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Extraordinary events in the past month, as the COVID-19 pandemic has unfolded globally, are certain to push Australia into recession for the first time in 28 years. Australia’s production in the second and third quarters of this year will contract by several percentage points, the Herculean stabilisation efforts by the government and RBA notwithstanding. The RBA Shadow Board’s conviction that the cash rate should remain at the historically low rate of 0.25% equals 94%, while the confidence in a required rate cut to the lower bound of 0% equals 6% and the confidence in a required rate hike equals 0%.
Many standard economic indicators are not a good guide in a fast-moving crisis, as they are based on lagging data. So while the latest official ABS figures show a seasonally adjusted unemployment rate in Australia of 5.1%, this may well, according to recent estimates, double within a couple of months due to the COVID-19 crisis. The numbers remain highly uncertain and it is unclear to what extent the government’s Job Seeker program will help workers remain attached to their employers.
Global financial markets have displayed unprecedented levels of volatility, with stock markets in particular taking massive hits. The Aussie dollar was temporarily in free fall, until finding support just below 58 US¢. It is currently trading around 61 US¢. Yields on Australian 10-year government bonds have also gyrated wildly in the past month, falling to a historic low of 0.62%, then spiking to above 1.6%, before retreating again to under 0.80%. The slight inversion of the yield curve in short-term maturities (2-year versus 1-year) has virtually disappeared. In higher-term maturities the yield curve is displaying the normal convexity. Following the global lead, the Australian share market took a serious pummeling. The S&P/ASX 200 stock index dropped more than 35% from its historic high of 7,166 in late February and now trades around 5,150.
Clearly, the outlook for the global economy is entirely dominated by the coronavirus pandemic. The policy responses to control the epidemic are widely believed to lead to a global recession, although there is disagreement about how deep and enduring it will be. For example, FitchRatings expects world economic activity to decline by 1.9% in 2020, with US and Eurozone GDP contracting by 3.3% and 4.2%, respectively. Other analysts are even more pessimistic. The global recession may lead to several knock-on effects that are not yet fully appreciated, ranging from sovereign default by developing countries whose (dollar-denominated) borrowing costs are soaring, to the long echo from the disruptions caused to trade patterns and labor migration.
The government’s and RBA’s efforts to stem the economic downturn are unprecedented. The government’s most recent $130 billion wage subsidy package brings the commonwealth’s direct, on-budget spending to over $210 billion. The states alone have committed more than $12 billion in fiscal stimulus, and the RBA has, in addition to lowering the overnight rate to the historic low of 0.25% and engaging in quantitative easing to bring down yields on 3-year government bonds, announced a $90 billion three-year funding facility to help banks continue to lend to business. The scale of these programs and the swiftness with which they are being implemented makes it very difficult to forecast their likely effects with any degree of conviction.
Consumer and producer confidence measures, which were mostly weak prior to the onset of COVID-19, have not been updated and therefore do not reflect the current situation.
These are expected to drop significantly, along with a large fall in firms’ capacity utilisation rates and, with a lag, a drop in real estate prices.
Unsurprisingly, the probabilities associated with the Shadow Board’s recommendations have shifted dramatically. The Shadow Board now attaches a 94% probability that the overnight interest rate should remain at the historically low rate of 0.25%. (In the March round the Shadow Board still attached a 49% probability that the overnight interest rate should remain at 0.75%.) The Shadow Board attaches a 6% probability that a final rate cut, to the lower bound of 0%, is appropriate and a 0% probability that a rate rise, to 0.5% or higher, is appropriate.
The probabilities at longer horizons are as follows: 6 months out, the estimated probability that the cash rate should remain at 0.25% is still very high, at 88%. The probability attached to the appropriateness for an interest rate decrease equals 6%, while the probability attached to a required increase likewise equals 6%. One year out, the Shadow Board members’ confidence that the cash rate should be held steady equals 78%, ten percentage points less than for the 6-month outlook. The confidence in a required cash rate decrease still equals 6% and in a required cash rate increase 16%. None of the members recommends that the Reserve Bank experiment with negative interest rates. The range of the probability distributions over the 6 month and 12 month horizons has narrowed considerably, extending from 0% to 1%.
The cash rate should be kept at 0.25% for a long time. The Bank has complemented the recent emergency cash rate reduction with a target for the 3-year Australian Government bond yield, conveying the expectation that the cash rate may remain at 0.25% for the next 3 years. This is a decisive response in the right direction. As the magnitude of the economic consequences from the COVID-19 crisis becomes clearer, it will be important to re assess the RBA’s forward guidance and increase the precision about the duration of the zero interest rate policy.
The RBA has moved the policy rate to its stated effective lower bound of 0.25% and also engaged in yield curve control to bring the 3-year government bond rate to around 0.25%. This is a welcome development given the clear enormity of the global economic crisis caused by the COVID-19 outbreak and the various measures implemented to mitigate the pandemic. The RBA will not change the policy rate at the April meeting and I would not recommend it do so. The policy rate could, in principle, be lowered further. But the stimulative effects of a further decrease in the policy rate even closer to zero or possibly to a negative value would be small compared with the effects of more unconventional policies such as the yield curve control. The main task for the RBA Board now is to explicitly confirm that the choice of a 3-year bond rate for yield curve control signals a strong expectation of keeping the overnight policy rate at 0.25% for at least 3 years and to explain what would be the conditions under which the yield curve control would be lifted (presumably an indication that the economic contraction due the COVID-19 crisis is easing) and subsequently when the overnight rate would be lifted (again, I would strongly suggest tying this to being at least 3 years from now and when a set of long-term inflation expectations measures return to the middle or top end of the 2-3% target range).
We are now almost splitting hairs when it comes to changing the cash rate. If there is a need for firms to “hibernate” during this crisis then actual borrowing rates for affected entities need to be pushed towards zero or to zero, and the banks compensated in other ways.
The cash rate is now at its effective lower bound, and I support the RBA’s declared plans for its unconventional response to the severe macroeconomic effects of the developing COVID-19 crisis.
Updated: 26 September 2021/Responsible Officer: Crawford Engagement/Page Contact: CAMA admin
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