrawal of the monetary stimulus” because “it is going to be some years before the goals for inflation and unemployment are achieved”. We strongly agree with this view as speculation of tapering at this point would be counterproductive.
- The RBA’s commitment to keeping policy easy enough to secure full employment is unlikely to be shaken by strength in the labour market. Governor Lowe has stressed that a very tight labour market was needed to produce a material lift in wages. He said while unemployment could fall faster than anticipated, the board and bank staff had discussed the powerful structural factors lowering the NAIRU – i.e., globalisation, supply-chain dynamics, technology, and the reduced bargaining power of workers – where the experience prior to the pandemic in the US, UK, and in Australia, New South Wales, was that wage growth remained stubbornly low in the face of unemployment reaching 40-50 year lows.
- Rising house prices are a non-issue at present. Higher asset prices are part of the transmission mechanism of the lower cash rate and national dwelling prices have only just reached the point they were in in 2017, something we’ve repeatedly canvassed that Governor Lowe has himself recently started highlighting. Financial stability is also currently a non-issue given conservative lending standards and slow growth in household debt. In this respect, QE is a “cleaner” policy option for the RBA since it operates mainly through the long-term bond market and a lower exchange rate with no direct impact on mortgage rates and/or housing demand. If the risks around financial stability changed, the RBA and APRA know they can cauterise these problems via macro-prudential policy measures.
- Further purchases, or QE4, are likely in 2022 with any tapering hinging on the path of the virus and the state of the economy. The RBA should dole out QE in six-month intervals, but the ultimate size and duration of this form of monetary stimulus depends on the rate of progress towards full employment, where the RBA could be derailed by:
- The path of the virus. Sporadic outbreaks may continue, but the government expects most Australians will be vaccinated by later this year. That said, Australia’s tough elimination strategy to deal with the virus may see the international border closed well into 2022 or even 2023 given the patchy distribution of vaccines overseas and the potential for dangerous mutations of the virus.
- The unwinding of an unprecedented fiscal stimulus, which will gather pace over 2021. The fiscal stimulus was temporary by design, with Prime Minister Morrison stressing that the Commonwealth is “not running a blank cheque budget”.
- Upward pressure on the exchange rate from easy money abroad. RBA modelling indicates effective QE requires a lower exchange rate, whereas ongoing bond purchases by other central banks has pushed the currency higher. Lowe said other banks are extending their purchases to the end of this year, noting that, “if some central banks are doing QE, most of the rest of us feel we need to do that as well otherwise our currency will go up”. As he testified, “we live in an interconnected world” and “if we were to cease bond purchases in April, it is likely that there would be unwelcome upward pressure on the exchange rate” that “would further delay the already slow progress on jobs and inflation (emphasis added)”.
- A modest take-up of the TFF. The TFF will close to new applications in June unless there is a “marked deterioration in funding and credit conditions”. The RBA expects banks will tap the remaining c$100bn in the facility over coming months; if these funds are not disbursed there would be less monetary stimulus in the pipeline, pointing to additional QE to fill the gap.
Longer term, if the economic recovery unexpectedly falters, then the RBA may have to consider less attractive policy options, such as buying foreign bonds to lower the Australia dollar, while the government could be forced to put its plans for fiscal consolidation on hold.