The minutes of the Reserve Bank Board meeting for August provided one significant surprise.
In the Governor’s decision statement following the meeting on August 6, the conclusion included “the Board would continue to monitor developments in the labour market closely and adjust monetary policy if needed to support sustainable growth in the economy and the achievement of the inflation target over time”. That statement was repeated almost verbatim in the Statement on Monetary Policy on August 9.
In the August minutes, the emphasis changed to the following “the Board judged it appropriate to assess developments in the global and domestic economies before considering further change in the setting of monetary policy. Members would consider a further easing of monetary policy if the accumulation of additional evidence suggests this was needed to support sustainable growth in the economy and the achievement of the inflation target over time”.
So the message here is that policy could be eased in response to an unexpected deterioration in the global economy without the labour market providing an adequate justification for a rate cut.
Nevertheless we expect that the Board is essentially locked into two more rate cuts regardless of international developments.
In that regard, it is important to be clear that the forecasts in the Statement on Monetary Policy (SMP), on which the minutes are based, assume market pricing for the cash rate path. At the time of the forecasts, the market pricing discounted two further rate cuts — one by the “end of this year”, and a second in the “first half of 2020”.
Despite this rate path, the August forecasts are, in some respects, less positive than those published in May. The August update indicates a lower profile for wages growth (reaching only 2.4% in 2021), an increase in the unemployment rate forecast (from 5% to 5.2% in December 2020), and the trimmed inflation rate forecast now below 2% by end 2020 (at 1.9%). These forecasts indicate that despite two more rate cuts, the RBA still does not expect the unemployment rate to go remotely close to its stated desired 4.5% over the forecast horizon, or reach the 2-3% target band for inflation before 2021.
However the RBA does remain upbeat about economic growth. In lowering the forecast for GDP growth in 2019 to 2.5% from 2.75% in May it is still expecting growth in the second half of the year to reach a 6 month annualised pace of around 2.75%. The RBA expects growth to be a trend 2.75% in 2020 (unchanged from May) and then lift to an above trend 3% in 2021.
That 2.75% annualised pace in the second half of 2019 is likely to be the best that could possibly be expected given the current weak momentum. So any idea that the RBA would delay the next cut in awaiting a few months of data to gauge the strength of the boost to growth in the second half (which can reasonably be expected from the political certainty, tax cuts, rate cuts, lower AUD, and recovery in the housing market) misses the point that the RBA is already banking on a lift from around a 2% pace in first half of 2019 to a 2.75% pace over the second.
Consequently we remain comfortable with our call that the next move will be in October – a respectable pause from the last cut in July but never indicating any doubt that another move was required.
A second respectable gap between October and February would also indicate a clear intention to move just based on the domestic outlook.
Although we saw substantial downward revisions to the domestic forecasts in August, the international forecasts remained largely unchanged. Growth amongst major trading partners was forecast at 3.7% in 2019 and 3.8% in 2020 in both May and August. In fact the forecasts are largely unchanged from February where growth was forecast at 3.8% (2019) and 3.8% (2020).
Terms of trade forecasts are still quite cautious (-1.5% in 2019 and -7.5% in 2020 in August compared to – 3.4% in 2019 and -5.5% in 2020 in May).
If global developments deteriorated substantially over the next 6 months or so, the intensified focus on global conditions would, presumably, argue for even more monetary policy stimulus than is currently anticipated by the RBA and the markets.
The markets currently anticipate a terminal rate of 0.5% by March/April next year with about a 40% chance of a further cut by September.
So what form would further stimulus take in the event of a sharp deterioration in global conditions?
Recall that on July 24 Westpac lowered its forecast for the terminal cash rate from 0.75% to 0.5%. We also argued that the RBA might decide to complement that cut with a package of unconventional policies, including asset purchases and term loans to banks and non-banks to enhance the impact of the rate cut.
That view was based on the recognition of the difficulty banks might have in passing on rate cuts as interest rates approach zero.
The RBA’s research seems to indicate considerable confidence that the effectiveness of rate cuts, at least for the next two expected moves, will be adequate.
The August Statement on Monetary Policy notes that prior to the July rate cut, only around 10% of bank deposits were at the zero level and deposits paying less than 0.5% had risen from 5% in February to 10% in June (reflecting the banks’ response to the June rate cut). While this information had not been updated for the July rate cut, there seemed to be an anticipation that policy would be quite effective in the move to a 0.75% cash rate and, arguably, even a 0.5% cash rate.
This response is yet to be tested but, it seems reasonable, that the RBA is not anticipating using unconventional policies to support rate cuts down to a cash rate of 0.5%.
But what if the RBA sees a need to provide further policy easing in the face of a sudden deterioration in global conditions?
We have estimated that the 10 year bond rate will hold at around 50 basis points above our expectation for the terminal cash rate of 0.5% – a fairly flat yield curve with little scope to flatten even further. Equally, we expect that the three year swap rate will settle around 20 basis points above the terminal cash rate at around 0.7%.
If unconventional policy is restricted to the RBA buying bonds then it seems unlikely that a marked change in yields would be likely given the current tight pricing. However, if the policy was linked with a further reduction in the terminal cash rate to 0.25%, then there would surely be a further downward adjustment to the yield curve.
More aggressive unconventional policy options (be that negative interest rates; term loans at the cash rate; or currency intervention) appear to be more sceptically viewed by the RBA.
In considering these options, which had been adopted by overseas central banks, the Board concluded in the minutes, “full evaluation could not be undertaken as many of these measures were yet to be unwound”. Certainly the RBA would be aware of the risks of “unintended consequences” associated with unconventional policies.
The RBA has become more concerned about global risks. Their current forecasts, which do not factor in any global growth deterioration, are still consistent with the need to lower the cash rate by a further 50 basis points.
Should these global concerns materialise, the RBA would need to consider further monetary stimulus. That would likely take the form of a further cut in the cash rate complemented by some form of unconventional policy. On our reading of public comments from the Governor, this is likely to be a program of bond purchases. We still believe that term loan facilities would be more effective, although, at this stage, such policies do not appear to be at the top of the agenda.