Lowe’s monetary policy revolution

In the AFR I write that in an important new speech on Thursday, RBA governor Phil Lowe confirmed that the central bank is grappling with the big macro questions that this column had researched in recent weeks: namely, when Australia secures herd immunity; when the borders will open back up to students and economic migrants; and what this means for the jobless rate, wages, and ultimately the RBA’s ability to hit its inflation goals.

For the avoidance of doubt, the RBA is not in conflict with the government over immigration nor is it seeking to whip-up a xenophobic debate about the impact of migrants on our collective welfare.

We are arguably the world’s most multi-cultural immigrant nation, and our prosperity has always relied heavily on population growth driven by attracting the best and brightest brains in the business, who power our ingenuity, productivity, earnings and wealth. One-in-three people living here were not born here, and every second Australia has a parent who migrated to this great land.

Lowe was simply echoing the analysis previously presented here, which showed that because of the COVID-19 catastrophe and the historical anomaly of closed borders, we have had vast numbers of foreign workers flee while not being able to onboard additional overseas talent to augment our human capital base.

He observed that if our borders remain closed forever, we will get artificially high wages growth as a result of shortages of workers, and if this is not remedied via open borders, the RBA might eventually have to respond by punishing everyone with higher interest rates.

We would demonstrably all be better off if Australia can grow more rapidly without triggering this wage-price spiral, and the higher interest rate burden that it could bring.

On this topic, Lowe also presented some astonishing new research showing that the jobless rate in an open economy really needs to decline to 3-point-something-per-cent before we get healthy wages growth.

The good news is that if the RBA sticks to its knitting and avoids relying on its uncertain forecasts, which are even more unreliable than normal because of the transition from closed to open borders, we should shortly have good visibility on when open borders will materialise.

Our research has shown that Australia should be able to fully vaccinate over 90 per cent of all adults, and more than 70 per cent of the total population, by early 2022. This will precede a federal election that will then pave the wave for open borders.

Coincidentally, the Commonwealth government struck a deal with the States after we outlined this analytical framework that almost exactly emulates it. All governments have agreed to adopt the Doherty Institute’s estimate of what proportion of the population will need to be vaccinated to obtain “herd immunity”. While we assumed that this number is around 70 per cent, the final figure might be a bit higher.

Every single chapter of the four phase plan the Federal and State governments have agreed seeks to facilitate the entry of students and economic visa holders. This is significant because its shows there is a bi-partisan consensus around minimising labour force bottle-necks and the spectre of interest rate hikes to combat an unnecessary wage-price spiral.

As well-informed pundits have noted, the RBA has given every indication that they are going to be extremely patient. Governor Lowe explicitly highlighted the impact the departure of hundreds of thousands of non-resident workers has temporarily had on reducing the jobless rate and boosting advertised vacancies, as we have canvassed here in recent weeks.

There is therefore a reasonable basis to believe that the RBA will not repeat historical mistakes, and start tightening monetary policy based on artificially sharp reductions in the unemployment or transitory increases in wages and inflation just as Australia is about to embrace a solution to these supply-side rigidities through open borders.

This patience was manifest in Lowe’s announcements regarding adjustments to the RBA’s monetary policy posture. In January 2021 we forecast a second, $100 billion RBA bond purchase, or quantitative easing (QE), program. The RBA announced this one week later.

In February, we projected a third, $100 billion QE program commencing in September this year. At the time, few if any analysts had QE3 in mind. In June we updated this expectation to an open-ended, $5 billion per week, QE3 program, which would be reviewed quarterly and sized at north of $120 billion. This adjustment was based on RBA signalling via media commentators.

On Tuesday the RBA delivered broadly as expected. It officially announced QE3, albeit in a slightly trimmed form at $4 billion per week with quarterly reviews tied to the publication of its updated economic projections.

While Lowe argued this week that the adjustment in the pace of weekly purchases reflected the economy’s strength, an alternative explanation posited by News Limited’s Terry McCrann was that it was driven by a sudden reduction in the Commonwealth’s budget deficits.

We’ve long maintained that both the Commonwealth and State budget deficits will be much skinnier than official claims, and this has proven out since late 2020. Last year the Commonwealth was issuing $2.5 billion of new government bonds every week. That run-rate has slumped to just $1 billion a week more recently.

Since the RBA is currently buying $4 billion of Commonwealth bonds each week, the dramatic reduction in new supply means that the RBA has de facto increased the potency of QE.

To be clear, the RBA is not trying to fund Commonwealth and State governments: there is huge local and global demand for these bonds. Yet in the same way that the RBA targets reducing business and household borrowing rates, and even more directly bank funding costs, to encourage us to borrow and spend more, it makes perfect sense for it to also seek to lower public sector borrowing costs, which is what our taxes pay for.

This encourages the Commonwealth and States to run more stimulatory fiscal policy, and to allocate more capital to crucial, productivity enhancing investments, such as much-needed infrastructure. In fact, Governor Lowe has overseen a revolution in the synergy between fiscal and monetary policy, which had historically been at odds with one another.

It’s not perfect: whereas the RBA directly lent $200 billion to our banks at a cost of just 0.1 per cent annually for 3-year funding, the much higher rated, and lower risk, State governments currently pay more than double that to raise 3-year money.

What Lowe explained during the week is that its QE program has become a conventional and mainstream part of its increasingly diverse and powerful counter-cyclical toolkit.

This is because it is socially and economically optimal for the RBA to channel stimulus through a wider range of interest rates than the historically narrow lever that is the overnight cash rate.

In the next recession, the RBA can use both overnight cash reductions and QE in concert to reduce both short and long-term interest rates. If by lowering long-term rates the RBA is able to make Australia’s exchange rate more competitive, it directly supports exporters and import-competing businesses.

This might mean it does not need to slash its cash rate as far as it has done in the past, which has sometimes had the nasty consequence of over-stimulating housing and creating financial stability concerns (given the preponderance of variable-debt in Australia).

Following the RBA’s news, banks have adjusted their estimates of the size of QE3, which is expected to be maintained until the RBA has very high confidence that it will meet its inflation target.

Previously in the “hard taper” camp, CBA upgraded its QE3 figure from $50 billion to a shade under $100 billion. Goldman Sachs and Citi have both increased their estimates to $130 billion and $140 billion, respectively. Our modal central case is now a touch above $140 billion.

One outstanding question is how much time should be expected to elapse between the end of QE3 and the first cash rate hike. In a perfect world one would want a smooth, and relatively short, transition between the high conviction that the RBA meets its inflation goals and absolute certainty. Any material gap between the two could reduce the RBA’s optionality.

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