Why the RBA is delaying much-needed stimulus

In the AFR I write (twitter link here) that the Reserve Bank of Australia’s deputy governor Guy Debelle has delivered one of the most dovish speeches of his career, which conceded that Martin Place was not remotely close to meeting its full employment, inflation and/or prosperity objectives legislated under the Reserve Bank Act.

Debelle made it clear that current monetary policy settings were inadequate, and much more needed to be done to support a massive federal fiscal policy program that is helping Australia recover from what he described as “the largest peacetime economic contraction since the 1930s”.

The RBA is currently forecasting in its “central scenario” that the jobless rate will still be around seven per cent by December 2022, miles above its estimate of the fully-employed jobless rate a touch above four per cent. Inflation is likewise projected to remain below the RBA’s target band for the entirety of governor Phil Lowe’s seven-year term.

What makes these misses even more worrying for Martin Place is that the outlook has deteriorated. While most economists overlooked the RBA’s monetary policy easing at its September meeting (by providing banks with an extra $57 billion of cheap money to lend to businesses and households), Debelle stressed this decision was motivated by the fact that “the recovery to be more protracted than previously had appeared to be the case”. Rather than a v-shaped bounce, Debelle explained a “slow grind” was more likely.

The post-COVID-19 normalisation process has been undermined by the advent of significant second waves in Victoria, Europe, the UK, and the US amongst other headwinds, including the intensifying decoupling between China and the West.

With the RBA’s next meeting looming on October 6, Debelle excited the economics community with the observation following his speech that “the right decision is to err on too much support than too little support—and those considerations would probably need to be taken into account over the period ahead”. This accented the final line of Debelle’s speech, which concluded that the RBA “will continue to assess the merits of the range of monetary options to best support the economic recovery”. It would be hard for the central bank to more directly signal that further stimulus is coming.

If the policy of least regret is to "kitchen-sink" this one-in-100 year shock with the RBA’s full arsenal of weapons, including additional purchases of government and semi-government bonds to put downward pressure on the currency and reduce public sector borrowing costs at a time when the RBA is encouraging politicians to spend as much as possible, it seems logical to launch this easing as soon as practicable.

This led many economists, including the market-mover-in-chief Bill Evans, to bring forward their forecasts for the next tranche of RBA stimulus to the October board meeting, which is the same day Treasurer Josh Frydenberg releases his long-awaited post-COVID-19 budget. It had the makings of yet another “Team Australia” moment that has involved unprecedented coordination between Treasury, the RBA, APRA and ASIC.

Alas, it was not to be. Hours after Evans outlined his rationale for an October cut, which immediately reduced bond yields, the RBA’s media commentators crushed this prospect, communicating Martin Place’s preference for any move to be put back to at least November instead. First there was the man traders have come to call “Mini-McCrann”, The Australian Financial Review’s inimitable John Kehoe, who spiked October in favour of November at the earliest. Any doubt was eviscerated by the "shadow governor" himself, Terry McCrann, who a few hours later emerged from his monetary policy slumber to excoriate economists for daring to contemplate October. A hat trick was completed by the Financial Review’s Karen Maley, who markets think is close to the RBA, writing essentially the same thing the next morning.

One non-credible explanation for the delay was that the RBA needed time to absorb Frydenberg’s budget decisions. The Treasury Secretary sits on the RBA’s board, and coordinates closely with it. The budget is very rarely price sensitive, and as a government institution the RBA can confidentially access whatever information it wants about the budget days ahead of its release.

A more persuasive rationalisation was that the RBA wants to give Frydenberg time and space to sell his budget messages. Here there is a possible case that any positive announcement effects could be diluted by concurrent fiscal and monetary policy releases.

This column prefers an alternative insight, which is that the RBA does not want to launch an enormous government bond purchasing program on exactly the same day that Treasury announces massive budget deficits that require record bond issuance. Martin Place might be justifiably concerned that this will appear like it is funding those deficits, which would be tantamount to unadulterated debt monetisation aka Modern Monetary Theory (MMT). Lowe has certainly been eager to resist this perception in the past.

The more prudent course may therefore be to wait one month and create clear divisibility between the RBA’s bond buying and the government’s ballooning deficits, doing everything possible to protect the RBA’s hard-won political independence.

Former Prime Minister Paul Keating was fond of boasting that the RBA did his bidding. As treasurer he famously declared that he would never "abrogate responsibility for the stance of monetary policy from the elected government to unelected and unrepresentative public officials in the name of fighting inflation first". In the March of Patriots, Paul Kelly relays that the RBA governor at the time, Bernie Fraser, recalled, “I was very disappointed when I heard about ”. “It caused enormous problems…and made it harder to establish the Bank’s credibility,” Fraser said. “Paul said he would correct it publicly when he got the opportunity but it never really was withdrawn.”

Kelly discloses that in mid 1994 Prime Minister Keating summoned the RBA governor, Fraser, and the treasury secretary, Ted Evans, to his official residence. “Fraser’s recommendation was for a full 1 percentage point increase,” Kelly writes. “The Prime Minister wanted a concession. He argued that the increase was too much. In the end, they knocked 0.25 per cent off Fraser’s proposal…Former RBA governor Macfarlane said: ‘I was told they brokered it down to three-quarters of the point’…Keating got a concession.”

With this in mind, Keating’s demands during the week that the RBA fully fund federal and state government spending should not come as a surprise. The more interesting observation is that Lowe is partial to the idea of central banks funding productivity-enhancing fiscal spending during crises when the cash rate has hit its effective lower bound. This is crucially subject to the central bank retaining political independence. In this context, Lowe has cited a paper published by two former central bank bosses, Stanley Fischer and Philipp Hildebrand, which suggests this type of central bank-controlled MMT could work.

The RBA has also recently released new research that shows that bond buying programs can reduce unemployment and boost inflation. And as this column has demonstrated before, there is a case for the RBA reducing state governments’ borrowing costs, which are far higher than what BBB rated banks—and the federal government—are currently paying.

While markets might have to wait until November for a cash rate cut, it’s possible the RBA and APRA could still announce potent policy measures in October. It has been speculated by bank treasurers and Mini McCrann that APRA and the RBA will free-up the banks to buy hundreds of billions of dollars of government bonds to replace the riskier and more illiquid “self-securitised home loans” that currently back the $223 billion Committed Liquidity Facility (CLF).

The RBA grants banks access to CLF as an emergency line-of-credit that they can tap during crises. Although they are supposed to hold liquid assets against it as security to protect the RBA if they default on repaying a CLF loan, the historically small size of Australia’s government bond market forced regulators to allow banks to hold cheaper alternatives like internally-originated loans. The concern is that these loans are much less liquid than government bonds and have far higher default risks (including “wrong-way risk” given they are loans pledged by a failing bank).

A final shout-out goes to Treasurer Josh Frydenberg for his bold decision to get-rid of Australia’s crazy responsible lending laws. Their enactment in 2009 shifted legal liability for repaying a loan from the borrower to the lender, which resulted in banks becoming much more risk-averse for fear of being litigated by borrowers. This column has for years advocated their removal, which would free-up credit creation across the economy. Those worried about banks behaving badly can draw comfort from the fact that APRA’s separate responsible lending guidelines are much tougher, and far more prescriptive, than the poorly drafted responsible lending laws.

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