- Australia’s cash rate, at 1.5%, already sits at the lowest level on record.
- Financial markets believe it’s a certainty it will be reduced to 1% by November. There’s also a reasonable chance seen that it could fall to 0.75% in the second half of next year.
- With traditional monetary policy ammunition nearing exhaustion, speculation is growing that the RBA may have to adopt unconventional monetary policy measures in order to stimulate the economy.
- Capital Economics says the RBA will only consider such measures should the cash rate fall to at least 0.5%. It expects that if the bank does shift to unconventional policies, it will most likely introduce quantative easing (QE).
- Earlier this decade, RBA governor Philip Lowe said unconventional policies would become more viable when the cash rate fell to “somewhere around 1.0% or plus or minus a bit”.
Australia’s cash rate, at 1.5%, already sits at the lowest level on record.
Following continued weakness in inflation, a sharp slowdown in the Australian economy in the second half of last year and a recent increase in unemployment, the Reserve Bank of Australia (RBA) adopted an explicit easing bias earlier this week, signalling that the cash rate is likely to be reduced further in the months ahead.
Financial markets currently see a 90% chance that the RBA will cut Australia’s cash rate to 1.25% next month. A further follow-up cut, taking the policy rate to 1%, is also deemed to be a certainty by November. There’s also around a 50% chance being attached to another 25 basis point cut being delivered by the September quarter next year.
As things currently stand, a cash rate of just 0.75% is seen as line-ball call within the next 18 months.
But what if halving the cash rate from already record-low levels doesn’t succeed in helping to drive down unemployment, lift wage growth and GDP and return underlying inflation to the RBA’s 2-3% medium-term target?
The RBA has already slashed the cash rate by 575 basis points since the GFC and yet here we are, stuck in a scenario where the economy isn’t growing sufficiently to reach full employment and lift inflation.
In the absence of some fiscal assistance from the government, something the RBA continues to call for in order to help achieve those goals, it’s little wonder why speculation is mounting that the RBA may need to follow in the footsteps of other major central banks and adopt unconventional monetary policies such as quantitative easing (QE), negative interest rates or even more experimental measures.
Quantitative easing involves a central bank purchasing assets, usually government bonds, to help lower borrowing costs, spur lending and encourage investment by injecting more money into the economy.
The RBA doesn’t have much conventional monetary policy ammunition left, put simply. The 50 basis points of cuts now fully priced by November will reduce the cash rate by a third, rather than less than a tenth as what would have been the case before the GFC.
So at what point may the RBA need to consider rolling out unconventional monetary policy settings in order to support the economy?
According to Marcel Thieliant, senior Australia and New Zealand economist at Capital Economics, the cash rate will have to fall further than markets currently expect for the RBA to tread down this path, meaning the prospect of QE or similar being implemented in the near to medium-term isn’t all that high.
“The RBA has made it clear that quantitative easing is its preferred tool once interest rates reach the effective lower bound,” Thieliant wrote in a note released on Tuesday.
“We suspect that the Bank would first cut interest rates from their current level of 1.5% to 0.5% or lower before QE is launched.
“The key point is that interest rates would have to fall much further before the RBA would ponder the introduction of QE.”
Thieliant says there’s two reasons why the RBA in unlikely to initiate QE before traditional policy measures are exhausted.
“First, cutting the cash rate target would almost certainly have a bigger impact on bank lending rates. While fixed mortgage rates may fall a little if QE succeeds in lowering long-term bond yields, mortgages based on fixed interest rates account for only a fifth of all mortgages,” he wrote.
“In order to get banks to lower their more popular standard variable rates, a cut in the cash rate would be more effective.”
Secondly, Thieliant believes the impact of QE on the broader economy is more difficult to predict than the impact of a further reduction in interest rates, including the transmission mechanism to the Australian dollar.
“The yen and the euro both weakened when the Bank of Japan and European Central Bank launched QE and we suspect that the Australian dollar would do much the same. But the experience from the US and the UK suggests that this is far from guaranteed,” he wrote.
Thieliant also believes it’s more likely the RBA will introduce QE, rather than lowering the cash rate below 0% as seen in Japan and other major European central banks.
“We suspect that the RBA would first try QE before cutting interest rates into negative territory,” he wrote.
“In analysis [released by the RBA in 2016], it noted that the costs of negative rates would probably outweigh their benefits.”
While the options available to RBA are, of course, hypothetical at this point, coming before the bank has even reduced the cash rate further, several senior bank officials, including current governor Philip Lowe and deputy governor Guy Debelle, have openly discussed the use of unconventional policy measures in the past.
As deputy governor in 2012, Lowe said that “options of unconventional monetary policy become more viable” once interest rates are reduced to “somewhere around 1.0% or plus or minus a bit”.
Late last year, Debelle said that QE was “a policy option in Australia, should it be required”.
So QE, as it has been in other monetary jurisdictions previously, is a policy option should it be required.
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