Experimental as anything

Australia’s monetary policy journey is moving into a second phase, but the jury is still out on the potential cost, writes AICD chief economist.

At its first meeting this year, the RBA said that it would exit from its bond-buying program with the final purchase taking place on 10 February. By then, it will have acquired around $350b of Australian government bonds (AGBs) — more than 40 per cent of all Australian government securities on issue — and its balance sheet will have more than tripled in size. February’s exit from quantitative easing (QE) also marked the end of one phase of the great Australian monetary policy experiment sparked by COVID-19 that began on 19 March 2020, when the RBA announced a “comprehensive economic package” that introduced several unconventional monetary policies (UMPs) to Australia for the first time.

That original package included a “conventional” 25bp (basis points) cut in the cash rate to 0.25 per cent, hot on the heels of a 25bp cut announced at the regular 3 March monetary policy meeting. But the conventional tool of the cash rate was later pushed into unconventional territory when the RBA cut it to the ultra-low rate of just 0.1 per cent on 3 November 2020.

The new UMPs, meanwhile, included yield curve control (YCC) with a target for the yield on the three-year government bond of around 0.25 per cent, later reduced to 0.1 per cent in line with the lower target for the cash rate; and a term funding facility (TFF) for the banking system, which initially offered access to three-year funding at a cost of 0.25 per cent. Again, this was lowered to 0.1 per cent in November 2020, in line with reductions in the cash rate and the YCC target. A third UMP was introduced at the same November meeting, in the shape of a $100b bond purchase program aimed at Australian government securities and semi-government (state and territory) bonds. In February 2021, the RBA extended this QE program to cover another $100b of purchases. This was extended again in September last year, although at that point the RBA “tapered” the rate of asset purchases from $5b to $4b per week.

Recovery mode

As the economy has recovered from the COVID-19 crisis, the RBA has successively retired these UMPs. First to go was the TFF, closed to new drawdowns at the end of June 2021. Next was YCC, with the RBA announcing on 2 November 2021 that it was discontinuing the target for the April 2024 Australian government bond. In February, QE was also ended. This leaves only the ultra-low cash rate — and financial markets are already anticipating a rapid “normalisation” of the policy rate. At the time of writing, the markets were predicting a minimum of three rate hikes this year.

However, the great COVID-19 monetary policy experiment is not over. While the RBA conceded in February that a cash rate increase in 2022 was now a “plausible” scenario, Governor Philip Lowe added it was also plausible that the first rate rise was still a year or more away.

Not only did that fly in the face of market pricing, it also seemed to jar with the facts that headline inflation had then been at or above the RBA’s target band for the past three quarters, while underlying inflation (the trimmed mean) had been in the band for the past two quarters. Moreover, even if the cash rate were to rise this year, the RBA reckoned that the pace of normalisation would be considerably more gradual than anticipated in market pricing at the start of February.

Patience and caution

The central bank’s immediate justification for caution on the likely path for interest rates is the high degree of uncertainty around the inflation outlook, with key unknowns including the duration of current disruptions to supply and the responsiveness of wages to an ever-tightening labour market.

Behind these quite reasonable considerations sits the possibility of what Lowe has described as an “historic milestone” — an unemployment rate sustainably below four per cent for the first time since the 1970s. That’s a particularly attractive prize for an economic policymaker. The new phase of the RBA’s pandemic-era monetary policy experiment, then, involves being patient and keeping the policy rate lower for longer in order to see if that glittering prize is attainable.

The risk is that lower for longer now could lead either to future rates having to be higher than they otherwise would be, or to a steeper adjustment path — or both. But Martin Place appears to view that risk as manageable enough to make the experiment worthwhile. The first phase of Australia’s great monetary policy experiment has helped to deliver a dramatically swift recovery from the pandemic, albeit at the cost of an inflated property market. It remains to be seen whether the second phase will prove as successful — and what the cost may be.