RBA Preview: Nov 2021

The RBA is likely to make major changes to the operating framework for monetary policy at their 2 November meeting. Having allowed the yields on the previously targeted (April 2023 and April 2024) bonds to float following CPI, it seems obvious that the RBA will change their forward guidance and officially end yield-curve targeting. The RBA will no longer target the yield on any market instruments, and new forward guidance will tie rate hikes to ‘sustainable inflation’. The form of words will be something like those used by Gov Lowe in his Anika speech.

The new forecasts will probably have core (trimmed mean) inflation around, or just below, the middle of the target range at the end of 2023. In 2022, slow wages are likely to keep inflation down somewhat. Growth is likely to go up a bit too — reflecting faster vaccination and re-opening (a classic case of something being so bad that it’s good). The forecasts use market pricing as an input for the cash rate, so inflation that’s a bit below 2.5%yoy is consistent with lift-off some time in 2023.

Having sold off hard last week, my guess is that the market rallies a bit. The end of YCC is already in the price, and pricing for hikes is already pretty aggressive. I think the RBA will firm the ES rate up to the target rate at the end of 2022, with the first hikes in Q1’23.

End of YCC and rates on hold; some chance of QE-taper

The BIG decision has become obvious: the RBA will no longer target the yield on any bond.

The RBA allowed the yield on the April 2024 to float following Q3 CPI, and I don’t see the point in trying to get it back. I also doubt that they’d be able to do so. Any attempt to push it back down would invite short selling of the bond.

The RBA stopped defending the 10bps target on the April 24s last week

While in theory the RBA could shorten the target to another bond, I don’t think that’d be wise. It’d simply invite the same problem all over again. The peg has broken. It broke for the right reason. I think they just let it go. Good riddance to a problematic policy. The probability of a new, shorter, target is 10%.

I’m curious as to how they explain the decision to dump YCC post-CPI. It seemed unusual to drop the target between meetings. For example, I judged that CPI meant the end of YCC, but I didn’t think they’d step away the very next day! Perhaps some scenario-planning was done at the October meeting, as part of the discussion about Australian inflation against the backdrop of accelerating inflation in other jurisdictions.

The end of YCC was very likely caused by the necessity of changing the RBA’s forward guidance. The elevated core inflation print, and difficulty predicting inflation, meant that the RBA had to move to state-based forward guidance. Without a date, it made no sense to target the bonds.

Gov Lowe made a step toward state-based forward guidance in his 2021 Anika speech, where he said “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” before hiking. The early acceleration of trimmed mean CPI (2.1%yoy), and the still-low level of WPI (1.7%yoy), means that we’ll probably hear more about the necessity of faster wages to make in-target CPI sustainable.

The interest rate part of their policy suite is almost certain to remain unchanged. Their 10bps target for the cash rate, and the 0bps bid rate on Exchange Settlement balances, are some way from being challenged.

The separate identification of the ES-balance rate in the post meeting statement began in June this year. At that time, the Board was discussing the withdrawal of policy stimulus against the backdrop of an economy that kept beating forecasts. My guess is that they teased out the ES rate because they were talking about the exit sequence.

When it comes time to move interest rate policy, the first rate to change will be the rate on Exchange Settlement Balances. If the RBA wants to raise the target rate while their balance sheet is large, they’ll have to do something to soak up all of those excess reserves. Otherwise the interbank rate will be persistently below their target rate. The RBA auctioned term deposits in 2009 and took in the excess cash at a yield that was around the target cash rate. They can do much the same thing in a more flexible way by increasing the ES bid rate in line with the target cash rate. The first move is likely to be the ES bid rate going up to 10bps.

Given that they changed their risk-capital rules in their annual report (to prevent a big capital call) on the basis that they’d be holding their portfolio of bonds to maturity, it seems very likely that the RBA will start hiking with a very large balance sheet. This could mean that the RBA remains on a floor system (rather than the prior corridor system) for the interbank rate for some time. I expect the ES bid rate will be equal to the target rate for some time.

Finally, we can be pretty sure that the RBA will continue QE purchases of 4bn per week until February 2022. If there’s a surprise, it’ll be a reduction in the pace of weekly QE purchases. The decision to end YCC between meetings should encourage the market’s distrust of the RBA. Higher inflation and the earlier re-opening of the economy would allow the RBA to justify early tapering. Losses on current bond holdings may have them questioning the wisdom of the policy. In light of last week’s surprise on YCC, a surprise taper is a 20% chance.

Forecast upgrade on early re-opening

It’s much easier to sell tighter monetary policy because the economy is good. So while the higher Q3 core inflation print is the catalyst for the changes at the November meeting, an economic upgrade will also get some focus. It should be kept in mind that the RBA assumes market pricing for the cash rate when making these forecasts, so outcomes that are a bit below target would be consistent with some tightening (though less than the market has priced).

The higher-than-expected Q3’21 outcome for core inflation will boost 2022 inflation forecasts. Wages remain low, and the RBA had invested a lot into the low wages -> low inflation theme, so I don’t see them going for high inflation outcomes in 2022. Core inflation will be between 2% and 2.25% in 2022 (from 1.5% in Q2’22 and 1.75% in Q4’22). I expect that 2023 will be upgraded 25bps (from 2% in Q2’23 and 2.25% in Q4’23, to 2.25% and 2.5%). Core inflation outcomes that are in the 2.25% to 2.5% range for 2023 are consistent with tightening in 2023.

The wage price index was a bit below 3% in 2023 in the August SOMP, and will probably be a nudged up to be around, or a bit above, 3% in 2023.

The RBA’s forecasts of 4% growth in Q4’21 and 4.25%yoy growth in Q4’22 will likely be nudged up a little. The earlier re-opening, due to higher vaccination rates, gives the RBA a window to upgrade. Both liaison and the high-frequency labour market data suggest that things were turning up in NSW anticipation of the re-opening. Q4’21 and Q1’22 are likely to be very strong quarters nationally, as they’ll be supported by the re-opening tailwind.

There’s some chance that the unemployment rate gets revised down a touch — however this is the most uncertain point. Participation effects have lowered measured unemployment during the Delta-lockdown, and it’s unclear how things will evolve. If they touch them, it’ll be to knock 25bps off the unemployment rates: taking Q4’22 down to 4% and Q4’23 down to 3.75%.

Conclusion

The RBA’s decision to let the YCC bonds float post CPI means that much of the excitement has been taken out of this meeting. There’s some chance of a surprise QE-taper, but it’s modest (say ~20%).

The RBA is likely to upgrade both growth and inflation. The earlier than expected re-opening allows them to upgrade growth, and makes it easier to sell the tightening of monetary policy that was catalyzed by the high Q3 core inflation print. I don’t, however, think that the RBA will signal a hike in 2022. Nor will they guarantee that rates will be on hold; but their prior emphasis on wages means that it’ll be hard justify a move so quickly.

Current market pricing is consistent with a scenario where CPI goes to 2.5% and stays there, and the unemployment rate falls to 4% by the end of 2023. There’s a lot of good news in the price. In contrast, I think the RBA will firm up the inter-bank market in Nov’22, by raising the ES rate to the 10bps target rate, and deliver the first two hikes in Feb (+15bps to 25bps) and March 2023 (+25bps to 50bps).

Leave a Comment