The Reserve Bank Board will meet next week and it is determined that the policy will remain unchanged.
The three-year bond yield of 0.25% is set to remain in place “until progress is made towards the bank’s goal of full employment and the inflation target…. and it would not increase the cash rate target “until progress is made towards full employment and it is convinced that inflation will be sustainable within the 2-3% target band”.
These guidelines are decidedly inaccurate, giving the board a significant scope – for example, what does “progress” mean – it must be a reduction in unemployment at a faster pace than the bank’s current forecast that unemployment will fall from 10% in December 2020 to 8.5% by the end of 2021 and 7% by the end of 2022?
What is progress with inflation?
Is it a better performance than the current forecast that the trimmed average measure will increase from 1% in December 2020 to 1.25% in December 2021 and 1.5% in December 2022.
If it has moved from 1% in December 2020 to 1.5% in December 2022, it gives sufficient confidence that inflation “will be sustainable within the 2-3% target band”.
The answer to the last question is almost certainly “no”, as the bank is ready to buy three-year bonds at 0.25%, indicating the current expectation that the cash rate will remain at 0.25% at least until August 2023 .
But does “sure that inflation will be sustainable within the target band of 2-3%” mean that inflation must SETTLE within the band for a period, or does it only require the bank to see the need to be preventive, ie. inflation promises fast enough that the RBA is sure it WILL settle in the band.
The US Federal Reserve has a significant influence on the minds of other central banks.
Overnight President Powell gave an important speech to the symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming.
From my perspective, he made some key points:
- Policy decisions will be informed by “assessing the shortcomings in employment from its maximum level”, while the previous approach considered “deviations from its maximum level”. (ie a robust job market can be maintained without causing an inflation outbreak – the policy must be targeted at achieving full employment and must be patient when full employment is reached).
- Inflation policy will change – “after periods in which inflation has fallen below 2%, appropriate monetary policy is likely to aim to reach inflation moderately above 2% for some time”. (important to maintain 2% inflation expectations after a long period of less than 2%).
- “Monetary policy interest rates are likely to be limited by their effective lower limit than before.”
The main economic developments that President Powell identified as relevant to the policy approach are:
- A decrease in potential growth from 2.5% to 1.8%, reflecting lower population growth; aging population; and a slowdown in productivity growth.
- A fall in the neutral interest rate (this rate is in line with full employment and stable inflation).
- Extraordinary progress in lowering unemployment – before the US had a pandemic, two years of 50 years low in unemployment.
- Inflation did not respond to the low unemployment rate, which lowered estimates of full employment.
- Persistently low inflation lowered inflation expectations, which further lowered actual inflation – low inflation fed into lower interest rates, which limited policy opportunities to raise interest rates in good times, which limited the scope for lowering interest rates in times of economic downturn.
The President’s concern is that by reducing the opportunities to support the economy by lowering interest rates due to the effective lower tied downside risks to employment and rising inflation. To address these risks, the Fed is prepared to use the full range of tools to support the economy.
Implications for policy
The obvious interpretation of this policy is that the policy will remain expansionary for longer than under the previous approach, where the inflation target was more closely aligned with a certain 2%. Any further deterioration of the economy will be met with a more aggressive easing of policy.
There seems to be a rebalancing of priorities with the labor market cross-cutting inflation as the central policy objective. Being less proactive and pushing the economy harder will eventually allow for higher rates in a period of full employment, so greater flexibility can be allowed when the economy requires stimulus.
From my perspective, there are two complications to this revised approach.
The chairman noted that “before the current pandemic provoked the downturn, a number of historically long expansions had been more likely to end with episodes of economic instability.”
This “new” approach does not draw attention to the likely constraint of asset market policies, but focuses only on the experience of forty years ago, when enlargement ended in high inflation.
It is more than reasonable to expect that the political constraint for a continued aggressive stimulus will be asset markets rather than inflation.
A key to the new approach is to establish some interest rate flexibility above the zero limit. But he does not explain why politics could not go in negative directions where the ZLB restriction would no longer hold.
It is also somewhat disappointing that the President does not outline new policies that can help with his goals.
How can this affect RBA?
If we consider some of the most important observations on the US economy, which were specified by President Powell, there are certainly some similarities.
The RBA is facing a declining potential growth rate, partly due to low productivity growth.
Its results on the inflation target have been disappointing – inflation has not been in the 2-3% range for six years.
However, Australia has not been able to replicate the US performance in terms of the low point unemployment rate as the JRC was 4.8% compared to a 4% low before the JRC. We estimate that the RBA sees the full employment rate as 4.5%.
We have not been able to repeat the two-year period in the United States where 50-year unemployment failed to trigger inflationary pressures.
Nevertheless, as the US, we have very low inflation expectations measured by the indexed bond market.
I believe that the risk / reward diversion for negative interest rates is much more attractive to Australia than in the US due to its sensitivity to the currency of a small open economy with large foreign debt.
So is there any experience from the Fed’s political focal point for the prospect of Australian monetary policy?
The RBA has given itself maximum flexibility around the political outlook. Only the real liability has set the three-year bond yield at 0.25%, indicating a stable cash yield over the next three years.
By using the term “progress” around its unemployment target and not identifying the full employment rate, it provides maximum flexibility.
I agree with the Fed that it is unlikely that the reduction in inflation will be a factor in limiting the key objectives of policy – a return to full employment.
For Australia and probably also the United States, the constraint on an expanded aggressive policy stimulus will be the “economic instability” that President Powell so incredibly identified as being the reason for the constraint on recent “historically long expansions”.
The RBA is in a good room at the moment and is providing rather vague guidance regarding future policy.
Over the next three years, a need to provide additional stimulus will be much more likely to change than any need to tighten policy.
When the US comes up with the need to tighten, it is more likely to be due to asset market imbalances than inflation.