With the RBA having frozen YCC, tapered QE, and set the pace of Bond purchases out to Feb 2022 it’s made all the major monetary policy decisions it’s going to make for 2021. However, there are developing themes that are crucial for gauging the policy outlook for 2022. In particular, you can see in the September decision, and subsequent events, the first signs of a pivot away from unconventional policy. Less QE means a greater emphasis on forward guidance, a longer period of low rates, and a steeper curve.
QE: looking toward the exit
The RBA got into regular QE (what is now called their Bond Purchase Program) as a shield. Other Central Banks were doing it, so foreign central bank balance sheets were growing more quickly than the RBA’s balance sheet. This divergence was putting (unwelcome) upward pressure on the Australian Dollar.
It is sometimes forgotten that the RBA’s balance sheet didn’t grow between April and September 2020. The YCC bond was around their 25bps target and banks had (predictably) delayed drawing the initial allocation of the TFF, so the balance sheet stalled around 280bn. Adding a regular QE program gave them control over the size and growth rate of their balance sheet – allowing them to keep up with foreign central banks and push down the Australian Dollar.
The framework for QE contained a three-part test:
1/ The economy (greater distance to targets = more QE);
2/ Market function; and
3/ What other central banks are doing.
I think the final point is the most important one: I doubt the RBA would have done regular QE if they weren’t losing the balance sheet race against other central banks.
Notwithstanding that the promise to buy at 4bn per week until February 2022 was characterised as as boost, it’s really tapering. The RBA stuck with their decision to taper despite a big domestic shock that increased the distance to their targets (or in their words, ‘delayed, but not derailed the recovery’). This suggests it’s the latter two parts of the QE framework – market function and what other central banks are doing – that are driving policy outcomes.
The minutes to RBA meetings show that what other central banks are doing has always been a topic of discussion at Board meetings. Contrasting the August minutes and September minutes, you can see greater confidence in their assessment that foreign central banks are in the process of reducing accommodation. In the monetary policy section, they say the Board “took account of the fact that a number of other central banks are tapering their bond purchases” when deciding to stick with the taper to 4bn per week in September.
So, the global taper is driving the Australian taper.
News since the RBA’s 7 September meeting will have emboldened them in this course. The Fed set up a QE taper later in Q4’21 in their September statement; and the ECB has strongly suggested a taper (at least that’s my reading of the review that will be held in Dec). The BoE and BoC have already started tweaking their QE policies (never mind that the BoE says it’s not a taper). By the time the RBA reviews QE in Feb’22, the Fed, ECB, BoE and BoC will all be in the process of tapering. The comparison with other central banks will help make the case for faster tapering.
The September meeting minutes also note that the RBA’s “bond purchase program is expanding faster relative to the stock of bonds outstanding than that of many other central banks”. I think this observation speaks to both the non-economic points (“Market Function” and “What other CBs are doing”). The pace of QE relative to issuance matters for market function; and they are buying a larger share of the market than other central banks. Both point to the RBA buying less.
The RBA’s footprint in the ACGB market is getting big – and is now a constraint on QE.
You can see this in how they added capacity after they boosted QE in September. The RBA offset the September decision by widening the QE-envelope to include a new bond. On Monday 13 September, the RBA purchased the Nov’28s in their short-BPP OMO (they previously purchased this bond in the long OMO basket on Thursdays); and on Thursday 16 September the RBA purchased the Nov’32 Bond for the first time ever (the longest bond they’d previously purchased in this OMO was the May’32). These changes show up as the spikes up of the blue line in the chart below.
The addition of the Nov’32 will add about 30bn of eligible stock to the program (once it’s tapped up to size). If the RBA targets ownership of 40%, this will add about 12bn of capacity to QE. This is very close to the incremental bond buying the RBA will do as a result the commitment to buy at 4bn per week until Feb’22.
Looking further forward, I think the RBA would like to buy less than the AOFM issues each week. To do that they’ll need to taper by 2bn per week, to 2bn per week of bond purchases, in February 2022.
The withdrawal of stimulus by other central banks and their focus on the pace of buying relative to the size of the ACGB market both suggest a faster taper.
I now think it is likely that the RBA tapers by 2bn in February, halving the pace of buying to 2bn per week. This would approximately align the pace of RBA buying with AOFM issuance (the AOFM currently issues 2bn per week, and the RBA would buy 1.6bn per week).
The Cash Rate: more emphasis on forward guidance
With the RBA looking to withdraw from QE the focus returns to their traditional monetary policy tools: the cash rate and forward guidance.
The case for a longer period of low rates is getting stronger, due to the damage caused by Delta-lockdowns and the slowdown in China (which is bigger than Evergrande, though made worse by current events). The likely imposition of debt-to-income ratio caps for lending, as flagged by Treasurer Frydenberg in comments on the most recent Council of Financial Regulators meeting, will also slow the return to targets. So, stronger forward guidance may be desirable to offset the ‘signaling effect’ from tapering QE.
The market naturally prices more risk premium into the short end as the RBA tapers QE — the RBA can, and should, try to contain it via forward guidance. That’s exactly what Gov Lowe did with (uncharacteristic) comments on market pricing in his 14 September Anika speech.
He started by reminding the market that the decision rule, and cost benefit calculus, had changed:
last year we moved to an approach under which actual inflation, rather than forecast inflation, plays the more central role in our cash rate decisions. In today’s low inflation world we do not want to run the risk that we increase the cash rate on the basis of a forecast that ultimately does not come to pass, leaving inflation stuck below the target band.Gov Lowe, Sep 2021, Delta, the Economy and Monetary Policy
The focus of policy is now on actual inflation with an emphasis on not getting ‘stuck below the target band’.
After reviewing the evidence of inertia in the Australian wage setting process, Gov Lowe commented that he found it “difficult to reconcile [market pricing] with the picture I just outlined and I find it difficult to understand why rate rises are being priced in next year or early 2023” (my emphasis).
As part of this Gov Lowe beefed up forward guidance. It seems like a small thing, but the emphasis on the middle of the target range was new and very important:
the Board has said that it will not increase the cash rate until actual inflation is sustainably within the 2–3 per cent target range. It won’t be enough for inflation to just sneak across the 2 per cent line for a quarter or two. We want to see inflation around the middle of the target range and have reasonable confidence that inflation will not fall below the 2–3 per cent band again. Our judgement is that this condition for a lift in the cash rate will not be met before 2024.Gov Lowe, Sep 2021, Delta, the Economy and Monetary Policy
This was the first time the RBA had been explicit that the lift-off condition is inflation near 2.5%yoy. Based on prior Bank communications I had been assuming that two quarters at 2.25%yoy would be sufficient. I think “sustainably within” means that trimmed mean inflation is the measure and that wage inflation (as measured by WPI) must be around, or above, 3%yoy.
Using actual trimmed mean inflation at 2.5%yoy pushes back my lift-off estimate by around a year. My guess is that we see the first hike in 2025.
A looming review of the RBA makes a hawkish surprise less likely
Following the OECD recommendation that the RBA be reviewed for persistently missing its inflation target, the ruling conservative party has said they are open to a review. So, a review is now bipartisan policy and very likely to occur. It should be noted that Lowe was reported to support a review in June 2020.
Given the catalyst for a review is the persistent inflation undershoot, this massively increases the cost of making another hawkish mistake – and so makes a hawkish surprise unlikely.
My hunch is that Gov Lowe knew of the OECD’s recommendation when he made his Anika speech. His decision to strengthen forward guidance and emphasise the middle of their target band (rather than his prior ‘two-point-something’) will be a useful shield if a review occurs.
The looming review makes it very unlikely that the RBA will lose their nerve and hike early – even if the unemployment rate is low and forecast inflation is rising toward the top of the target range.
Some have suggested a review may lower the inflation target. That seems unlikely. While I personally think that widening the RBA’s inflation target range to 1% to 3% would be a good idea — as it would align the RBA’s mid-point with global central banks and so help to stabilise the exchange rate — the debate was had, and lost, in 2019.
Gov Lowe didn’t like the idea: he used his 2019 Anika speech to kill the issue, saying that:
Lowering the target might have the short-run advantage of allowing us to say we have achieved our goal, but shifting the goalposts hardly seems a good way to build long-term credibility. Shifting the goal posts could also entrench a low inflation mindset.Gov Lowe, July 2019 Anika Speech, Inflation Targeting and Economic Welfare
He’s unlikely to have changed his mind. And I doubt Treasury would do anything that might bring forward rate hikes.
Recall from Gov Lowe’s 2021 Anika speech that a key objective of the new focus on actual inflation was to prevent early tightening leading to inflation getting “stuck below the target band”. Given that avoiding “getting stuck” is a key focus of current policy, change that might re-enforce a low inflation mind-set seems improbable.
The RBA already has trouble with a structural break lower of inflation around the time that Lowe took over. It may or may not be Gov Lowe’s fault, but it’d be a lot easier to manage a review if inflation was ~2.5%yoy.
Notwithstanding that the RBA has just boosted QE, you can see the outlines of a pivot away from unconventional monetary policy. The main reason the RBA got into QE was because other central banks were doing it. Now other central banks are tapering, so the RBA is following (despite the distance to their targets increasing). The RBA’s large and growing share of the ACGB market is also a concern and a constraint. The solution to this problem is to buy less than the AOFM issues.
Taken together, this makes a 2bn taper, to 2bn per week, the most likely decision when the RBA next reviews QE in February 2022.
The tapering of QE means the market will put greater emphasis on the cash rate — and forward guidance — in 2022. Gov Lowe has already started pivot toward forward guidance for the cash rate, using his Anika speech to directly push back on market pricing of hikes and emphasise that lift-off requires actual (not forecast) core inflation around 2.5%yoy.
The looming review of the RBA, for persistent undershooting of inflation, makes a hawkish mistake more costly for the institution. It follows that it also makes a hawkish surprise much less likely.