Upgrades With Stimulus
At its board meeting last week, the RBA decided to ease monetary conditions further, including cutting the cash rate and target rate for three-year bonds 15 basis points to 0.10%. They also announced an initiative to purchase $A100 billion of longer-dated government bonds. The policy easing came with a commitment not to lift interest rates over the next three years at least. It also came as the RBA was about to announce in the quarterly Monetary Policy Statement sizeable increases in its economic growth forecasts compared with its forecasts three months ago, which at that time had also been increased from its forecasts produced back in May.
Increased monetary stimulus for an economy rising more strongly than expected and with building business and consumer confidence points to an extended period ahead of well above average economic growth. As the RBA is predicting in its latest forecasts Australian GDP could return to its pre-COVID-19 level by end-2021. Increasingly, the key question will be at what point will higher inflation return to upset the happy combination of stronger economic growth with very low interest rates?
Just about every Australian data release over the past three months has come in on the stronger side of market and RBA expectations – especially those relating to housing, the most interest-rate sensitive sector. These upside surprises have occurred even with Victoria in extended lockdown and with only slow progress removing border restrictions between various states.
Certainly, there are risks that this run of good economic news might not last. Stronger spending by households may falter with step-downs in government income support programs. Optimism in housing could return to pessimism as housing loan holiday arrangements continue to run-off. There could be a resurgence of COVID-19 infections and new restrictions. A widely distributable, effective COVID-19 vaccine could be further away than expected.
Set against these downside risks, the immediate news on COVID-19 infections in Australia is very low and very encouraging. Australia is about to start manufacturing one promising version of COVID-19 vaccine. Restrictions are easing fast in Victoria and state borders are begging to come down. The earlier higher-level government income support boosted household savings providing the wherewithal for households to spend more freely later. That time to spend may have arrived according to burgeoning readings of consumer confidence.
The RBA may have had several reasons why it chose to ease policy further - including explicitly deploying the QE weapon for the first time - at a time of clear evidence of strengthening economic activity.
The first reason is that however strongly the economy is starting to grow there is substantial excess capacity to bring back to production in the wake of the deep recession in the first half of 2020. Unemployment and under-employment are both running high and need to be brought down by speeding up economic growth. Speeding up growth is a comparatively risk-free exercise while excess capacity exists, in the sense that there is little near-term risk of excessive near-term rise in producer and consumer prices.
The RBA’s latest “baseline” economic forecasts show annual GDP growth lifting from an actual –6.3% y-o-y back in June 2020 to –4% (August forecast –6%) in December 2020 and +6% (August forecast +4%) in June 2021. The associated unemployment rate forecast runs from an actual 7.0% in June quarter 2020 to 8.0% (August forecast 10.0%) in December quarter 2020 and 7.5% (August forecast 9.0%) in June quarter 2021. Even with stronger GDP improvement forecast, the unemployment rate, although lower in June quarter 2021 than forecast three months ago, is still high at 7.5% and well above the low 5% readings just ahead of the COVID-19 recession.
Persistent excess capacity in the face of stronger growth forecasts has led the RBA to dial down forecast inflation to 2.25% y-o-y in June 2021 (3.0% forecast in August). June 2021 is also a temporary high point for annual inflation as the base for the annual calculation in June 2020 was unusually low because of temporarily free childcare and unusually low petrol prices. Beyond June 2021 the RBA forecasts annual CPI inflation will fall to 1.0% in December 2021 and rise to only 1.5% in December 2021.
Persistently low forecast inflation is the reason why the RBA is saying there will be no rise in official interest rates over the next three years at least.
A second reason why the RBA eased further when it did was that to use up what little interest rate ammunition it had left when the economy was weaker a few months earlier risked being ineffective. Households were in a more constrained position and unable to spend more in some cases because of COVID-19 restrictions. Far better to deploy stimulus with the greater ability for households to spend and with confidence rising.
As for the formal introduction of QE the reasons are partly to show some semblance of similarity with the policy moves of other major central banks overseas in turn helping to stem untoward Australian dollar exchange rate appreciation and partly to complement (monetise) increased government spending and borrowing.
Whatever the reasons for the easing moves by the RBA what is in no doubt is that the easing has been deployed knowingly against a backdrop of strengthening economic growth – it is a pro-cyclical policy move and possibly not the last. It is a move that weights risks to economic forecasts more towards upside surprises. While there is still plenty of economic capacity to use up after the recession, the risk is rising that capacity will be used up more quickly than the RBA is forecasting currently with inflation returning late in 2021, more quickly than the RBA expects. The RBA’s commitment not to raise interest rates over the next three years could be tested in 2022.