Markets are closely scrutinising the next moves from the RBA.
It is important to recall that the key lesson of recent years for central banks and the likely current thinking of the RBA as expressed last year by the Deputy Governor is that it is better to err on the side of providing too much stimulus – even more so when exiting a damaging recession which has left the unemployment rate at unacceptable levels (albeit not as high as feared).
The next Board meeting is on February 2 to be followed by an address (30 minutes speech; 30 minutes Q and A) by the Governor to the National Press Club on February 3. The week will be capped by the Statement on Monetary Policy on February 5.
The December Employment Report showed an increase in jobs of 50,000 and a fall in the unemployment rate from 6.8% in November to 6.6%.
When the RBA last released its forecasts in the November Statement on Monetary Policy on November 6 it forecast that the December quarter average unemployment rate would be 8.0% – the 6.8% (quarterly average) actual will come as a significant and welcome surprise.
The November forecast anticipated the unemployment rate falling through 2021 from 8% to 6.5%.
With the starting point now at 6.8% rather than 8% that end 2021 forecast of 6.5% is likely to be reduced to 6% with limited progress expected in the first half of 2021 as the economy negotiates the unwinding of JobKeeper.
A 6% end 2021 forecast would be in line with Westpac’s current forecast.
It will also need to significantly upgrade its GDP forecast for 2020; we expect the -4% growth rate, which figured in the November forecast, will be adjusted in line with the Westpac forecast of –2%.
While we will not see the December quarter GDP Report until March 3 the hours worked data from the December Employment Report is broadly consistent with Westpac’s forecast of 2.3% GDP growth in the December quarter pointing to the -2% growth rate for 2020.
With a much stronger than expected end to 2020 there will be a need to scale back the RBA’s 5% growth forecast in 2021 to be more in line with Westpac’s forecast of 4%.
That change would be consistent with our thinking that activity in the economy returned to pre-Covid levels in the June quarter 2021 – a remarkable achievement by global standards (with due recognition for China’s “miracle”).
Furthermore the December Employment Report showed a significant fall in the underemployment rate from 9.6% to 8.5% – only 0.3% above the level one year earlier, in December 2019.
Overall the measure of spare capacity in the economy – the underutilisation rate – has fallen from its peak of 20.2% in April to 15.5% in December – although still 2.2% above the level of December 2019.
So, how might this success with the labour market and the growth rate impact RBA policy?
The policies that are up for consideration for the RBA will be the Quantitative Easing Policy (QE) – the $100 billion program is set to be completed in early May; the Term Funding Facility (TFF) – drawdowns on that facility are set to expire on June 30;and the yield curve control initiative that has no “expiry” date
Quantitative Easing
In December, Westpac forecast that the QE program would be extended with a further $100 billion facility ($70 billion AGS; $30 billion semi-government) to replace the current facility($80 billion AGS; $20 billion semi government) from early May. The program would then be scaled back to $50 billion from November and a further $50 billion from May 2022.
If we are correct then the first extension will need to be announced by the April Board meeting. It is reasonable to expect that the announcement of the extension of the facility will be delayed until the April Board meeting as the Board acquires further information about the state of the recovery, particularly given that the Employment Report generally reflects the first half of December and “misses” the impact of the state border closures and lockdowns later in the month and through to January
Note that the high frequency data from the Westpac Melbourne Institute Index of Consumer Sentiment showed a 4.5% fall in Sentiment in January, to a still elevated 107.0.
In his Statement following the December Board meeting the Governor noted that, “The Board will keep the size of the bond purchase program under review particularly in light of the outlook for jobs and inflation”.
There is the precedent that the decision to extend the TFF which was due to expire on September 30 was announced at the latest possible Board meeting on September 1.
An earlier announcement at the February or March meetings is entirely possible but in general central banks are cautious, delaying decisions until the maximum amount of information is available.
The timing of an April decision would also support the RBA’s objective of publicly promoting the Federal Government’s initiatives to provide ongoing fiscal support for the economy.
An announcement that the RBA intended extending the QE program by a further $100 billion would send a clear message to the government, in the month immediately prior to the announcement of the May Federal Budget, that the Bank was continuing to contribute to the highly successful “Team Australia” objective of restoring equilibrium to the Australian economy.
A decision to abandon or even cut back the size of the program would indicate a tightening of monetary policy. The impact of such a move by the RBA around the time of the scaling back of JobKeeper and JobSeeker would risk a solid dent in confidence and lessen the RBA’s leverage on fiscal policy
The cost associated with the extension of the policy might relate to the RBA “over bloating” its balance sheet or dominating the Federal government’s new funding program.
Below we argue that by June the RBA is likely to announce that the TFF facility of around $200 billion is likely to be scaled back to specifically target business lending.
The TFF will eventually add around 10% of GDP to the RBA’s balance sheet.
With the first $100 billion QE tranche (5% of GDP); the TFF and earlier bond purchases associated with yield curve control the RBA’s balance sheet is likely to be expected to reach around $550 billion (27% of GDP) by June 2021. That figure will be moderately higher if significant further purchases are required to support the YCC program or the expected extension of the TFF to directly support business lending takes off.
Under our scenario we would envisage the balance sheet expanding to 33-35% of GDP by June 2022.
The best comparison of whether that constitutes a “bloated” balance sheet is with the US Federal Reserve. (Figure 1)
The Fed’s balance sheet is currently around 34.3% of GDP. We expect that the Fed will not be tapering its commitment to purchasing $120 billion in US Treasuries and Asset Backed Securities any time before June 2021.
That annual pace of around 7% of GDP per annum would boost the Fed’s balance sheet to around 44% of GDP by June 2022 – much larger than the projected size of the RBA’s balance sheet.
Other major central banks such as BOJ; ECB and BoE all have even larger balance sheets (relative to GDP) than we envisage for the FED or the RBA.
This expected consistent approach from the FED is a likely significant factor for the RBA. Recall the Governor’s speech on October 25, “Australia is a mid- sized open economy in an interconnected world, so what happens abroad has an impact here on both our exchange rate and our yield curve”.
With the other central banks, in particular the FED, not easing up on their QE policies a decision to tighten domestic policy would be untimely.
The Mid Year Economic and Fiscal Outlook (MYEFO) estimates that by June 2022 AGS on issue will increase by around $150 billion over fiscal 2021/22. Those estimates are on a no policy change basis while we expect that the Federal Government will adopt a range of policies aimed at maintaining support for the economy significantly boosting the required volume of new issuance.
The forecast purchases of AGS by RBA over fiscal 2021/22 would be around $80 billion( perhaps around half the total new issuance), although certainly targeted at the 5–10 year maturities.
That level of activity should not be seen as distorting the market.
We can look back to assess the “success” of the first QE tranche.
At the time of the announcement of the QE program the yield spread between AUD bonds and US Treasuries had contracted to around minus 1–2 basis points. But this spread fell quickly from around the middle of October from a positive margin of around 10–12 basis points once the market began to confidently anticipate the advent of QE; supporting evidence of the effectiveness of the QE program.
Arguably, the slight widening of this spread to around 1–2 basis points could reflect market concerns that the QE program is not likely to be extended.
The AUD, of course, has lifted significantly, particularly against the USD since the QE program was introduced from around USD0.71 to USD 0.77 (up 8%).
But central banks will generally never assess a policy that is theoretically sound as having “failed” because the counterfactual can never be observed. It is entirely reasonable for RBA to argue that AUD would have been even stronger without the QE policy.
Indeed a policy to abandon or scale back QE at a time when AUD may be seen to have significant momentum would only risk further upward pressure on the currency, which may not be justified on fundamentals
The Term Funding Facility
By December 1 authorised deposit taking institutions had drawn down $84 billion under the facility and have access to a further $105 billion, which must be drawn down by the end of June 2021.
The first tranche of the facility, which was announced in March 2020, allowed ADI’s to draw down 3% of existing outstanding credit (around $90 billion) by September 2020. That was followed by a second tranche in September 2020 for an additional 2% of existing outstanding credit (around $57 billion) to be drawn down by June 2021.
In addition ADI’s were allowed to link further TFF to growth in business loans with the emphasis on small business, (factor of 1x for Large Business Credit and 5x for Small Business Credit).
With the RBA expanding the TFF but at a slower rate of increase and the delayed take up of the facility (Tranche 1 was largely taken up near the expiry date) it seems reasonable that a decision by the RBA to respond to the improved performance of the economy by not further extending the TFF except for those tranches associated with business lending.
From a credit perspective the TFF tranches related to overall existing credit could be seen as largely supporting housing credit growth where the RBA should be comfortable that lenders have access to adequate low cost funding.
However, business credit growth has been contracting in recent months pointing to the need to provide additional support.
Yield Curve Targetting
When most were focussing on the near term, Westpac was looking forward to the timing of the scaling back of the Yield Curve Targetting policy.
Our view has been, and remains, that the policy will need to be adjusted in early 2022.
Targetting the three year bond rate at the cash rate (0.1%) clearly indicates that the RBA expects the cash rate to remain on hold for the next three years.
The conditions necessary for an increase in the cash rate have toughened.
“The Board will not increase the cash rate until actual inflation is sustainably within the 2–3% target range. For this to occur wages growth will have to be materially higher than it is currently”(Governor’s Statement post December Board meeting).
Note that the pre Covid experience with wages growth was that even with an unemployment rate around 5% wages growth languished around 2.5% – well below the level associated with a tight labour market( 3.5%–4.0%) and necessary to keep inflation in the 2–3% range.
Overachieving on the inflation target after five years of underperformance would be an attractive bias for RBA (and consistent with the FED’s recent pivot).
We do not expect damaging imbalances in asset markets in 2021 which might prompt an earlier adjustment from the RBA; and even if that were the case macro prudential policy focussed on the housing market would be the preferred policy option.
Markets are impatient and we can therefore expect some early upward pressure on the three year swap rate but we believe markets will have to wait until 2022 for the adjustment in the three year yield target.
