Videoconference – 6 October 2020
Philip Lowe (Governor and Chair), Guy Debelle (Deputy Governor), Mark Barnaba AM, Wendy Craik AM, Ian Harper AO, Steven Kennedy PSM, Allan Moss AO, Carol Schwartz AO, Catherine Tanna
Michele Bullock (Assistant Governor, Financial System), Luci Ellis (Assistant Governor, Economic), Christopher Kent (Assistant Governor, Financial Markets)
Anthony Dickman (Secretary), Ellis Connolly (Deputy Secretary), Alexandra Heath (Head, International Department), Bradley Jones (Head, Economic Analysis Department), Jonathan Kearns (Head, Financial Stability Department), Marion Kohler (Head, Domestic Markets Department)
International Economic Developments
Members commenced their discussion of the international economy by reviewing economic and health outcomes across a range of countries. Countries that had struggled to contain the coronavirus, and/or had imposed severe nationwide lockdowns, had experienced larger contractions in output in the first half of the year. Members noted that Australia’s economic and health outcomes this year had compared favourably with the international experience.
In their discussion of developments over recent weeks, members noted that a number of countries, including in Western Europe, were experiencing a second wave of COVID-19 cases. Most countries had imposed targeted restrictions in response, rather than nationwide lockdowns as had been the case earlier in the year. More broadly, timely readings on global activity and labour markets, including job advertisements, were pointing to a gradual recovery in the global economy, but with significant spare capacity remaining. This was likely to keep underlying global inflation pressures low.
In turning to the recovery in China and other east Asian economies, members noted that exports and industrial production had both recovered, but at different speeds. The extent of supply disruptions, differences in industry composition and changes in demand had all contributed to this pattern. Members noted that demand for China’s exports had picked up. Elsewhere in east Asia, changing trade patterns highlighted the varied nature of the economic shock induced by the pandemic. Economies most involved in the production of semiconductors and other technology items for export, such as South Korea, had recorded a strong recovery in industrial production. By contrast, in those economies more geared to the global automotive market, such as Japan and Thailand, industrial production had experienced a more subdued recovery.
Domestic Economic Developments
Members commenced their discussion of domestic economic developments by reviewing the very large contraction in activity in the June quarter. Excluding public demand, expenditure had declined very sharply. Consumption fell by 12 per cent, driven by a halving in spending on discretionary services. Dwelling investment fell by 7 per cent and business investment declined by 4 per cent. These contractions in investment had been less than expected. Activity in the construction industry had not been disrupted to the extent initially anticipated, while the accelerated depreciation allowance had encouraged more business spending on vehicles and other equipment than initially expected.
In comparing consumption in the June quarter in Australia with that in other advanced economies, members noted that domestic consumption of durable goods had been positive and stronger than elsewhere, while domestic consumption of non-durable goods and services had experienced large declines more in line with the experience abroad. Members also noted that indicators of consumption in the September quarter had been stronger than expected.
Members discussed the significant increase in household savings in the June quarter and the implications of this for the outlook. The sharp increase in savings reflected the record decline in household consumption, mainly driven by constraints on certain types of consumption owing to the restrictions on activity, as many services could not be offered for sale. At the same time, household income had increased, supported by a number of policy measures, including the JobKeeper program and the Coronavirus Supplement paid to JobSeeker recipients. There had been some substitution toward the consumption of goods and services not affected by restrictions (such as home office equipment and household goods), but the overall effect of the restrictions on activity, combined with large income transfers from the government, had been to reduce consumption relative to household income. A higher level of precautionary savings also accounted for part of the increase in household savings. In addition, household cash flow had been boosted by the significant volume of superannuation withdrawals.
In discussing the implications of the increase in savings for the outlook, members noted that savings behaviour in the period ahead could differ markedly across households. Some people were likely to increase their consumption (relative to income) as remaining restrictions on activity were lifted, while households concerned about potential job losses would be inclined to maintain higher-than-usual levels of savings as insurance against lower income in the future.
Members discussed a range of other policy changes that had supported economic activity in recent months. Activity in the detached housing market had picked up, particularly in Western Australia, as a result of the Australian Government’s HomeBuilder package and state government incentives. The instant asset write-off scheme had also contributed to the stronger-than-expected outcome for non-mining business investment in the June quarter.
In turning to the labour market, members noted the substantial effect of the Stage 4 restrictions in Victoria, while conditions in the labour market in other parts of the country had continued to improve. Jobs, employment and hours worked had recently declined in Victoria to around levels previously recorded in May. For the country as a whole, however, members noted that the deterioration in the labour market through the pandemic had been somewhat less severe than had been expected. The unemployment rate was now expected to peak below the 10 per cent level projected under the baseline forecast scenario in the August Statement on Monetary Policy. Nevertheless, substantial spare capacity remained in the labour market and its recovery over the medium term was expected to be gradual.
Members concluded their discussion of economic developments with a review of how businesses had responded to the pandemic. A recent survey indicated that some of the changes made by firms were likely to be retained as a permanent feature of their business models, including, for example, the way that products and services are offered, such as the increased use of online distribution channels. Information from business liaison contacts also suggested that, relative to the global financial crisis, many firms had responded faster in reducing investment and employment, although this may have been because the shock to activity was significantly larger. Members noted that cost control and major levels of government assistance had supported the health of the business sector in aggregate, although the future viability of some firms remained uncertain.
Members were briefed on the evolution of financial stability risks in the Bank’s regular half-yearly assessment. An unprecedented policy response had quickly restored financial market functioning in the period soon after the onset of the pandemic. But with the economic recovery expected to take some time, financial stability risks were now more related to declining credit quality.
Financial asset prices had rebounded from their lows in March, in part because of expectations of an extended period of low risk-free interest rates. However, there had also been a sharp fall in the compensation investors receive for risk. This was despite uncertainty stemming from the shape of the recovery and a rise in political tensions internationally, as well as expectations of rising insolvencies and defaults. For some heavily affected sectors, lost output would not be recovered quickly and some businesses could face difficulty servicing their debts. These factors raised the risk of a sharp fall in asset prices. Globally, there had been a decline in credit quality prior to the pandemic, which increased risks for investors, particularly those with leverage. Of note, there had been an increase in the share of investment-grade bonds with a lower credit rating, and a substantial increase in the share of leveraged loans with few covenants.
Banks in the advanced economies had started the year with high levels of capital and liquidity as a result of reforms that had followed the global financial crisis of over a decade earlier. Their balance sheet strength had enabled banks to act as a shock-absorber for the real economy, rather than magnifying the shock as they had during the global financial crisis. Policy actions, including decisions that loans with repayment deferrals be treated as performing and restrictions on shareholder pay-outs, had contributed to banks’ capital ratios remaining high. However, in some jurisdictions, banks had entered the period with structurally low profitability; this would make it more difficult if they needed to raise equity in stressed times and would be likely to make those banks more cautious in expanding their lending. These risks were particularly high for those European countries where low bank profitability occurred in tandem with high levels of government debt, since a fall in sovereign debt values would erode bank capital and lead investors to question the government’s ability to support troubled banks.
Members noted that many businesses in Australia had increased their cash buffers in 2020. Prior to the pandemic, firm-level data suggested that around half of businesses had enough cash to pay their expenses for less than one month. However, by mid 2020, support measures provided by the government, landlords and lenders had boosted businesses’ cash buffers, with estimates suggesting that a significant share of businesses could cover at least six months of expenses. Listed companies had larger buffers than private companies and unincorporated businesses. Members also noted that, for some businesses, their best survival strategy would be to hibernate until economic conditions had sufficiently normalised. Business failures had been substantially lower in 2020 than in preceding years because of insolvency moratoriums and the various support measures. However, business failures were expected to rise, particularly for small businesses.
Risks for some types of commercial property were high as declining demand had increased the chance of falling property values. Retail property vacancy rates had been rising prior to 2020 because of structural changes in the retail sector. Efforts to contain the spread of the coronavirus had accelerated this trend in the first half of 2020. Office vacancy rates had also increased given the decline in economic activity, although this had been from low levels of vacancies, particularly in Sydney and Melbourne. Nevertheless, an increase in office supply coupled with uncertainty about future working conditions (and therefore office demand) increased the risk of falls in office property prices, particularly for secondary-grade buildings. Members noted that demand for industrial property had been strong prior to the pandemic, driven by increasing e-commerce, and that, if anything, this had since been reinforced. Banks’ direct commercial property exposures had declined since the global financial crisis, although members noted there was uncertainty about the size of banks’ indirect exposures through lending to non-banks that subsequently lent to property investors, as well as the use of commercial property as collateral for business lending.
Many households had increased their liquidity buffers in 2020. This reflected a reduction in living expenses and, more so for some renting households, an increase in income from government payments. In the early 1990s’ recession the unemployment rate had increased by less for households with mortgages than for households that rent, but in 2020 the unemployment rate had increased by a similar amount for both types of households. The unemployment rate for households with mortgages, nevertheless, remained lower than for renters. Members noted that repayments had been deferred on around 7 per cent of housing loans, a slight decline from the peak earlier in the year. Loans with a repayment deferral were more likely to have a higher loan-to-valuation ratio and to have been extended to those employed in industries relatively more adversely affected by the pandemic. Demand for housing had moderated slightly, with only relatively small falls in housing prices in Sydney and Melbourne. Housing prices had increased in all other cities in September. Most borrowers for housing had large amounts of equity in their properties, with only 3 per cent of borrowers estimated to have negative equity.
Banks in Australia had increased their provisions in the first half of 2020 to account for expected future losses resulting from the pandemic. Banks’ non-performing loan ratio was low, but had been increasing gradually since the start of the year. This had reflected a decline in credit quality for housing loans to both owner-occupiers and investors. The increase in the non-performing loan ratio for personal lending was partly due to a reduction in outstanding personal credit, particularly credit card balances, as those borrowers in a stronger financial position had been repaying their debts. Both large and small banks had high levels of capital. Stress tests of the banks indicated they had sufficient capital to withstand an economic contraction that was far more severe than expected. Members noted that, given their strong balance sheets, banks were well placed to continue lending and thereby support the economic recovery.
International Financial Markets
Members commenced their discussion of international financial markets by noting that financial conditions had continued to support the global economy over the preceding month. Central banks in the advanced economies had left their policy rates unchanged, but financial market prices implied that some central banks were expected to ease policy further. In the case of some central banks, such as the European Central Bank, this was in response to weaker-than-expected economic conditions and rising downside risks to the economic outlook. In the case of the Reserve Bank of New Zealand and the Bank of England, the expectation of further easing had followed guidance from these central banks that they were preparing for the possibility of negative policy rates.
Central banks in the advanced economies had also continued to purchase substantial amounts of government debt in the secondary markets. At its September meeting, the US Federal Reserve had left the pace of asset purchases unchanged, but acknowledged that asset purchases were being undertaken to foster accommodative financial conditions, in addition to sustaining market functioning.
Low policy rates and large asset purchase programs had contributed to sovereign bond yields in major advanced economies remaining low and stable. Members noted that longer-term yields for Australian Government Securities (AGS) had been higher than in almost all other advanced economies, although there had been some narrowing of the interest rate differential between Australia and other major advanced economies in recent weeks. The recent narrowing in yield differentials had contributed to a broad-based depreciation of the Australian dollar over the previous month, as had an increase in risk aversion and a decline in some commodity prices, which had been related to rising concerns about the prospects for global output growth. Nevertheless, the Australian dollar had remained just below its peak of the previous few years. While members noted that the Australian dollar exchange rate was broadly consistent with its fundamental determinants, a lower exchange rate would provide more stimulus to the Australian economy in the recovery phase.
In emerging markets, financial conditions had also been supported by accommodative policy settings. Financial conditions in China had remained broadly accommodative, although they had tightened in recent months together with the economic recovery there. Growth in total social financing had remained stronger than the previous year, consistent with the stated goal of the authorities. The Chinese renminbi had appreciated over the preceding couple of months. However, other emerging market economies had remained vulnerable to a further deterioration in their economic outlook because of the ongoing increase in COVID-19 cases, pre-existing macroeconomic fragilities and a reliance on external financing, which limited the scope for additional fiscal stimulus.
Domestic Financial Markets
Domestically, the Bank’s policy measures had continued to underpin accommodative financial conditions. Financial market prices implied that investors now expected the cash rate to decline to below 10 basis points, compared with earlier expectations that the cash rate would remain at around its current level of 13 basis points for some time. Money market rates and bond yields had also declined in line with this change in market expectations.
The Bank had purchased bonds in the secondary market in early September in support of the 3-year AGS yield target. Subsequently, the 3-year yield had moved well below 20 basis points as market participants’ expectations for further policy actions by the Bank had increased. Members noted that investor demand for recent AGS issuance had been strong and that spreads of semi-government yields to AGS had remained narrow.
Members also noted that banks had drawn down nearly all of their initial allowances of $84 billion from the Term Funding Facility by the 30 September deadline. This was supporting historically low bank funding costs. From the start of October, banks were able to draw on the new supplementary allowance of $57 billion in total, as well as additional allowances, which amounted to $59 billion at the time of the meeting.
Interest rates on housing and business loans remained historically low. Business credit had decreased a little further in August as large businesses continued to repay revolving credit facilities, which they had drawn down in March and April for precautionary purposes. Members noted that, notwithstanding this, large businesses had issued more corporate bonds over the year to date than the average of recent years, as had been the case in other economies. Large businesses had also increased their credit limits at banks. Meanwhile, lending to small and medium-sized businesses had remained little changed. Weakness in business credit growth appeared to be driven mostly by lower demand in response to weak economic conditions and the uncertain environment, although the availability of credit to businesses had also tightened a little following the onset of the pandemic.
Growth in credit for owner-occupied housing had remained steady in recent months. Commitments for housing loans to owner-occupiers had picked up further in August across all states, consistent with a general increase in activity in the housing market. By contrast, credit to investors in housing had remained weak, although it had stopped declining in August. Following an earlier tightening in response to the pandemic, more recently constraints on the supply of housing finance had eased slightly.
Considerations for Monetary Policy
In considering the policy decision, members observed that the global economy was gradually recovering, but that most economies were still some way from the output levels that prevailed before the pandemic. The continuation of the recovery was dependent on containment of the virus. The recovery was most advanced in China, where conditions had improved substantially over preceding months. Globally, inflation remained very low and below central bank targets.
The Australian economy had experienced the largest peacetime economic contraction since the 1930s. Nevertheless, members noted that the decline in output in the June quarter had been smaller than in most other countries and smaller than had been expected. A recovery was under way in most of Australia, although the second COVID-19 outbreak in Victoria and associated restrictions on activity had been having a major effect on the economy in that state. Labour market conditions had improved somewhat over the preceding few months, with the unemployment rate likely to peak at a lower rate than earlier expected. Nevertheless, both unemployment and underemployment were expected to remain high for an extended period. The recovery was likely to be slow and uneven, and inflation was expected to remain subdued for some time.
Members agreed that the Board’s policy package was continuing to support the Australian economy by underpinning very low borrowing costs and the supply of credit to households and businesses. There was a very high level of liquidity in the Australian financial system and the policy package had helped to lower funding costs. Authorised deposit-taking institutions had drawn down $83 billion of low-cost funding through the Term Funding Facility and had access to a further $114 billion under the facility. Members noted that the Australian banking system, with its strong capital and liquidity buffers, had remained resilient and was helping the economy traverse the current difficult period.
Over the prior month, the Bank had purchased AGS in support of the Board’s 3-year yield target of around 25 basis points. Government bond markets had been operating effectively, also during a period of significant increase in issuance. The Bank stood ready to purchase AGS and semi-government securities in the event of a recurrence of market dysfunction.
Members recognised that the substantial, coordinated and unprecedented easing of fiscal and monetary policy in Australia was helping to sustain the economy through the current period. Members noted that public sector balance sheets in Australia were strong, which allowed for the provision of continued support, with the Australian Government Budget for 2020/21 to be announced that evening. The Secretary to the Australian Treasury briefed members on the main features of the Budget. Members considered that fiscal and monetary support would be required for some time given the outlook for the economy and the prospect of high unemployment.
The Board discussed the case for additional monetary easing to support jobs and the overall economy. As in previous meetings, members discussed the options of reducing the targets for the cash rate and the 3-year yield towards zero, without going negative, and buying government bonds further along the yield curve. These options would have the effect of further easing financial conditions in Australia.
In considering the case for further monetary measures, members discussed monetary policy developments abroad and their implications for financial conditions in Australia, through the yield curve and the exchange rate. Members noted that the larger balance sheet expansions by other central banks relative to the Reserve Bank was contributing to lower sovereign yields in most other advanced economies than in Australia. Members discussed the implications of this for the Australian dollar exchange rate.
Members also discussed how much traction further monetary easing might obtain in terms of better economic outcomes. They recognised that some parts of the transmission of easier monetary policy had been impaired as a result of the restrictions on activity in parts of the economy. However, as the economy opens up, members considered it reasonable to expect that further monetary easing would gain more traction than had been the case earlier. Members also considered the effect of lower interest rates on community confidence and on those people who rely on interest income.
Members discussed the possible effect of further monetary easing on financial stability. A further easing would help to reduce financial stability risks by strengthening the economy and private sector balance sheets, thereby lowering the number of non-performing loans. This benefit would need to be weighed against any additional risks as investors search for yield in the low interest rate environment, including those resulting from higher leverage and higher asset prices, particularly in the housing market. On balance, the Board thought it likely that there were greater financial stability benefits from a stronger economy, while acknowledging that risks in asset markets had to be closely monitored.
The Board also considered the nature of the forward guidance regarding the cash rate. Over recent months, the Board had communicated that it would ‘not increase the cash rate target until progress is being made towards full employment and it is confident that inflation will be sustainably within the 2–3 per cent target band’. Given the higher level of uncertainty about inflation dynamics in the current economic environment, the Board agreed to place more weight on actual, not forecast, inflation in its decision-making. Members indicated that they would also like to see more than just progress towards full employment before considering an increase in the cash rate, as the Board views addressing the high rate of unemployment as an important national priority. Members recognised that while inflation can move up and down for a range of reasons, achieving inflation consistent with the target is likely to require a return to a tight labour market.
Members agreed that this evolution in forward guidance would best be announced in a speech by the Governor on 15 October. This would allow for greater context to be provided than was possible in the post-meeting statement. The Board remains of the view that it would be appropriate to remove the yield target before the cash rate itself is raised.
The Board affirmed its commitment to supporting jobs, incomes and businesses in Australia. Its actions, including the decision in September to expand the Term Funding Facility, were keeping funding costs low and assisting with the supply of credit. It agreed to maintain highly accommodative policy settings as long as required and to continue to consider how additional monetary easing could support jobs as the economy opens up further.
The Board reaffirmed the existing policy settings, namely:
- a target for the cash rate of 0.25 per cent
- a target of 0.25 per cent for the yield on 3-year Australian Government bonds
- the expanded Term Funding Facility to support credit to businesses, particularly small and medium-sized businesses
- an interest rate of 10 basis points on Exchange Settlement balances held by financial institutions at the Bank.