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Address by Mr Philip Lowe, Governor of the Reserve Bank of Australia, at the Reserve Bank of Australia, Sydney, 21 April 2020. | Philip Lowe: An economic and financial update Address by Mr Philip Lowe, Governor of the Reserve Bank of Australia, at the Reserve Bank of Australia, Sydney, 21 April 2020. * * * Good afternoon and thank you for joining us today. When I spoke a few weeks ago, I talked about the importance of building a bridge to the recovery and helping as many people and businesses as possible get across that bridge. Over the past month, the scale of that national bridge-building task has grown in size – as our efforts to contain the virus have stepped up, that bridge has had to be bigger, longer and stronger. As a country, we have been up to this task. While we still face some difficult days ahead, Australians can take some reassurance from the fact that all arms of public policy are pulling in the same direction. We are all working to support the Australian economy through what is a very challenging period and to make sure we are well placed to recover. Today, I would like to provide some details about the economic outlook and an update on the implementation of the Reserve Bank’s recent policy package. The Economic Outlook Economic forecasting is difficult at the best of times. It is even harder at times like this when we are experiencing a once in a lifetime event. Given this, I don’t think it makes sense at the moment to focus on forecasts to the nearest decimal point, as we often do. Instead, I would like to focus on two broad issues: the immediate outlook for the economy the nature and speed of the recovery. The next few months are going to be difficult ones for the Australian economy. One very obvious consequence of the efforts needed to contain the virus is that many normal activities are restricted or not permitted. This means that, for as long as these restrictions are in place, we don’t have the jobs and incomes that come from these activities. On top of this, there is a high level of uncertainty about the future, which means that many households and businesses are holding back their spending and investment. The result of both the restrictions and the uncertainty is that over the first half of 2020 we are likely to experience the biggest contraction in national output and income that we have witnessed since the 1930s. Putting precise numbers on the magnitude of this contraction is difficult, but our current thinking is along the following lines: National output is likely to fall by around 10 per cent over the first half of 2020, with most of this decline taking place in the June quarter. Total hours worked in Australia are likely to decline by around 20 per cent over the first half of this year. The unemployment rate is likely to be around 10 per cent by June, although I am hopeful that it might be lower than this if businesses are able to retain their employees on lower hours. The unemployment rate would have been much higher than this without the 1/5 BIS central bankers' speeches government’s JobKeeper wage subsidy. These are all very large numbers and ones that were inconceivable just a few months ago. They speak to the immense challenge faced by our society to contain the virus. In terms of inflation, we are also expecting a significant decline in the June quarter. The large fall in oil prices, combined with the introduction of free childcare and the deferral or reduction in some price increases mean that it is quite likely that year-ended headline inflation will turn negative in June. If so, this would be the first time since the early 1960s that the price level has fallen over a full year. In underlying terms, however, inflation is expected to remain positive. As the economic data roll in over coming months, they will present a very sobering picture of the state of our economy. There will be many reports of record declines in economic activity. As Australians digest this economic news, I would ask that we keep in mind that this period will pass, and that a bridge has been built to get us to the other side. With the help of that bridge, we will recover and the economy will grow strongly again. That bridge has been partly built with the help of Australia’s strong balance sheets – in particular, the strong balance sheets of our governments, our private banks and of the Reserve Bank. Australia’s long record of responsible fiscal policy has allowed the government to use its balance sheet to help smooth out the income shock and to offer protection to those most affected. In doing so, it is making a major difference. The strong balance sheets of our banks are also helping. By offering payment deferrals and concessional terms, our banks are rightly acting as shock absorbers and helping the country through this difficult period. And as I will speak about in a few minutes, the Reserve Bank itself is using its balance sheet to keep funding costs low and credit available to both businesses and households. Without these strong balance sheets, we would have been in a more difficult position. I would now like to turn to the speed and nature of the recovery. We can be confident that our economy will bounce back and that we will see it recover. We need to remember that once the virus is satisfactorily contained, all those factors that have made Australia such a successful and prosperous country will still be there. Inevitably, the timing and pace of this recovery depend upon how long we need to restrict our economic activities, which in turn depends on how effectively we contain the virus. So it is difficult to be precise and it makes sense to think in terms of scenarios. Consistent with this, the Bank will discuss some possible scenarios in the Statement on Monetary Policy in a few weeks’ time. One plausible scenario is that the various restrictions begin to be progressively lessened as we get closer to the middle of the year, and are mostly removed by late in the year, except perhaps the restrictions on international travel. Under this scenario we could expect the economy to begin its bounce-back in the September quarter and for that bounce-back to strengthen from there. If this is how things play out, the economy could be expected to grow very strongly next year, with GDP growth of perhaps 6– 7 per cent, after a fall of around 6 per cent this year. There is though quite a lot of uncertainty around the numbers, with the exact profile of the recovery depending not only upon when the restrictions are lifted but also on the resolution of the uncertainty that people feel about the future. It is harder to make forecasts about the unemployment rate given the uncertainty about how many employees will remain attached to their firm and whether people who are stood down will be looking for employment and thus be counted as unemployed. But it is likely that the 2/5 BIS central bankers' speeches unemployment rate will remain above 6 per cent over the next couple of years. With many firms delaying or cancelling wage increases, year-ended wage growth is expected to decline to below 2 per cent, before gradually picking up again. In underlying terms, inflation is expected to remain below 2 per cent over the next couple of years. Of course, there are other scenarios as well. On the optimistic side, the restrictions could be lifted more quickly, with the virus being contained. In that case, a stronger recovery could be expected, particularly in light of the very large monetary and fiscal support that is in place. On the other hand, if the restrictions stay in place longer, or they have to be reimposed, the recovery will be delayed and interrupted. In that case, the loss of incomes and jobs would be even more pronounced. Whatever the timing of the recovery, when it does come, we should not be expecting that we will return quickly to business as usual. Rather, the twin health and economic emergencies that we are experiencing now will cast a shadow over our economy for some time to come. It is highly probable that the severe shocks we are now experiencing will change the mindsets of some people and businesses. Even after the restrictions are lifted, it is likely that some of the precautionary behaviour will persist. And in the months ahead, we are likely to lose some businesses, despite best efforts, and some of these businesses will not reopen. There will also be a higher level of debt and some households might revaluate the risks of having highly leveraged balance sheets. It is also probable that there will be structural changes in the economy. We are all learning to work, shop and travel differently. Some of these changes will probably stay with us, requiring a rethinking of business models. So the crisis will have reverberations through our economy for some time to come. The best way of dealing with these reverberations is to reinvigorate the country’s growth and productivity agenda. As we look forward to the recovery, there is an opportunity to build on the cooperative spirit that is now serving us so well to push forward with reforms that would move us out of the shadows cast by the crisis. A strong focus on making Australia a great place for businesses to expand, invest, innovate and hire people is the best way of extending the recovery into a new period of strong and sustainable growth and rising living standards for all Australians. The Reserve Bank’s Policy Response I would now like to change tack and turn to the Reserve Bank’s policy response. To recap, that response has had five elements: 1. a reduction in the cash rate to 25 basis points with forward guidance that the cash rate will not be increased until we are making sustainable progress towards our goals for full employment and inflation 2. the introduction of a target for the yield on 3-year Australian government bonds of 25 basis points, and a preparedness to buy government bonds in whatever quantities are needed to achieve that target 3. the introduction of a Term Funding Facility, under which authorised deposit-taking institutions (ADIs) have access to funding from the Reserve Bank for three years at 25 basis points, with additional funding available if ADIs increase lending to business, especially small and medium-sized businesses 4. using our daily open market operations to make sure that there is plenty of liquidity in the financial system and using our bond purchases to promote the smooth functioning of the market for government securities 5. modifying the interest rate corridor system so that balances held in Exchange Settlement Accounts at the Reserve Bank earn 10 basis points, rather than zero. 3/5 BIS central bankers' speeches This is a comprehensive package and is an important part of that national effort to build the bridge to the recovery that I spoke about earlier. It was designed to keep funding costs low across the economy and ensure credit is available to businesses and households. Following the announcement of the package, the yield on 3-year government bonds has declined and is now around the target level of 25 basis points, after having been around 50 basis points immediately prior to our announcement. Liquidity in the Australian government bond market has also improved substantially and this important market is working much better. Bid-ask spreads are still a little wider than they were a couple of months ago, but they have narrowed substantially recently. To date, the Reserve Bank has bought around $47 billion of government bonds. We have bought bonds along the yield curve and bonds issued by the Australian government and by the states and territories. We have done this through daily auctions in the secondary market. The initial daily purchases were quite large – $4 and $5 billion a day. In those first days we were keen to underline our commitment to the target and we were also seeking to relieve some of the very severe dislocation in the government bond market at the time. As conditions in the market have improved and the 3-year yield has settled around 25 basis points, we have scaled back our daily bond purchases – over recent days, the purchases have averaged around $750 million. We will scale up these purchases again if needed and we will buy bonds in whatever quantity is required to achieve our goals. With conditions more settled at the moment, our plan for the immediate future is to schedule any bond auctions we conduct for three days each week – Mondays, Wednesdays and Thursdays. That does not mean that we will necessarily purchase bonds on each of these days. Whether or not we do so will depend upon the yield on 3-year government bonds and on market functioning. It is likely, though, that for the foreseeable future we will be purchasing semi-government securities weekly. As is the case now, we will announce our intentions at 11.15 am. If conditions warrant it, we will return to daily bond purchases. I would like to restate that we are buying bonds in the secondary market and we are not buying bonds directly from the government. One of the underlying principles of Australia’s institutional arrangements is the separation of monetary and fiscal policy – that is, the central bank does not finance the government, instead the government finances itself in the market. This principle has served the country well and I am confident that the Australian federal, state and territory governments will continue to be able to finance themselves in the market, as they should. While we are not directly financing the government, our bond purchases are affecting the market price that the government pays to raise debt. Our policies are also affecting the price that the private sector pays to raise debt. In this way, our actions are affecting funding costs right across the economy as they should in the exceptional circumstances that we face. But our actions should not be confused with the Reserve Bank financing the government. Another element of the recent package was the Term Funding Facility. Around $3 billion of the initial allowance of $90 billion has already been drawn under this facility, with around 35 institutions participating so far. The knowledge that ADIs have access to this scheme over coming months has reduced any concerns there might have been about possible future liquidity strains. In doing so, this scheme has supported confidence that Australia’s ADIs will be able to access the liquidity needed to support their customers. It has also contributed to the low cost of borrowing new funds at fixed interest rates for businesses and households. The drawings under this facility, combined with the bond purchases and the Reserve Bank’s open market operations, have resulted in the balances held in Exchange Settlement Accounts increasing substantially. At the beginning of March these balance stood at around $2½ billion. Today, they stand at $83 billion. On the other side of the Reserve Bank’s balance sheet, there 4/5 BIS central bankers' speeches are increased holdings of government bonds, purchased both outright and under repurchase agreements in our daily open market operations. The very large increase in the balances in Exchange Settlement Accounts has affected the operation of the cash market. The number of transactions in this market has declined as fewer institutions need to borrow settlement balances each day. The cash rate has also drifted below 25 basis points and today is at 15 basis points. Both of these changes are consistent with experience in other countries and have not come as a surprise to us. The increase in liquidity in the financial system has also resulted in the spread between the bank bill swap rate (BBSW) and the overnight indexed swap rate (OIS) falling significantly. At the three-month horizon this spread is now around zero, which has further reduced funding costs for both the banking system and for the non-bank lenders. The increased liquidity in the system also means that the Bank’s daily open market operations are now on a smaller scale and we have adjusted the frequency of the longer-term operations. We will continue to adjust these operations as required to support the liquidity of the system. So that is where we are four weeks after the announcement of our policy package. This package, combined with the government’s fiscal policies and the work of the banks and many businesses, is building that strong bridge that I have spoken about. Our monetary response is keeping funding costs low across the economy and credit available. The fiscal response is providing significant support to both jobs and incomes. Businesses are also helping their employees by keeping them on where they can and the banks are supporting their customers with more flexible terms. Together, these efforts are helping the Australian economy through a difficult period and positioning us well for the recovery. Thank you very much for listening. I am here to answer your questions. 5/5 BIS central bankers' speeches | reserve bank of australia | 2,020 | 4 |
Opening statement (via videoconference) by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to the Senate Select Committee on COVID-19, 28 May 2020. | Philip Lowe: Opening statement to the Senate Select Committee on COVID-19 Opening statement (via videoconference) by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to the Senate Select Committee on COVID-19, 28 May 2020. * * * Good morning and thank you for the invitation to appear before this Committee. The past three months have been extraordinary ones in the life of our nation and there has been an unprecedented policy response. On the economic front, there has been very close coordination between monetary and fiscal policy, as there should be at times like this. As part of the RBA’s contribution to dealing with the pandemic, we announced a comprehensive package in mid March. The goal is to support the economy by keeping funding costs low and credit available, especially to small and mediumsized businesses. As banker to the Australian Government, the RBA has also processed the many billions of dollars in government assistance to households and businesses. We have also made sure that the payments system is working well and that banknote supply is maintained. And we have done this with around 90 per cent of our staff working from home. The evidence so far is that our mid-March package is working as expected and it is helping build the necessary bridge to the recovery. The shape and timing of that recovery depends not only on when restrictions are lifted, but also on the confidence that Australians have about their own health and their finances. With the national health outcomes better than earlier feared, it is possible that the economic downturn will not be severe as earlier thought. Much depends on how quickly confidence can be restored. But even as the recovery gets under way, there will still be a shadow cast by the pandemic. As a country, we will need to turn our minds as to how to move out of this shadow. A reform agenda that makes Australia a great place for businesses to expand, invest, innovate and hire people would certainly help. For its part, the RBA will maintain its expansionary settings until progress is being made towards full employment and we are confident that inflation will be sustainably within the 2–3 per cent target band. I look forward to answering your questions. The Governor was invited to make a brief opening statement to the Committee of no more than two minutes. 1/1 BIS central bankers' speeches | reserve bank of australia | 2,020 | 5 |
Keynote address by Ms Michele Bullock, Assistant Governor (Financial System) of the Reserve Bank of Australia, at the Morgan Stanley Disruption Evolved Webcast, Online, 3 June 2020. | Speech Panic, Pandemic and Payment Preferences Michele Bullock [ * ] Assistant Governor (Financial System) Keynote Address at the Morgan Stanley Disruption Evolved Webcast Online – 3 June 2020 Thank you to Morgan Stanley for the opportunity to speak this morning. We are living through quite extraordinary times. The COVID-19 pandemic is having dramatic effects on economies around the world, impacting employment, businesses and households. Monetary and fiscal policies have been heavily mobilised to help bridge the impact of the containment measures on economic activity. But the health crisis has also disrupted aspects of the retail payments system; payment patterns have seen large, sudden shifts as merchants and consumers have changed both their payment preferences and their mode of interaction. Payment service providers have tried to accommodate these shifts in preferences in a fast-changing environment. Today I want to address the potential implications of COVID-19 for the payments system. While we have until now been thinking about disruption to the payments system mostly in terms of the entry of new technologically enabled service providers, the abrupt changes in payment preferences induced by the health crisis could be a similarly disruptive force. The extent to which it is will depend on whether the changes in behaviour are temporary or permanent. Today I am going to discuss the potential payments policy implications if the changes we have seen during this period are a step change in payment preferences. I will start with some context on how the retail payments system has been evolving over recent years and the changes we have seen as a result of the COVID-19 crisis. I will then go on to discuss a number of policy issues arising from these changes. The way we pay has been changing … Over the past couple of decades, the way Australians make payments has followed a fairly consistent trend. The main feature of this trend has been the decline in ‘paper’ payment instruments and the rise of electronic payment instruments (Graph 1). Use of cheques has declined from around 50 per capita per year in the 1990s to around 2 per capita in 2019, as payments such as bills increasingly moved electronic. Use of cash for transactions has also been declining. The rise of cards, first credit cards and more recently debit cards, has been a consistent feature as well. Cards have increasingly been used in place of cheques for bill payments and cash at the point of sale. They were also an important enabler for online commerce, allowing payments to be made in a remote environment. Graph 1 In recent years, substantial innovation in the payments industry has furthered these trends and also widened payment options (Graph 2). The introduction of contactless payments has made it quicker and easier to make lower-value transactions by card, eating further into the traditional domain of cash transactions. The use of mobile devices like smartphones for payments has reinforced this trend – now you don't even have to pull out a card. Real-time person-to-person payments are now available using the New Payments Platform. Buy now, pay later payment options are now widely available for online and point-of-sale purchases. There has been plenty of discussion about the potential disruption to the payments space coming from ‘bigtechs’ – Amazon, Apple, Google, Facebook, Alipay and WeChat Pay. And then there are digital currencies – private sector or central bank issued. Although some of these newer methods of payment may not be extensively used, consumers are increasingly aware of them. Graph 2 But cash is still important. The increasing innovation in the payments system has resulted in substantial changes to the way we pay, yet there is still a significant minority of the population that continue to use cash for face-to-face payments. Our most recent consumer payments survey conducted late last year showed that there were still around 25 per cent of consumer payments undertaken using cash, accounting for around 10 per cent of the value of transactions (Graph 3). And while a third of survey respondents did not use cash for any payments, around 10 per cent used cash for all their payments. Cash users tended to be older or people on lower incomes. Graph 3 COVID-19 might be the ultimate disrupter Enter COVID-19. The anecdotal evidence suggests that there has been some behavioural change. It has come from fast-changing consumer and merchant payment preferences, changing purchasing behaviour and responses by payment service providers to facilitate change. Both merchants and consumers appear to have been keen to reduce their use of cash. Many merchants made it clear through signage that they preferred contactless card payment, even for low-value payments. Some even went as far as to indicate that they would not accept cash. Maybe partly in response to this, and their own concerns about hygiene, many people reduced their use of cash in stores. In addition, there was a significant shift to online shopping, where cash is simply not a payment option. As a result of these changes, ATM withdrawals in April were down 30 per cent from the month before and over 40 per cent lower than twelve months earlier. Payment providers have facilitated these moves. The transaction limit below which a PIN is not required for a contactless card payment was (temporarily) raised from $100 to $200 to further reduce the need to touch terminals. Banks promoted mobile payments, which, because of biometric identification, often do not require PINs even for large purchases. And banks also obtained dispensation to mail out debit cards to a large number of their customers that did not already have them. All of these changes are likely to result in permanent shifts in behaviour as some people maintain the new ways of doing things. People who have recently obtained a debit card for the first time now have the ability to use a card at the point of sale as well as make online purchases. The increased use of online shopping, either through necessity or preference during the ‘stay at home' period, seems likely to be a permanent shift. In response, many retailers have increased their online offerings and may even find that they can reduce their physical presence. There have been some calls for the ‘no PIN’ limit to be maintained at the current higher level, which would make point-of-sale card payments even easier. And mobile payments have probably received a permanent leg-up. There are a number of policy implications We have been thinking about the policy implications of the changing payments system for some time. Many of the issues were raised in our consultation document on the Review of Retail Payments Regulation (the Review). [1] I am going to focus on five issues here: the cost of electronic payments; technological lock-out; resilience of electronic payments; access to cash; and the future of cheques. Costs to merchants of electronic payments must be kept as low as possible The cost of payments for merchants is an issue that the Bank has been focused on since it was given responsibility for efficiency and competition in the payments system in 1998. From the early days of its work on interchange fees, the Bank has been concerned with the way in which competition between payment systems works. In particular, since merchants are reluctant to refuse any payment method that consumers present, for fear of losing a sale, they typically take as many as possible. If a sufficient number of their competitors take a payment method, it is very difficult for a merchant to refuse that payment mechanism. The result of this is that they have limited ability to resist increases in the cost of taking payments. And as costs of payments rise, they ultimately find themselves into the prices charged to consumers. While cash is not costless for merchants to accept, it does provide some competitive pressure on the cost of payments more broadly. So as cash use declines, it is even more important than ever that we ensure competitive pressure remains on the costs of electronic payments to merchants. There are a couple of ways in which this competitive pressure can manifest. The first is the use of surcharging. Merchants may not feel that they can refuse to accept a particular payment method. But they may be prepared to signal to customers that it is costly to them by imposing a surcharge for its use. They may not even need to surcharge – in some cases simply the threat of surcharging may be enough to negotiate a lower fee with the payment provider. Second, and particularly relevant for card payments, is least-cost routing. Least-cost routing puts some power into the hands of merchants by providing them the ability to route a dual-network debit card transaction through the network that costs them the least to accept. In Australia, for many merchants, this is the eftpos network (Graph 4). The evidence is that the growing availability of least-cost routing has increased competition among card schemes through reductions in interchange fees, and this has resulted in a lower cost of acceptance for card payments for some merchants. Graph 4 But while least-cost routing has been available for a couple of years, it has not been widely promoted by the major banks which account for most of the acquiring market in Australia. So with many customers switching to contactless in response to COVID-19, some merchants are finding their payment costs rise as debit card payments are automatically routed through the international schemes. It is therefore important that merchants be given the option of least-cost routing. So far, the Bank has not mandated that acquirers explicitly offer least-cost routing to all their merchants. But it remains an option that will be considered in the Review. In the meantime, we are talking with merchants to understand their experience with payment costs through this period. We will also be considering how transparency of the cost of the payment plans offered to merchants could be improved. Ultimately though, if market forces are not generating competition to lower the cost of debit card payments, we may need to consider lowering the benchmarks that serve as a cap on average interchange fees. We need to be on guard against technological lock-out Least-cost routing works because the physical cards being presented at the point-of-sale terminal are provisioned with two networks – so-called dual-network debit cards. But what if there is no physical card, as is the case with mobile payments? How do we encourage provisioning of dual networks in these circumstances and encourage the mobile and terminal technology to enable merchant choice of routing. There are already some disputes in this area. Some banks have been choosing to provision only one debit system, so the option to route is being limited. And there are further disputes in the wings on schemedependent tokenisation of ‘card on file’ transactions and the problems this might create for least-cost routing. As highlighted in our consultation document, this is a challenging area. But ultimately, if banks or other stakeholders are acting in ways that prevent downward pressure on merchant fees, we may need to consider regulatory options for keeping the cost of electronic payments low. With people carrying less cash, resilience is paramount So far during the COVID-19 period, the electronic payment system has had very few severe outages (despite the need for providers to quickly adopt different working arrangements). This is a welcome outcome. Given the reduced use of cash during this period, it could have been even more difficult for merchants were there to be disruptions to the electronic payment system. And in the circumstances a loss of access to funds could have caused harm to customers and dented confidence within the community. But this episode does highlight something we have been concerned about for some time – the importance of the resilience of the retail payments system. There are effectively two parts to this – the resilience of the shared infrastructure such as the payment card message and switching infrastructure, and the resilience of financial institutions' own systems. While there have occasionally been system infrastructure outages, most of the outages over the past few years have been in banks' systems. Sometimes it has been their account systems affecting the ability of customers to make payments. Sometimes it has been their merchant-facing systems so that merchants were unable to take payments. In these cases, often the only fall-back at the point of sale is cash. Prior to COVID-19, there was already a sizeable proportion of people who tended to have little or no cash in their wallets. So when disruptions did happen there were stories of people leaving goods at the counter and merchants effectively having to close until the systems were restored. Post-COVID-19, disruptions to electronic payment services are likely to have a bigger impact. With some merchants discouraging use of cash, we can expect fewer people to be carrying cash than before. The Bank has already been working with the industry and APRA to develop a set of standard operational performance statistics to be disclosed by individual institutions. The proposed disclosures are intended to focus the minds of banks' executives and directors and ensure that appropriate attention is paid to the reliability of their retail payment services. They will also provide customers with transparency about the operational performance of different institutions. While this work is being delayed a bit by the competing operational priorities created by the current circumstances, it has become even more important. The work to enhance the reliability of retail payments services provided by individual institutions must also be complemented by efforts to identify and mitigate risks of reliance on supporting infrastructure that can be ‘single points of failure’, such as the telecommunications and energy sectors. While disruptions to these types of infrastructures have been more isolated than those at individual institutions over the past few years, they can have a major impact if they occur. As part of its strategic agenda, the Australian Payments Council is developing a framework for assessing and responding to system-wide risks. What does decreased demand for cash mean for the ATM system? Withdrawals of cash from ATMs have declined sharply over the past couple of months (Graph 5). ATM withdrawals have been on a trend downward decline for a number of years. But the decline seen in March and April was a substantial downward shift in the level of withdrawals. This no doubt reflects both a decrease in spending overall as people stayed home as well as a shift to other payment mechanisms – contactless cards and online shopping in particular. It seems likely that a large part of this will become a permanent change in behaviour. Graph 5 With cash withdrawals declining, there will be further pressure to consolidate ATM networks. The industry had been already considering this issue over the past couple of years but the changes induced by COVID-19 will make this more urgent. I expect that there will be action on this issue more quickly now. But there are still some people that prefer to use cash, so consolidation of the ATM network will need to be managed in such a way that it does not disadvantage certain parts of the population that still rely heavily on cash. Is this suggesting the end of the cheque system? I think it may well be. Use of cheques has been on a steep decline for the past 20 years, both in terms of number of cheques written and the value (Graph 6). In April, the value of cheque payments was more than 40 per cent lower than twelve months earlier, compared with annual rates of decline of around 20 per cent in previous months. And the level of cheque usage has now fallen to such low levels that there is an active discussion about the future of the system. Cheques have always been a costly payment instrument – estimates from our latest cost study in 2014 suggested that cheques were around six times more costly than card payments in terms of resource costs per transaction. With the continuing decline in the number of cheques being processed, the fixed costs of maintaining the system are becoming a more significant issue. Graph 6 One option that is actively being considered by the industry is closure of the cheque system. With electronic conveyancing increasingly the norm, a major use of financial institution cheques is being phased out. And for bill payments, where cheques are still sometimes used, there are many alternatives. But there has been a concern that there are some people for which there is no suitable alternative to payment using a cheque. They may not have reliable access to the internet to undertake online banking, for example, or may not have a debit or credit card. The changes associated with COVID-19 provide an opportunity to reassess this. With social distancing affecting some branch services and the ability of people to get to branches, there has been a push by the banks to get people signed up to internet banking. Payment options such as BPAY and NPP will therefore be available to a wider range of people. As noted earlier, the banks have mailed out debit cards to customers, typically passbook holders who did not have them, providing the option of online and in-person payments by card. It seems likely that these changes, which have happened much more quickly than they might have otherwise, will further reduce the use of cheques and demonstrate to people that there are alternative and more efficient ways of making payments. This may bring the efficiency implications of maintaining the cheque system into even sharper focus. Conclusion The changes in payment preferences associated with the COVID-19 health crisis have given fresh prominence to a number of policy issues in the payments system. Some of the sharp and sudden shift to contactless and mobile payments, and away from cash is likely to be permanent. It is therefore even more important that the costs of electronic payments are kept low and the electronic payments system is resilient. While it will be important to ensure that people who have traditionally used cash and cheques are adequately catered for, the experience of the past few months has demonstrated that the shift to electronic is perhaps not as difficult as many had thought. Endnotes [*] Thanks to Faye Wang for assistance with this speech. See RBA (2019), ‘Review of Retail Payments Regulation – Issues Paper’, November. Available at <https://www.rba.gov.au/payments-and-infrastructure/review-of-retail-payments-regulation/>. See Australian Payments Council (2019), ‘Payments in a Global, Digital World – The Australian Payments Council Strategic Agenda’. © Reserve Bank of Australia, 2001–2020. All rights reserved. The Reserve Bank of Australia acknowledges the Aboriginal and Torres Strait Islander Peoples of Australia as the Traditional Custodians of this land, and recognises their continuing connection to Country. We pay our respects to their Elders, past, present and emerging. | reserve bank of australia | 2,020 | 6 |
Remarks by Mr Guy Debelle, Deputy Governor of the Reserve Bank of Australia, to The Economic Society Australia, online, 30 June 2020. | 30/06/2020 The Reserve Bank's Policy Actions and Balance Sheet | Speeches | RBA Speech The Reserve Bank's Policy Actions and Balance Sheet Guy Debelle [ * ] Deputy Governor The Economic Society Australia Online – 30 June 2020 Australia is experiencing an historic event. It is first and foremost a health event. Thankfully, thus far the health outcomes in Australia have been better than feared. The health decisions taken by the government and the public in response to the virus have been the primary shaper of the economic and financial landscape that the Reserve Bank has been operating in. The virus has had a large economic and financial impact. The decline in output in the second quarter in Australia and around the world has been extraordinary, as significant parts of the economy were shut down. The decline in output is much larger and much more widespread globally than we saw in 2008. Accompanying this, there has been a large decline in hours worked. Unemployment has risen sharply, although the extent of the rise in the unemployment rates has varied around the world depending on the nature of the support provided by governments (as well as some definitional differences). In Australia, the rate of unemployment is high at 7 per cent, but has been materially contained by the JobKeeper package that has helped to maintain the employment relationship between workers and businesses. This will help considerably in the recovery. Overlaid on top of the health and economic developments was a full-scale financial market disruption in March. Again this was global in nature, most notably including the dislocation to the US Treasury market, which serves as a critical pricing benchmark for global financial markets. There was an imperative to prevent a financial crisis exacerbating the significant impact of the health and economic shocks. In that environment, policy actions were taken in Australia on multiple fronts including fiscal, monetary and prudential. Reflecting these policy actions and the health outcomes, the Australian economy has turned out to be somewhat better in the June quarter than feared. While the outcomes rba4-local.rba.gov.au/speeches/2020/sp-dg-2020-06-30.html 1/18 30/06/2020 The Reserve Bank's Policy Actions and Balance Sheet | Speeches | RBA to date have been better than expected, it is important to remember that the declines in GDP and in hours worked have still been historically large. The objective of the monetary policy response is to support the economy by keeping borrowing costs low and credit available for households and businesses, complementing the necessary and large fiscal policy stimulus. It has also sought to address the disruption in financial markets, particularly in the government bond market, given the central role that the market plays in underpinning the interest rate structure in the Australian financial system. The response had a number of elements. 1. A reduction in the cash rate target to 25 basis points. This is the level the Reserve Bank Board has assessed to be the lower bound for the target cash rate in the current circumstance. In saying that, we fully expected the actual cash rate to move below 25 basis points, as it subsequently has. I will explain this shortly. 2. A target for the yield on three-year Australian Government bonds of around 25 basis points. The Reserve Bank commenced a program of buying government bonds to achieve that target and also to address the dysfunction in the market for both Australian Government bonds and the bonds of the state governments (semis). 3. The Reserve Bank's daily market operations were expanded in size and in maturity in response to the large increase in demand for liquidity from the banking system. 4. A Term Funding Facility (TFF) for the banking system to provide three-year funding at a rate of 25 basis points. This was complemented by the Australian Office of Financial Management's (AOFM's) program to support non-bank lenders. 5. Setting the rate paid on Exchange Settlement (ES) balances at the RBA at 10 basis points. In the rest of this talk, I will explain these policies in more detail and provide an assessment of their effectiveness thus far. These policies have also had a material impact on the size and the composition of the Reserve Bank's balance sheet, which I will describe (Graph 1). [1] I will also explain the other main influence on the size of the RBA's balance sheet, which results from the fact that the RBA is the banker for the Australian Government. rba4-local.rba.gov.au/speeches/2020/sp-dg-2020-06-30.html 2/18 30/06/2020 The Reserve Bank's Policy Actions and Balance Sheet | Speeches | RBA Graph 1 Reduction in the Cash Rate Target to 25 Basis Points The reduction in the cash rate target to 25 basis points is standard monetary policy. It has affected the interest rate structure of the economy in a similar way to other earlier reductions in the cash rate target. target actual However, while the cash rate has remained at 25 basis points, the cash rate traded in the market has declined to around 13–14 basis points currently. [2] This decline in the cash rate was expected and is consistent with the aim of reducing funding costs in the Australian economy. It reflects the large amount of ES balances in the system. I will come to the reasons why ES balances are high shortly. But with high ES balances in the cash market, the supply of these balances is large relative to demand. Hence, as in any market, with supply greater than demand, the price to clear that market, the cash rate, has declined. The cash rate is higher than the rate of return on ES balances of 10 basis points. Banks are incentivised to lend their excess ES balances held at the RBA but the transaction costs and greater rba4-local.rba.gov.au/speeches/2020/sp-dg-2020-06-30.html 3/18 30/06/2020 The Reserve Bank's Policy Actions and Balance Sheet | Speeches | RBA credit risk involved mean that they are generally willing to do so only if they can earn a return a few basis points more than they get from leaving their balances on deposit at the RBA at 10 basis points. The transaction volumes in the cash market have declined (Graph 2), reflecting the fact that on any given day most banks have enough ES balances to meet their liquidity needs. But depending on the distribution of payment flows throughout the day, even with large ES balances, some banks may still need to borrow at the end of the trading day to ensure their ES balances remain positive. [4] It is worth remembering that the banking system as a whole has to hold the level of ES balances supplied by the Reserve Bank. So while any individual bank may try to lend their excess ES balances, at the end of the day, some bank in the system has to hold them. Graph 2 The higher level of ES balances in the system has not only meant that the cash rate trades closer to the rate the Reserve Bank pays on these balances, but also anchors other money market rates such as short-term repos (repurchase agreements), foreign exchange (FX) swaps and bank bills. With these money market rates anchored, the full spectrum of borrowing rates for households, business and governments is also at historically low levels. I will come back to this later. It is worth noting that once the supply of ES balances is sufficiently high to lower these rates towards the rate on ES balances, the exact amount of ES balances has little effect on where the cash rate and other money market rates trade. That is, additional ES balances do not tend to lower market rates any further. Nor does a reduction increase market rates as long as ES balances remain rba4-local.rba.gov.au/speeches/2020/sp-dg-2020-06-30.html 4/18 30/06/2020 The Reserve Bank's Policy Actions and Balance Sheet | Speeches | RBA sufficiently high. Since late March, ES balances have moved in a very wide range between $40 billion and $90 billion without having a noticeable effect on money market rates. The market expectation is that the cash rate will remain around its current level of 13–14 basis points for at least the next year (Graph 3). This is consistent with the Board's guidance that the cash rate target will not be raised until progress is being made towards full employment and it is confident that inflation will be sustainably within the 2–3 per cent target band. Given the outlook for inflation and the labour market, this is likely to be some years away. Graph 3 Target for the Three-year Australian Government Bond Yield The Board has announced a target for the three-year Australian Government bond yield of around 25 basis points. As I just said, given the outlook for unemployment and inflation, the Board expects that the cash rate will remain at its current low level for some years. The target for the three-year bond rate reinforces the forward guidance on the cash rate. At the same time, the Reserve Bank also stands ready to purchase Australian Government bonds to address market dysfunction. In March, bond markets around the world were very dysfunctional. This included the market for US Treasuries, which sits at the core of the global financial system. US Treasuries are a critical benchmark for pricing in global financial markets. rba4-local.rba.gov.au/speeches/2020/sp-dg-2020-06-30.html 5/18 30/06/2020 The Reserve Bank's Policy Actions and Balance Sheet | Speeches | RBA Similar dynamics that contributed to the dysfunction in the US Treasury market occurred in the Australian Government bond market and other advanced economy bond markets: A desperate scramble for cash: portfolio managers and other investors sought to increase the amount of cash in their portfolios, in part to meet redemption requests and margin calls and in part reflecting asset reallocation by their investors. The portfolio managers achieved this by selling the most liquid part of their portfolios, which was often fixed income and particularly government bonds. Rebalancing: as equity prices declined but the value of bonds rose sharply (bond yields declined), asset managers rebalanced their portfolios by selling bonds and buying equities. Leveraged trade unwinds: Leveraged traders in the government bond market had positions exploiting small pricing ‘discrepancies’, such as the difference between bond futures and the underlying bonds they reference as well as between these reference or ‘on-the-run’ bonds and the ‘off-the-run’ bonds. [8] Because these discrepancies are generally very small, leverage is required to make the trades worthwhile. As interest rate volatility increased, these traders were required to unwind these positions, generating further selling pressure and even higher interest rate volatility. Foreign exchange intervention: a number of emerging economy central banks intervened in their foreign exchange markets to support their exchange rates as they depreciated. This involved selling US Treasuries and other bonds in their foreign reserves portfolios, including Australian Government bonds. The effect of these sales are evident in the TIC data in the US and in Australia's balance of payments statistics for the March quarter, which showed a marked decline in the foreign holdings of Australian Government bonds (Graph 4). rba4-local.rba.gov.au/speeches/2020/sp-dg-2020-06-30.html 6/18 30/06/2020 The Reserve Bank's Policy Actions and Balance Sheet | Speeches | RBA Graph 4 Dealer balance sheet constraints: investors sell their bonds to the dealers who act as the main intermediaries in the bond market. In the face of the large selling pressure, dealers were constrained in their ability to absorb these flows by the changed regulatory environment over the past decade as well as their own internally imposed risk limits. Whilst this should not have been that surprising, it nevertheless increased the degree of price volatility and dysfunction in the market. The dysfunction was evident in the heightened interest rate volatility in the bond market, reflecting the reduced liquidity even in the US Treasury market, which is generally regarded as being amongst the most liquid of all markets. It was also evident in a widening in bid/ask spreads (Graph 5), that is, the difference between the prices at which a dealer is willing to buy and sell a bond. At times, the dysfunction was such that government bond prices fell (yields rose) at the same time as equity prices were also falling, when normally the opposite is the case, reflecting the important role that government bonds play as a hedge. rba4-local.rba.gov.au/speeches/2020/sp-dg-2020-06-30.html 7/18 30/06/2020 The Reserve Bank's Policy Actions and Balance Sheet | Speeches | RBA Graph 5 As was the case with many other central banks, the Reserve Bank bought government bonds in the secondary market to try to alleviate the dysfunction in the Australian government bond market. These purchases helped to restore the functionality to this important pricing benchmark in the Australian financial system, which serves as the risk-free pricing curve for most financial assets. Clearly, an effectively functioning bond market is also necessary to allow governments to issue bonds to finance the fiscal stimulus. The Reserve Bank bought bonds at or near the three-year horizon to achieve the three-year yield target but also along the yield curve to help achieve the target and address the market dysfunction. Graph 6 shows the bonds the RBA has purchased by maturity. To date, we have purchased just over $40 billion in Australian Government bonds. The graph shows that a sizeable share of the purchases were in off-the-run bonds out to the 10-year bond. These purchases significantly reduced the constraints on dealer balance sheets, which facilitated a faster return to a more functional bond market. rba4-local.rba.gov.au/speeches/2020/sp-dg-2020-06-30.html 8/18 30/06/2020 The Reserve Bank's Policy Actions and Balance Sheet | Speeches | RBA Graph 6 The RBA chose not to buy bonds beyond the 10-year maturity, nor indexed bonds. These bonds play a less important role as a pricing benchmark in the economy. Very few other financial instruments price off them. Our assessment was that bond purchases could be more effectively directed to restoring functionality in the parts of the yield curve that are typically quite liquid. This would see functionality return to these other parts of the market over time. Indeed, that has turned out to be the case. The RBA's purchases in the second half of March and into April helped to improve the functionality in the broader bond market and achieved the Board's target for the three-year bond yield of around 25 basis points (Graph 7). The improved functionality of the market has occurred alongside very sizeable issuance by the AOFM, which has been met with very strong demand. rba4-local.rba.gov.au/speeches/2020/sp-dg-2020-06-30.html 9/18 30/06/2020 The Reserve Bank's Policy Actions and Balance Sheet | Speeches | RBA Graph 7 The three-year bond yield has been consistent with the Board's target and the government bond market has been functioning effectively for a number of weeks now. If the three-year bond yield target is credible to the market, then the Reserve Bank does not need to purchase many bonds at all to achieve the target. Indeed, that has been the case over the past month or so and the RBA has not needed to buy any bonds since early May. Nevertheless, the RBA stands ready to scale up its purchases if necessary to achieve these objectives. The Reserve Bank has also purchased state government bonds (semis) to improve the functioning in that market. The state governments also require a functioning bond market to be able to finance their fiscal stimulus. Again these purchases were conducted in the secondary market. To date, these purchases have totalled $11 billion and the amount of bonds bought from each state has been broadly proportional to their size. Conditions in the semis market have also returned to their preCOVID state and the state borrowing authorities have also been able to issue sizeable amounts of bonds in a short period of time. With the cash rate around 13–14 basis points and the target for the three-year Australian Government bond yield around 25 basis points, one would expect yields on bonds with maturities between the overnight cash rate and three years to be no more than around 25 basis points. However, those bonds with maturities shorter than the three-year futures basket are off-the-run and tend to be less in demand. They can trade at a higher yield than bonds included in the futures basket, reflecting their lower liquidity. We would not expect the illiquidity premium to be very high. If these yields were to be noticeably above the three-year target, this would be inconsistent with a rba4-local.rba.gov.au/speeches/2020/sp-dg-2020-06-30.html 10/18 30/06/2020 The Reserve Bank's Policy Actions and Balance Sheet | Speeches | RBA gradually upward sloping yield curve between cash and three-year yields. It would also be inconsistent with the policy objective of lowering borrowing costs. Hence the Reserve Bank is prepared to buy these bonds should their yields rise too high for a sustained period. The Reserve Bank is also continuing its long-run practice of buying Australian Government bonds that are very close to maturity (less than 18 months) for liquidity management purposes. An individual bond line can often have between $20 billion and $30 billion on issue. When a bond matures, there is a large increase in liquidity in the system as the Government repays the bondholders. We have been buying these near-to-maturity bonds for many years to reduce the impact on system liquidity when they mature. Currently, there is less need for tight liquidity management as overall system liquidity is so much higher. [11] But it is still desirable to avoid the large increases in ES balances that occur when a bond matures, so we have continued these operations. These purchases also support an effectively functioning bond market. When the RBA is buying government bonds, we are buying them in the secondary market. That is, they are bonds that have been issued to investors some time earlier. The RBA buys these bonds via an auction mechanism with the dealer panel banks as counterparties, though the dealers in turn have been sold the bonds from other investors. The RBA is not participating in any of the AOFM's bond tenders and does not purchase bonds directly from the state government borrowing authorities. As the RBA buys government bonds, the amount of ES balances in the system increases as we credit the accounts of the banks that we buy them from. These purchases are not sterilised. [13] The $50 billion of bond purchases have increased ES balances and provided a substantial boost to the liquidity in the system. Other factors also affect the level of ES balances, as discussed below, which have offset some of this impact. Upon maturity of the bonds that the RBA holds, the Government repays the funds to the RBA in the same way it does every other holder of the maturing bond. In terms of the RBA's balance sheet, there is a decrease on the asset side by the amount of the maturing bonds the RBA holds. On the liability side of the RBA's balance sheet there is a matching decrease in the Government's deposit account at the RBA, as the Government uses the funds it has accumulated there to repay the RBA. While the bond purchases by the RBA increase liquidity in the system, I do not see this posing any risk of generating excessively high inflation in the foreseeable future. Indeed, the opposite seems to be the more likely challenge in the current economic climate, that is, that inflation will remain below the RBA's target. Nor do I see any issue at all with the capacity of the Government to repay the bonds it has issued. Firstly, even with the increased issuance to fund the fiscal stimulus, the stock of government debt relative to the size of the Australian economy remains low. Secondly, the Government is borrowing at yields that are very low historically. Importantly, the yields on government debt are considerably below the long-run growth rate of the economy; that is, is less g r than . While ever this remains the case, as Olivier Blanchard has highlighted, there are no concerns at all about fiscal sustainability from increased debt issuance. [14] This is because growth in the economy will work to lower government debt as a share of nominal GDP. rba4-local.rba.gov.au/speeches/2020/sp-dg-2020-06-30.html 11/18 30/06/2020 The Reserve Bank's Policy Actions and Balance Sheet | Speeches | RBA Provide Liquidity to the Financial System As the dysfunction in markets intensified in March, the RBA responded to the increased demand for liquidity by significantly increasing the supply of liquidity in its daily market operations. This alleviated funding pressures in the banking system and met the increase in precautionary demand for liquidity. (The RBA undertook similar actions in the financial crisis in 2007–08. [15] ) Through March and April, the RBA increased the size of its daily operations and provided regular three and six-month terms in its repo operations to meet this demand for liquidity. These operations also boosted ES balances. The ES balances are a liability for the RBA on its balance sheet (and a corresponding asset for the banking system). The asset side of the RBA's balance sheet rises in the form of the collateral posted to the RBA as the banking system accesses these funds through repurchase agreements (repos). In recent weeks, there has been much less demand for funding at the Reserve Bank's daily market operations. This is because financial conditions have stabilised and because the liquidity position of the banking system is now much greater, with ES balances at a high level. Indeed, some of those earlier liquidity injections in March are now maturing. As they mature we expect them to be replaced, but probably not one for one, again reflecting the ample liquidity in the system (as well as the availability of the TFF). Given this, the RBA will scale back the frequency of its longer-term offerings. [16] Currently, for the terms it offers, the RBA is prepared to satisfy whatever amount of funding is demanded in its daily market operations to keep money market rates low. If liquidity conditions were to tighten up, we would expect to see more demand in our daily operations, which we would be prepared to accommodate. The ample amount of liquidity in the system is sufficient to ensure that money market rates remain at low levels. The cash rate remains low at around 13–14 basis points. Market expectations derived from the overnight indexed swap (OIS) curve imply it should stay around this level for at least a year. Repo rates are around 18 basis points. Reflecting the large amount of system liquidity as well as strong deposit growth in the banking system, the rate at which banks can borrow in the money market – the bank bill swap rate (BBSW) – is also at a low level (Graph 8). It is currently trading with close to no spread relative to OIS. The low level of these money market interest rates are materially contributing to the lower borrowing costs for households and businesses. rba4-local.rba.gov.au/speeches/2020/sp-dg-2020-06-30.html 12/18 30/06/2020 The Reserve Bank's Policy Actions and Balance Sheet | Speeches | RBA Graph 8 Term Funding Facility The RBA has also announced a Term Funding Facility (TFF). [17] This provides three-year funding for the banking system (secured against appropriate collateral) at a fixed interest rate of 25 basis points. One can think of this as equivalent to the repo transactions in the RBA's daily market operations, but for a considerably longer term than normal. Under this facility banks can borrow an amount up to 3 per cent of their loan book until the end of September. They are able to draw on additional amounts if they increase their lending to businesses, particularly small and medium-sized businesses. The cost of funding available to the banking system under the TFF at 25 basis points is significantly lower than the cost of three-year funding in the market, which is currently around 75 basis points for the major banks, and even lower relative to the cost of funding in the market for the regional and smaller banks. Hence the TFF is contributing to a lower cost of funding for the banking system and thereby to lower household and business borrowing costs. In aggregate, the initial TFF allocation is sufficient to replace all of ADIs' maturing bond funding over the next six months. We have seen the announcement of the TFF contribute to lower borrowing costs even though the total drawings by banks under the TFF have been modest to date relative to the size of the available funding. [18] So far, over 60 institutions have drawn on the TFF, with smaller institutions drawing a higher share of the funding available to them. We expect increased drawings in the coming months as banks use the TFF funds to replace maturing wholesale funding. The strong growth in deposits has reduced the immediate need for TFF funding (Graph 9). Some of that deposit growth was likely temporary as businesses drew on precautionary lines of credit and rba4-local.rba.gov.au/speeches/2020/sp-dg-2020-06-30.html 13/18 30/06/2020 The Reserve Bank's Policy Actions and Balance Sheet | Speeches | RBA placed the funds drawn on deposit at a bank. And we have seen some of this reverse since April. But some of the increase in deposits is likely to be more long-lasting. Graph 9 Hence as a result of the RBA's recent policy actions, there has been a substantial increase in system liquidity in the form of ES balances held by the banking system, which is evident on the RBA's balance sheet. This increase in system liquidity is coming through a number of channels: the RBA's daily market operations; drawings under the TFF; and the RBA's purchases of Australian Government bonds and semis. These policy actions are working as expected. The target for the cash rate, the level of the actual cash rate and the target for the three-year Government bond yield mean that these important pricing benchmarks anchor a low risk-free yield curve in the Australian financial system. Together with the liquidity provided through market operations and the TFF, this has lowered the cost of funding for the banking system. In turn, this has been transmitted through to lower borrowing costs for households and businesses (Graph 10). rba4-local.rba.gov.au/speeches/2020/sp-dg-2020-06-30.html 14/18 30/06/2020 The Reserve Bank's Policy Actions and Balance Sheet | Speeches | RBA Graph 10 Banker for the Australian Government Let me briefly talk about one other factor that has a major influence on the RBA's balance sheet, namely Government transactions. As banker for the Australian Government, the Government's transactions in the form of spending, taxation and debt raisings all settle across the RBA's balance sheet. For example, when the Government issues a bond to investors, it deposits the money raised from the investors in its account with the RBA. This removes funds from the system. Similarly, payments such as tax withdraw liquidity from the system as the payments flow through to a deposit in the Government's account. Conversely, government spending puts money into the system as the spending ends up as deposits in someone's bank account. In normal times, the RBA aims to sterilise the impact of such transactions on system liquidity to ensure that the cash rate remains at the target set by the Board. But with system liquidity at a high level, this is no longer necessary. As a result, ES balances will fluctuate with these Government flows. [19] These flows can be quite large and move ES balances significantly. Particularly obvious is the settlement of $19 billion of the December 2030 bond on 21 May, which was the largest bond syndicated in Australian history and resulted in a large rise in Government deposits (Graph 11). rba4-local.rba.gov.au/speeches/2020/sp-dg-2020-06-30.html 15/18 30/06/2020 The Reserve Bank's Policy Actions and Balance Sheet | Speeches | RBA Graph 11 The RBA has historically sterilised the effect of government transactions either with domestic repos or foreign exchange swaps. With the focus on supporting domestic liquidity, the RBA's foreign exchange swap book for domestic liquidity management has gradually matured to be zero currently. [20] This decline in the FX swap book is evident on the RBA's balance sheet. It is important to remember that these foreign exchange swap transactions have no impact on the Australian dollar and are solely undertaken for domestic liquidity management. Conclusion To conclude, the Australian economy has been significantly affected by the virus and the associated health policy actions. This has warranted a comprehensive policy response from both fiscal and monetary policy. The monetary policy response has been directed at supporting households and businesses by keeping funding costs low and ensuring credit is available. The monetary policy actions have worked as expected by lowering the key interest rate benchmarks in the economy to historically low levels, which has been transmitted through to historically low borrowing rates for households and businesses, as well as governments. The Reserve Bank's policy response has also resulted in large changes in its balance sheet, and I have sought to provide a guide to them. The size of the balance sheet can be affected by a number of factors in addition to the Bank's policy actions and as such, is not the best way to assess the stance of policy. rba4-local.rba.gov.au/speeches/2020/sp-dg-2020-06-30.html 16/18 30/06/2020 The Reserve Bank's Policy Actions and Balance Sheet | Speeches | RBA Recent data indicate that the outcomes in the Australian economy have been better than earlier feared. But we should not lose sight of the fact that the decline in the economy and the impact on households and businesses is historically large. Notwithstanding the better than feared outcomes, the fiscal and monetary support that has been provided was, and remains, warranted. There is considerable uncertainty over the path from here. This uncertainty includes the behavioural responses as health restrictions are eased. There is also considerable uncertainty about the future, which will affect the decisions of businesses and households. It has taken a long time to recover from large declines in the economy in the past. The cause of the decline this time is much different from those in the past. Many of the imbalances that exacerbated declines in previous downturns are not present this time. But it is still quite likely that this decline will have a long-lived impact that will require considerable policy support for quite some time to come. While much of that support is likely to be on the fiscal side, the Reserve Bank will maintain the current policies to keep borrowing costs low and credit available, and stands ready to do more as the circumstances warrant. Endnotes [*] Thanks to Chris Becker, Matt Boge and Ellis Connolly for their assistance with this talk, and the RBA staff who have operationalised the Board's policy decisions over recent months. The details of all of these operations, as well as the statistics on their usage, can be found on the RBA website. Recall that the cash rate is the overnight interest rate at which banks borrow and lend their ES balances at the RBA to ensure they maintain a positive balance in their account. A similar dynamic has been seen in other equivalent markets around the world as central banks have increased the supply of liquidity, both in the global financial crisis and again in the current episode. Hing A, G Kelly and D Olivan (2016), ‘The Cash Market’, RBA The expectations theory of the term structure implies that the three-year Government bond yield should be approximately equal to the expected path of the cash rate over the next three years, with some (potentially small) compensation for uncertainty over that three-year horizon. A functioning bond market is also important for ensuring that the plumbing of the financial system is functional, in terms of repo financing and collateral provision more generally. Singh M and J Aitken (2010), ‘The (Sizable) Role of Rehypothecation in the Shadow Banking System’, IMF Working Paper 10/172. M Singh (2020), , Risk Books. Bulletin, December, pp 33–41. Collateral Markets and Financial Plumbing Liberty Street Economics Fleming M and F Ruela (2020), ‘Treasury Market Liquidity during the COVID-19 Crisis’, , Federal Reserve Bank of New York, April. Available at <https://libertystreeteconomics.newyorkfed.org/2020/04/treasury-market-liquidity-during-the-covid-19-crisis.html>. Hauser A (2020), ‘Seven Moments in Spring: Covid-19, financial markets and the Bank of England's balance sheet operations’, speech on 4 June, Bloomberg, London. Available at <https://www.bankofengland.co.uk/-/media/boe/files/speech/2020/seven-moments-in-spring-covid-19-speech-byandrew-hauser.pdf?la=en&hash=43D022917D76095F1E79CBDD5D42FCD96497EA5F>. 8 LTCM in 1998 is an example of these sorts of strategies. See also Becker C, A Fang and JC Wang (2016), ‘Developments in the Australian Repo Market’, RBA , September, pp 41–46. rba4-local.rba.gov.au/speeches/2020/sp-dg-2020-06-30.html Bulletin 17/18 30/06/2020 The Reserve Bank's Policy Actions and Balance Sheet | Speeches | RBA Debelle G (2018), ‘Lessons and Questions from the GFC’, Address to the Australian Business Economists Annual Dinner, Sydney, 6 December. The US Treasury market started to stabilise as the Federal Reserve began large purchases of US Treasuries. The stabilisation of the US Treasury market contributed to improved conditions in other markets around the world. The AOFM has currently suspended its buyback program of bonds, which also increases the size of the possible impact on liquidity when these bonds mature. Some bond holders have a mandate that prevents them from holding bonds with less than one year to maturity. Hence we can see increased selling of bonds as they approach this time to maturity. That is, the RBA does not undertake market operations to withdraw the additional ES balances from the system. Blanchard O (2019), ‘Public Debt and Low Interest Rates’, See Debelle G (2018), ‘Lessons and Questions from the GFC’, Address to the Australian Business Economists Annual Dinner, Sydney, 6 December. Dealing intentions are posted to the market data services prior to daily open market operations and then republished on the Reserve Bank website in statistical table A3. Refer to the Reserve Bank website for more details on the Term Funding Facility: https://www.rba.gov.au/mktoperations/term-funding-facility/overview.html. The TFF is however having a significant effect in boosting banks' liquidity coverage ratios (LCR) as APRA recognises the banks have access to the facility. Banknote issuance and transactions by other Reserve Bank clients also continue to have a liquidity impact but tend to be much smaller and less volatile. This is evident in the data we publish on our foreign exchange operations on our website in Table A4. American Economic Review, 109(4), pp 1197–1229. The materials on this webpage are subject to copyright and their use is subject to the terms and conditions set out in the Copyright and Disclaimer Notice. © Reserve Bank of Australia, 2001–2020. All rights reserved. The Reserve Bank of Australia acknowledges the Aboriginal and Torres Strait Islander Peoples of Australia as the Traditional Custodians of this land, and recognises their continuing connection to Country. We pay our respects to their Elders, past, present and emerging. rba4-local.rba.gov.au/speeches/2020/sp-dg-2020-06-30.html 18/18 | reserve bank of australia | 2,020 | 7 |
Address by Mr Christopher Kent, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to KangaNews, Online, 27 July 2020. | 27/07/2020 The Reserve Bank's Operations – Liquidity, Market Function and Funding | Speeches | RBA Speech The Reserve Bank's Operations – Liquidity, Market Function and Funding Christopher Kent [ * ] Assistant Governor (Financial Markets) Address to KangaNews Online – 27 July 2020 Introduction In the early stages of the pandemic, there was extreme uncertainty about how much economic activity would decline and how long the economic disruption would last. It was also uncertain how much support would be provided by monetary and fiscal authorities. And so, as the virus spread around the world through early March, extreme uncertainty and the prospect of a sizeable decline in economic activity was reflected in financial markets globally. In particular, there was a sharp rise in the volatility of asset prices, a decline in the prices of risky assets, and before too long, dislocation in a number of key financial markets (Graph 1). Most notable were the problems affecting government bond markets, which are critical to the pricing and operation of financial markets more broadly. Australia was no exception. https://www.rba.gov.au/speeches/2020/sp-ag-2020-07-27.html 1/14 27/07/2020 The Reserve Bank's Operations – Liquidity, Market Function and Funding | Speeches | RBA Graph 1 These conditions underpinned a general rush for liquidity, including by banks and other financial institutions. More generally, investors in a wide range of financial markets also sought to shore up their liquidity and reduce their exposures to riskier positions. In reaction to this increase in the demand for liquidity around the world, central banks increased the supply of liquidity as part of a broader policy response to support their economies (Graph 2). They provided that liquidity initially by scaling up their open market operations. Central banks also bought government bonds in secondary markets. They did this with a view to restoring more normal functioning in those markets, but it also had the effect of providing additional liquidity to those selling the bonds. Furthermore, a number of central banks started new facilities, or extended existing ones, to provide longer-term funding to banks at favourable rates. https://www.rba.gov.au/speeches/2020/sp-ag-2020-07-27.html 2/14 27/07/2020 The Reserve Bank's Operations – Liquidity, Market Function and Funding | Speeches | RBA Graph 2 Central banks that had room also cut policy rates. In many cases that was accompanied by forward guidance that policy rates would remain low for some time. Some pursued quantitative easing (or ‘QE’), whereby they committed to buying particular quantities of government bonds (and in some cases other assets) over and above what was required to restore market functioning. Rather than announcing a quantity target, the Reserve Bank opted for a yield target, whereby we stand ready to buy Australian Government Securities (AGS) so that the bond yield at the 3-year mark stays around 25 basis points. To be clear, our 3-year yield target applies to the bond with residual maturity closest to 3 years (as opposed to the futures basket). That means that the focus of our target will shift from the April 2023 bond to the April 2024 bond later this year. In what follows, I'll focus much of my attention on the details of our operations affecting liquidity, market function and term funding. I'll finish by considering the implications of these various developments for conditions in markets for fixed income securities. Liquidity In response to the sharp rise in demand for liquidity from the banks in early March, the Reserve Bank began to increase the supply of liquidity to the banking system via our normal daily open market operations (OMOs). For a time, this was done by dealing more liquidity than our announced intentions (in Graph 3, this is seen by the orange ‘filled’ orders bar exceeding the blue ‘dealing intentions’ line). By mid March, this increase in the amount dealt had become very substantial, and we began offering longer terms on a regular basis. https://www.rba.gov.au/speeches/2020/sp-ag-2020-07-27.html 3/14 27/07/2020 The Reserve Bank's Operations – Liquidity, Market Function and Funding | Speeches | RBA Graph 3 By the latter part of March, liquidity in the banking system – as measured by banks' Exchange Settlement (ES) balances held at the Reserve Bank – rose even further. This was a result of the Reserve Bank's purchases of government bonds in secondary markets to help achieve the yield target on 3-year AGS as well as improve the functioning of government bond markets. [3] By the early part of April, take-up of the Term Funding Facility (TFF), also part of the Reserve Bank's policy package, was adding further to banks' ES balances. By mid April, there were signs that the increased supply of ES balances had met the surge in demand for liquidity in the banking system. This was evident in the sustained drop in the amounts dealt at our morning auctions. Financial conditions more broadly had also become more settled. Graph 3 shows that we had switched our approach in our OMOs over this period. Previously, we had targeted a particular level of ES balances and used the price (i.e. the repo rate) to determine which counterparty bids were filled (and which were unfilled). Lately, we have been meeting the demand of banks that present at auctions at a steady repo rate. Given the high level of ES balances supplied by the Reserve Bank, it was not surprising that the cash rate fell below 25 basis points (Graph 4). Since the latter part of April, it has generally been either 13 or 14 basis points. Daily volumes of cash transactions between banks have declined, since many banks don't need to borrow overnight from one another given the relatively large balances they each have in their ES accounts. Indeed, on some days there have been insufficient volumes to calculate the cash rate based on market transactions. On these days we have instead used expert judgement as set out in our fall-back procedures to determine the published cash rate. These fall-back https://www.rba.gov.au/speeches/2020/sp-ag-2020-07-27.html 4/14 27/07/2020 The Reserve Bank's Operations – Liquidity, Market Function and Funding | Speeches | RBA procedures ensure that we can continue to publish the cash rate. Typically, we have used the last published rate based on sufficient market transactions. But there has been one occasion when we published another rate that we judged to have better reflected recent market conditions. Graph 4 One thing we are continuing to do as usual during our regular operations is to buy back AGS that are near to maturity. This is done in order to reduce very large swings in the supply of ES balances that would otherwise occur on days when a large bond line matures. These buy-back operations occur either via our OMOs or bilaterally. They are conducted separately from the purchases at auctions for the purposes of hitting the target for the 3-year AGS yield and to improve market function. The low level of the cash rate and the high levels of liquidity provided by the Bank have contributed to low rates in other money market instruments, such as bank bills (Graph 5). For some time now, 3month and 6-month bank bills have been trading around market expectations of the future cash rate (i.e. the OIS rate). https://www.rba.gov.au/speeches/2020/sp-ag-2020-07-27.html 5/14 27/07/2020 The Reserve Bank's Operations – Liquidity, Market Function and Funding | Speeches | RBA Graph 5 So the actions of the Reserve Bank have contributed to historically low funding costs for banks. Also, banks have benefited from an influx of low-cost deposits. Some of that has come from businesses that tapped their lines of credit but then left those funds on deposit. There are a number of other reasons for the increase in bank deposits. This includes increased spending by the Australian Government (net of taxes), which leads to funds being paid out from the government's account at the Reserve Bank to customers of commercial banks. The purchase of government bonds by the Reserve Bank from non-banks has the same effect. Market Function A number of key financial markets became dysfunctional through early March, including the critical markets for AGS and semi-government securities (semis). This was recently discussed by my colleague Guy Debelle, so I'll just provide a short summary of some key points before turning to the mechanics of these operations. The substantial fall in risky asset prices in early March underpinned a sharp increase in financial market volatility more broadly. This meant that a range of investors needed to sell assets to reduce leverage, cover margin calls, and meet redemptions. Many investors sold government bonds and it didn't take long before dealers were unable to absorb more of the one-sided flows, including because of their own internal risk limits. Hence, we faced the extremely unusual situation whereby prices of https://www.rba.gov.au/speeches/2020/sp-ag-2020-07-27.html 6/14 27/07/2020 The Reserve Bank's Operations – Liquidity, Market Function and Funding | Speeches | RBA risky and risk-free assets were both falling. The fact that markets were not functioning well was apparent in a range of other metrics, including: the sharp rise in bid-offer spreads for AGS and semis; a sharp fall in the ability to trade in bond futures without moving the price; and the breakdown of various no-arbitrage relationships, including between bond futures and the underlying bonds that they reference (Graph 6). Graph 6 Given that the underlying cause of the market dysfunction was an urgent need to sell bond holdings and raise cash, the Bank decided to step in and provide the market with some liquidity. We did this by offering to buy government bonds at auctions. For each auction, we announced the amount we would purchase, which particular bond lines we would be willing to buy, and let counterparties bid to sell those bonds to us. The bonds we actually bought within that suite depended on the bids at auction, whereby we purchased those at the lowest possible prices (highest yields). The choice of which bonds we offered to buy, and the overall amount, was informed by a number of sources including liaison with market participants, the AOFM, and the state and territory government borrowing authorities. We also assessed the extent of dysfunction based on some of the indicators I mentioned earlier, including which bonds appeared most mispriced. [8] The auction results themselves were also informative for subsequent auctions. For example, at some auctions we received a lot of offers to sell bonds, and those offers were priced ‘to sell’ (that is, they were offered at yields above mid-market levels). That was a good indication that there was an excess stock of bonds in that segment of the market clogging up dealer balance sheets. In such cases, we https://www.rba.gov.au/speeches/2020/sp-ag-2020-07-27.html 7/14 27/07/2020 The Reserve Bank's Operations – Liquidity, Market Function and Funding | Speeches | RBA conducted further auctions in that part of the yield curve within quick time. On the other hand, if an auction did not receive that many offers, or the pricing we received was relatively unattractive, this indicated that there was no large supply-demand imbalance and, therefore, no pressing need for further auctions in that part of the curve. The Bank's purchases have had the intended effect: as we purchased bonds the imbalance of supply and demand was redressed. This was evident in a decline over time in the volume of attractively priced offers to sell. [9] It was also evident in other measures, including bid-offer spreads, mispricing along the yield curve, and the ability to trade in futures without moving the price. These all improved, to be close to pre-crisis levels. The general improvement in financial sentiment – aided by the range of other policies, both monetary and fiscal – is also likely to have played a role. In any case, since late April we have scaled back purchases significantly and have not needed to purchase any bonds for some time. We stand ready though to buy bonds if bond market conditions deteriorate significantly, or indeed, if needed to achieve the target of around 25 basis points for the 3-year AGS yield. Term Funding Another initiative from the Bank was the Term Funding Facility to lower borrowing costs and support lending, particularly to businesses. The TFF does this by providing a guaranteed source of funding to ADIs for 3 years at the low cost of 25 basis points, with an incentive to increase lending to businesses, especially small and medium-sized enterprises (SMEs). Funds provided under the TFF are secured against collateral, as is the case with the Bank's other facilities. The TFF provided banks with the option of an initial allowance of around $90 billion. This has since grown to around $150 billion, with additional allowances granted to individual banks that have increased their lending to businesses since the facility began in April. Take-up of the TFF is currently around $26 billion, or around 17 per cent of the total currently on offer (Graph 7). There are a few reasons why banks have not taken up more of this funding at this stage in the program. One is simply that many banks have accessed even cheaper funding from other sources in recent months, albeit at shorter tenors than three years. In particular, banks have been able to issue bank bills at rates below 25 basis points. Similarly, bank deposits have grown, and an increasing share of deposits have been paying rates below 25 basis points. Also, the TFF provides funding for three years from the date of the drawdown, so the longer an ADI waits to draw funds, the later they will have to repay the money. With no pressing funding need right now, and ample alternative short-term funding at low cost, delaying the drawdown is a useful option. https://www.rba.gov.au/speeches/2020/sp-ag-2020-07-27.html 8/14 27/07/2020 The Reserve Bank's Operations – Liquidity, Market Function and Funding | Speeches | RBA Graph 7 The calculus underpinning the decision of some banks to delay drawing on their initial TFF allocations will change closer to the deadline of 30 September. At that time, it will make sense for banks to compare the certain 25 basis point cost of the TFF with the uncertain cost of other sources of funding over the next three years, including bonds that would mature over that period. So our expectation and liaison with the banks suggest that the take-up of the TFF will ramp up as we get closer to the end of September. Despite only part of the funding being drawn down to date, it's worth noting that the TFF – combined with the Bank's other policy measures – has already had a significant impact. On the funding side, the ability to draw on the TFF means that banks can be selective in how they raise money, and this has contributed to overall bank funding costs falling by around 60 basis points since February. And on the lending side, we have seen interest rates on new fixed-rate mortgages fall by around 65 basis points since February, and rates on SME loans fall by around 60 basis points. Private Sector Fixed Income Markets I now want to turn my attention to what all of these developments imply for private sector fixed income markets. https://www.rba.gov.au/speeches/2020/sp-ag-2020-07-27.html 9/14 27/07/2020 The Reserve Bank's Operations – Liquidity, Market Function and Funding | Speeches | RBA Like government bond markets, private sector fixed income markets also became dysfunctional in March. These markets were significantly disrupted for a time as concerns and uncertainty about the economic and financial effects of the pandemic rose sharply. Issuers typically try to avoid going to market with new bonds at such times, given the very high premiums demanded by investors, particularly if they have the option of waiting because they are already well funded or have other funding options. However, with the aid of monetary and fiscal policies, it did not take too long for financial conditions to settle and fixed income markets to ‘reopen’. Issuance though has varied considerably across different types of issuers. The major banks have let their existing bonds mature without replacement, so their issuance has declined in net terms, and they have not issued any residential mortgage-backed securities (RMBS, Graph 8). This is not surprising given a number of forces at work. First, with credit growth likely to remain low or even decline, their funding needs will remain modest for a time. Second, they had issued quite a lot of bonds prior to the pandemic and have subsequently found themselves flush with other sources of funding, including low-cost deposits. While those sources do not have the same maturity profile as longer-term bonds, they lessen the need for near-term issuance. And third, they have the option of accessing funds from the TFF at a cost of 25 basis points, while the cost of a newly issued bond of similar maturity is around 30-60 basis points (based on secondary market prices in recent weeks). Graph 8 https://www.rba.gov.au/speeches/2020/sp-ag-2020-07-27.html 10/14 27/07/2020 The Reserve Bank's Operations – Liquidity, Market Function and Funding | Speeches | RBA Other, smaller banks, have issued bonds over recent months. In part this reflects the fact that they haven't benefited to the same extent as the major banks from an influx of deposits. But in any case, their issuance is roughly offsetting maturities so in net terms issuance isn't increasing. Similarly, mortgage originators have resumed issuance of RMBS over the past few months, following a pause in April. The AOFM has supported this by purchasing RMBS directly at issuance, and in the secondary market (with investors then recycling those funds into new primary issuance). [10] Spreads at issuance are a little higher than they were at the start of the year, but do not stand out when taking a slightly longer perspective (Graph 9). And yields are at low levels, driven by the fall in BBSW rates. Graph 9 Over the year to date, non-financial corporations have been issuing bonds to about the same extent as they have in recent years (Graph 10). After a period when markets were disrupted during the height of the market stresses in March, these firms have been able to issue bonds in good quantities and relatively favourable yields, which is welcome (Graph 11). The relatively low level of yields reflects the historically low level of risk-free rates, with 3-year AGS yields consistent with the Board's target of around 25 basis points. Also, spreads on corporate bonds are relatively low. Spreads in secondary markets rose earlier in the year in response to fears about the health of the business sector, but have eased somewhat since then, aided by significant support provided by monetary, fiscal and prudential policies. https://www.rba.gov.au/speeches/2020/sp-ag-2020-07-27.html 11/14 27/07/2020 The Reserve Bank's Operations – Liquidity, Market Function and Funding | Speeches | RBA Graph 10 Graph 11 https://www.rba.gov.au/speeches/2020/sp-ag-2020-07-27.html 12/14 27/07/2020 The Reserve Bank's Operations – Liquidity, Market Function and Funding | Speeches | RBA Finally, many large firms also tapped their credit lines at banks in March and April, providing a significant boost to business credit. Part of that appears to have been precautionary given that firms have repaid some of their revolving facilities more recently. Another source of funding has been the very substantial issuance of equity in recent months by a wide range of listed firms. Those companies raising equity cited the desire to strengthen their balance sheets, and in some cases to pursue opportunities for growth. Conclusion In response to the severe impact of the pandemic on economic activity and financial markets, the Australian authorities have provided unprecedented support, including via fiscal, monetary and prudential policies. Monetary policy has been focused on supporting the economy by keeping the cost of borrowing low and helping to maintain the supply of credit to households and businesses. To help achieve these ends, the Reserve Bank has undertaken a number of significant operations. First, it responded to the sharp rise in the demand for liquidity by the banking system by scaling up its daily open market operations. It met the demand for liquidity from banks, providing that at longer terms, against high-quality collateral. Second, the Bank provided much needed liquidity in a different manner, by purchasing government bonds outright at a time when there were plenty of sellers and very few buyers in those critical markets. And third, we provided the option of low-cost funding to banks by rolling out the Term Funding Facility. While we refer to this as funding, it is liquidity provision by another name – the banks obtain cash, for three year terms, by posting collateral. So while these operations are novel in some respects, in many ways they can be thought of as representing the ‘bread and butter’ of central banking – providing liquidity to meet demand at a time of considerable need, thereby acting to stabilise crucial markets. From my perspective, these operations have worked well. Along with other monetary, fiscal, prudential and health policies, they contributed to a noticeable improvement in market sentiment and accommodative financial conditions. Among other things, we clearly see the effect of that in the ability of firms to gain access to a wide range of funding, at low rates, including in fixed income markets. Endnotes [*] I thank Richard Finlay for invaluable assistance in preparing this material. Debelle G (2020), ‘The Reserve Bank's Policy Actions and Balance Sheet’, Address to the Economic Society Australia, 30 June. For further details see https://www.rba.gov.au/media-releases/2020/mr-20-07.html. For further details see https://www.rba.gov.au/media-releases/2020/mr-20-08.html. This option allows us to account for information about the rates and size of trades that have occurred over a number of days, even if the volume on any one of those days was not sufficient to publish a reliable measure of the cash rate. For full details of the fall-back procedures see https://www.rba.gov.au/mkt-operations/resources/cash- https://www.rba.gov.au/speeches/2020/sp-ag-2020-07-27.html 13/14 27/07/2020 The Reserve Bank's Operations – Liquidity, Market Function and Funding | Speeches | RBA rate-methodology/cash-rate-procedures-manual.html. These procedures allow for the cash rate to continue to be published, including in the absence of market transactions, and allow for changes in the benchmark design in response to market conditions to ensure that the cash rate continues to reflect the interest rate relevant to unsecured overnight funds. Statistical Table A3 contains data on such purchases; see https://www.rba.gov.au/statistics/tables/xls/a03.xls. The purchase by commercial banks of the bonds of the states and territories also contributes to a rise in bank deposits since the states and territories hold their accounts with commercial banks, whereas the Federal Government holds their accounts at the Reserve Bank. For further details see Finlay R, C Seibold and M Xiang (2020), ‘Government Bond Market Functioning and COVID19’, RBA , September. See Finlay R, C Seibold and M Xiang (2020), ‘Government Bond Market Functioning and COVID-19’, RBA September. As market function improved and the supply-demand imbalance lessened, the Bank reduced the size of its auction operations, and it is possible that this reduction may also have contributed to the fall in attractively priced offers to sell bonds. For further details see <https://www.aofm.gov.au/sfsf>. Bulletin Bulletin, The materials on this webpage are subject to copyright and their use is subject to the terms and conditions set out in the Copyright and Disclaimer Notice. © Reserve Bank of Australia, 2001–2020. All rights reserved. The Reserve Bank of Australia acknowledges the Aboriginal and Torres Strait Islander Peoples of Australia as the Traditional Custodians of this land, and recognises their continuing connection to Country. We pay our respects to their Elders, past, present and emerging. https://www.rba.gov.au/speeches/2020/sp-ag-2020-07-27.html 14/14 | reserve bank of australia | 2,020 | 8 |
Address by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to the Anika Foundation, Online, 21 July 2020. | 21/07/2020 COVID-19, the Labour Market and Public Sector Balance Sheets | Speeches | RBA Speech COVID-19, the Labour Market and Public Sector Balance Sheets Philip Lowe [ * ] Governor Address to the Anika Foundation Online – 21 July 2020 I would like to thank you for your support of the Anika Foundation. The pandemic that we are all living through is traumatic for our entire community. Young people are no exception, with many anxious about their future job prospects and suffering from a loss of social connectivity. This means that the work of the Foundation is as important as ever. Thank you for your support. In this year's Anika Foundation talk, I would like to discuss two topics. The first is the impact of the pandemic on Australia's labour market. And the second is the important role that public sector balance sheets are playing in softening the economic downturn and in building the bridge to the recovery. The Labour Market I wanted to start with the labour market because for many people, the economic costs of the pandemic really hit home when they, or somebody they know, lost their job or their hours were cut. In April and May, employment fell by around 870,000 people and a further 760,000 people had zero hours of work, although they still had a job. Many other Australians had their hours cut, with young people bearing a lot of the burden (Graph 1). All up, total hours worked in Australia fell by 10 per cent in just a few weeks. As staggering as this fall is, it is smaller than we earlier feared. In early May, we were expecting a decline of almost 20 per cent in total hours worked. It is also a smaller than the decline we have seen in many other countries. In Canada, for example, hours fell by 28 per cent and in the United States they fell by 19 per cent. https://www.rba.gov.au/speeches/2020/sp-gov-2020-07-21.html 1/13 21/07/2020 COVID-19, the Labour Market and Public Sector Balance Sheets | Speeches | RBA Graph 1 Fortunately, we have now turned the corner. In June, hours worked increased by 4 per cent and the number of employed people rose by 210,000. Notwithstanding this turnaround, the path ahead is expected to be bumpy and there are some major cross-currents in the labour market at the moment. On the positive side of the ledger, many firms that were heavily affected by the shutdowns are now rehiring and lifting hours as the restrictions are eased in most of the country. This is most clearly evident in the retail, hospitality and arts & recreation sectors (Graph 2). Some other firms have also hired large numbers of people as they respond to the increase in demand as a result of the pandemic. The supermarkets are a good example of this. https://www.rba.gov.au/speeches/2020/sp-gov-2020-07-21.html 2/13 21/07/2020 COVID-19, the Labour Market and Public Sector Balance Sheets | Speeches | RBA Graph 2 But on the other side of the ledger, there are also factors working in the opposite direction. Through our business liaison we are hearing that many firms, including in the construction sector and in professional services, were able to keep many of their employees over recent months because they had a pipeline of work to complete. But as new orders have declined, this pipeline is drying up. If it is not replaced soon, hours worked in these businesses will decline further, just at the same time that other parts of the economy are coming back to life. Some firms have also used recent months to reconsider their business models. In some cases this is because of the decline in demand that is likely to persist, but for others there has been a reassessment of how they manage their workforce. Some firms have identified new opportunities and there has been plenty of innovation. Yet despite this, restructuring and the uncertainty about future demand is likely to weigh on the labour market as it recovers. Adding to this complicated picture is the fact that the unemployment rate is likely to increase further, even with the recovery underway. This is because many of the people who lost their jobs over recent times have been classified as not in the labour force and so are not counted as unemployed. As the labour market continues to improve, we expect many of these people will start looking for jobs, and thus be classified as rejoining the labour force. This will push up the measured unemployment rate at the same time that the share of the working-age population with a job is also rising. We saw an https://www.rba.gov.au/speeches/2020/sp-gov-2020-07-21.html 3/13 21/07/2020 COVID-19, the Labour Market and Public Sector Balance Sheets | Speeches | RBA example of that in the figures for June, released last week, when despite employment increasing by a record 210,000 people, the unemployment rate also rose to 7.4 per cent, a 21-year high (Graph 3). Graph 3 Looking forward, one of the keys to returning to a strong labour market is restoring confidence. This starts with people being confident about their own health and the public health response. The global evidence is that without this, people are reluctant to resume their normal activities and firms are reluctant to hire and invest. The other element is people being confident about their own finances and jobs, and businesses being confident about future demand. Addressing the health issues will help here, but so too will the policy response on the economic front. Public Sector Balance Sheets This brings me to the second issue that I wanted to talk about: the important role that is being played by public sector balance sheets in softening the economic downturn and in providing the best platform for the economy to recover. I will first talk about use of the RBA's balance sheet and then about the government's balance sheet. The RBA's balance sheet In mid March, the RBA announced a comprehensive monetary policy package to keep funding costs low and the supply of credit available, especially to small and medium-sized businesses. As part of this package, we have used our balance sheet: https://www.rba.gov.au/speeches/2020/sp-gov-2020-07-21.html 4/13 21/07/2020 COVID-19, the Labour Market and Public Sector Balance Sheets | Speeches | RBA to make sure the financial system has plenty of liquidity to address dislocations in the government bond markets to provide low-cost funding to the banking system, so that lenders can support the provision of credit to their customers to reduce funding costs across the whole economy by having a target of around 25 basis points for three-year Australian Government bond yields. Reflecting these various measures, the Reserve Bank's balance sheet has increased from around $180 billon prior to the pandemic to around $280 billion today and further increases are expected over coming months (Graph 4). Graph 4 To date, around $25 billion has been advanced under the funding scheme for the banking system, with 66 ADIs having used the facility (Graph 5). We expect further drawings to be made over coming months, with the total amount available currently standing at $150 billion. This facility is working as expected and is contributing to the plentiful supply of liquidity in the Australian financial system. https://www.rba.gov.au/speeches/2020/sp-gov-2020-07-21.html 5/13 21/07/2020 COVID-19, the Labour Market and Public Sector Balance Sheets | Speeches | RBA Graph 5 The three-year yield target is also working well. In the weeks immediately after the announcement of the target, the Bank used its balance sheet to purchase $50 billion of government bonds, to support the yield target and address market dysfunction. Since late April we have scaled back purchases significantly and have not needed to purchase any bonds for some time (Graph 6). The target is viewed as credible by market participants, not least because it is consistent with the outlook for the cash rate over the next three years. There is also a broad understanding that the RBA is prepared to use its balance sheet in whatever quantity is needed to maintain the target. Government bond markets are also again operating normally, after the signs of dysfunction in bond markets around the world in March and April. https://www.rba.gov.au/speeches/2020/sp-gov-2020-07-21.html 6/13 21/07/2020 COVID-19, the Labour Market and Public Sector Balance Sheets | Speeches | RBA Graph 6 I would now like to address one idea for the use of the central bank's balance sheet that I sometimes hear – that is, we should use it to create money to finance the government. A variant on this idea is that the central bank should just deposit money in every bank account in the country – this is sometimes known as ‘helicopter money’ because, before we had an electronic payments system the idea was that banknotes could simply be dropped by helicopter. For some, this idea is seen as a way of avoiding financing constraints – it is seen as holding out the offer of a free lunch of sorts. The central bank, unlike any other institution, is able to create money and the resource cost of creating that money is negligible. So the argument goes, if the government needs money to stimulate the economy, the central bank should simply create it in the public interest. The reality, though, is there is no free lunch. The tab always has to be paid and it is paid out of taxes and government revenues in one form or another. I would like to explain why. I will start with some central bank accounting. When a central bank creates money to finance government spending it does so by crediting the government's deposit account with it. These extra deposits represent a liability of the central bank. And on the asset side of the balance sheet, the central bank might have an IOU from the government to be paid in the future. Now suppose that the additional government spending is successful in stimulating the economy and this starts to push inflation up. At some point, interest rates would need to be increased to avoid https://www.rba.gov.au/speeches/2020/sp-gov-2020-07-21.html 7/13 21/07/2020 COVID-19, the Labour Market and Public Sector Balance Sheets | Speeches | RBA inflation rising too far. If this lift in interest rates did not occur, inflation would rise, perhaps to a very high level. In this case, it would be through the inflation tax that the community pays for the extra government spending. So there is no free lunch – the spending is just paid for in a different way. Now instead suppose that interest rates are increased to avoid high inflation successfully. Even then, there is still no free lunch. How the tab is paid though depends on the nature of the arrangements that are in place. One possibility would be for the government to pay back the IOU along with any accumulated interest at some point down the track. This repayment would need to be funded by future taxes. If instead the IOU was not interest-bearing and was not repaid, the central bank would start accumulating losses as the interest rate it paid on its deposit liabilities increased and there was no offsetting income. This would lead to a decline in dividends to the government and possibly a future recapitalisation of the central bank. Both have to be funded through tax revenue. Another possibility would be to increase the general level of interest rates to deal with inflation, but to maintain the low interest rate on deposit balances held at the central bank. This approach would limit losses at the central bank even if the IOU was not interest bearing. But it would effectively amount to a tax on the banking system, as it is the banks that would hold these low-interest balances once the government has spent the money. In this case, it is this tax that would help finance the extra spending. The message here is that somebody always pays. It certainly is possible for the central bank to change when and how the spending is paid for, but it is not possible to put aside the government's budget constraint permanently. Where countries have, in the past, sought to put aside this constraint the result has been high inflation. Notwithstanding this historical experience, some prominent mainstream economists, including Stanley Fischer, a former governor of the Bank of Israel and Vice Chair of the US Federal Reserve, have recently argued that central bank financing of government spending may be appropriate in some circumstances. In particular, they have focused on the situation in which: i. conventional monetary policy options have been exhausted ii. the central bank is falling short of its goals, and crucially iii. public debt is high and the government cannot borrow in financial markets on reasonable terms. They argue that under these particular circumstances, central bank financing may be welfare enhancing, provided that there are strong safeguards to avoid the inflation problem. The main safeguard proposed is that the amount of monetary financing and the conditions under which it is provided, are determined solely by the independent central bank, not by the government. It is envisaged that the central bank provides finance up until the point that its goals for inflation and https://www.rba.gov.au/speeches/2020/sp-gov-2020-07-21.html 8/13 21/07/2020 COVID-19, the Labour Market and Public Sector Balance Sheets | Speeches | RBA perhaps unemployment are met. Importantly, the government would continue to determine how the financing is spent. This idea has attracted a lot of attention recently, although many commentators have pointed out that there are likely to be very significant challenges in maintaining this type of safeguard over time. It is worth repeating that this proposal is only relevant to the situation where high government debt constrains the ability of the government to provide necessary fiscal stimulus financed through the normal channels. Clearly, it is not relevant to the situation we face in Australia. So I want to make it very clear that monetary financing of fiscal policy is not an option under consideration in Australia, nor does it need to be. The Australian Government is able to finance itself in the bond market, and it can do so on very favourable terms. There is strong demand for government debt and the Australian government can borrow for five years at just 0.4 per cent and for ten years at just 0.9 per cent (Graph 7). These are the lowest borrowing costs since Federation. Graph 7 While monetary financing is not an option in Australia, the Reserve Bank Board continues to review overseas experience with other monetary options. We had another discussion on this at our meeting two weeks ago. Central banks around the world have all moved in the same general direction, but they have configured their monetary support packages differently. Using international experience as a guide, it https://www.rba.gov.au/speeches/2020/sp-gov-2020-07-21.html 9/13 21/07/2020 COVID-19, the Labour Market and Public Sector Balance Sheets | Speeches | RBA would have been possible to configure the existing elements of the RBA package differently. For example, the various interest rates currently at 25 basis points could have been set lower, at say 10 basis points. It would also have been possible to introduce a program of government bond purchases beyond that required to achieve the 3-year yield target. Different parameters could have also been chosen for the Term Funding Facility. After discussing these possibilities, the Board concluded that that there was no need to adjust our package of measures in the current environment. The Board has, however, not ruled out future changes to the configuration of this package if developments in Australia and overseas warrant doing so. At our meeting, we also reviewed some alternative monetary policy options. One of these is negative interest rates. There has been no change to the Board's view that negative interest rates in Australia are extraordinarily unlikely. Our reading of the international evidence is that the main potential benefit from negative rates is downward pressure on the exchange rate. But negative interest rates come with costs too. They can cause stresses in the financial system that are unhelpful for the supply of credit. They can also encourage people to save more, rather than spend more, so they can be counter-productive from that perspective too. So this is not a direction we need to head in. Another monetary option that has been used elsewhere is to intervene in the foreign exchange market. The evidence here is that when the exchange rate is broadly in line with its economic fundamentals, as the Australian dollar is currently, this approach has limited effectiveness. It can also involve substantial financial risks to the public balance sheet and complicate international relationships. So this too is not a direction we need to head in. The conclusion of our discussions at the July Board meeting was that the best course of action is to maintain the mid-March package and to continue to monitor the effects of the pandemic on the economy. The Board has not ruled out future changes to this package, though it recognises that, in the current environment, there are limitations to what more can be achieved through monetary policy. Given these limitations, and the outlook for the labour market, there is an important ongoing role for fiscal policy and use of the government's balance sheet. I would now like to turn to this issue. The government's balance sheet Over recent decades, the conventional wisdom has been that the government's balance sheet has a limited role in managing economic fluctuations, with the main focus instead being on structural and intergenerational issues. The global financial crisis, and now the pandemic, have caused some rethinking here. What we have seen over recent times is the government balance sheet being used to smooth out large shocks to private sector incomes. By smoothing things out, the government is helping people right now and also limiting the longer-term damage to the economy. https://www.rba.gov.au/speeches/2020/sp-gov-2020-07-21.html 10/13 21/07/2020 COVID-19, the Labour Market and Public Sector Balance Sheets | Speeches | RBA The clear evidence from history is that the deeper and more protracted a downturn, the more severe are the economic scars. These scars occur through: young people not getting onto the jobs ladder, or slipping off it, with permanent effects on their lives people losing training opportunities with long-term consequences for their career prospects lower levels of investment in physical capital and research the damage to the fabric of our society and to people's lives that is caused by a long spell of unemployment. We need to do what we can to limit the severity of these costly scars. These scars have long-term effects and they damage our society and our economy. The government can play an important role here by using its balance sheet to smooth things out and reduce the severity of the downturn. In doing so, it helps not only in the present but in the future as well. In principle, this smoothing function can work in a few ways. One is through direct transfers to households and businesses. Another is for the government to spend money directly itself on activities that create jobs. The JobSeeker and JobKeeper programs are examples of the former and spending on infrastructure and public health are examples of the latter. Both are important. By helping the economy today, these measures also support the all-important confidence that I spoke about earlier. So they assist with a return to more normal patterns of spending and consumption, without the need for ongoing fiscal stimulus. future Using the public balance sheet in this way inevitably requires government borrowing against income. It is through this borrowing that we are able to smooth out the hit to our income. current For a country that has got used to low budget deficits and low levels of public debt, this is quite a change. But it is a change that is entirely manageable and affordable and it's the right thing to do in the national interest. Debt across all levels of government in Australia, relative to the size of our economy, is much lower than in many other countries and it is likely to remain so (Graph 8). As I said before, the Australian governments can borrow at the lowest rates since Federation. So the public balance sheet is well placed to smooth out the shock to private incomes and support the economy through the pandemic. https://www.rba.gov.au/speeches/2020/sp-gov-2020-07-21.html 11/13 21/07/2020 COVID-19, the Labour Market and Public Sector Balance Sheets | Speeches | RBA Graph 8 Looking forward, we should have confidence that the pandemic will pass, either because of scientific breakthroughs or we become better at managing the effects of the virus. Until it does pass, our incomes will be temporarily lower and it makes sense to smooth this out through fiscal support. At the same time, we need to recognise that the task is complicated by the fact there is still considerable uncertainty about how long this period of weak income will last. The longer it lasts and the more uncertain things are, the harder it is to smooth out. At some point in the future, attention will rightly return to addressing the ratio of public debt to GDP, as low levels of public debt do give us the capacity to use the public balance sheet to smooth out future shocks to private income. When the time does come to address the build-up of debt, the best way to do this will be through economic growth. Given that we are borrowing against future income, we will be better placed if that future income is strong. I have spoken on previous occasions about some of the options here and the need for Australia to be a great place for businesses to expand, invest, innovate and hire people. It is important that as a country we focus on this, not only to deal with our current challenges but also our future ones. I want to conclude by reminding you that the foundations of the Australian economy are strong and that at some point the pandemic will pass. We have handled the health crisis better than many other countries and our economy is also faring better than many others. Public balance sheets in Australia https://www.rba.gov.au/speeches/2020/sp-gov-2020-07-21.html 12/13 21/07/2020 COVID-19, the Labour Market and Public Sector Balance Sheets | Speeches | RBA are also in a strong position and they have been used to deliver unprecedented monetary and fiscal support to the Australian economy. These measures are helping to provide an important bridge to the days when the recovery is well entrenched and we are making renewed progress towards full employment. Thank you for listening and I am happy to answer your questions. Endnotes [*] I would like to thank Ellis Connolly for assistance in the preparation of this talk. For a fuller discussion of these measures see Debelle G (2020), ‘The Reserve Bank's Policy Actions and Balance Sheet’, Speech to The Economic Society of Australia, 30 June. Available at: <https://www.rba.gov.au/speeches/2020/sp-dg-2020-06-30.html>. See Bartsch E, J Boivin, S Fischer and P Hildebrand (2019), ‘Dealing with the next downturn: From unconventional monetary policy to unprecedented policy coordination’, SUERF Policy Note, Issue No 105. Available at: <https://www.suerf.org/policynotes/8209/dealing-with-the-next-downturn-from-unconventional-monetary-policy-tounprecedented-policy-coordination>. The Board also reviewed the experience of other advanced economies with unconventional monetary policy measures at its August 2019 meeting. See Lowe P (2019), ‘Unconventional Monetary Policy: Some Lessons from Overseas’, Address to Australian Business Economists Dinner, 26 November. Available at: <https://www.rba.gov.au/speeches/2019/sp-gov-2019-11-26.html>. The materials on this webpage are subject to copyright and their use is subject to the terms and conditions set out in the Copyright and Disclaimer Notice. © Reserve Bank of Australia, 2001–2020. All rights reserved. The Reserve Bank of Australia acknowledges the Aboriginal and Torres Strait Islander Peoples of Australia as the Traditional Custodians of this land, and recognises their continuing connection to Country. We pay our respects to their Elders, past, present and emerging. https://www.rba.gov.au/speeches/2020/sp-gov-2020-07-21.html 13/13 | reserve bank of australia | 2,020 | 8 |
Speech by Ms Luci Ellis, Assistant Governor (Economic) of the Reserve Bank of Australia, at the Australian Business Economists Lunchtime Briefing, online, 7 August 2020. | Speech The Economic Outlook Luci Ellis [ * ] Assistant Governor (Economic) Australian Business Economists Lunchtime Briefing Online – 7 August 2020 Thanks to Australian Business Economists for hosting this webcast. A short while ago the Bank Statement on Monetary Policy released its regular (SMP), including details on our updated outlook. But these times are far from regular. Australia, along with the rest of the world, has been subjected to a shock without modern precedent. The COVID-19 pandemic has induced an enormous contraction in the global economy. Labour markets have been severely disrupted everywhere. The policy response has also been enormous, from public health agencies to financial regulators, central banks and fiscal authorities. All arms of public policy are needed to deal with the health crisis and support the recovery. Today I would like to take you through some of the detail on the outlook, and provide some background on the thinking and analysis behind those numbers. Our baseline scenario As we did three months ago, today we are presenting three separate scenarios. We are doing this to provide more guidance on the range of uncertainty in the current environment. There are many potential risks and uncertainties at present. The main one, though, is the spread of the virus, both here and abroad. The difficult situation in Victoria is an example of how quickly this can change. So that is the dimension our various scenarios rest on. I will talk about the upside and downside scenarios later. In the first instance I will focus on the baseline scenario, while being mindful of the uncertainty surrounding it. Different countries have had different experiences with the pandemic (Graph 1; Graph 1.1 in the SMP). In one group of countries, including the United States and a range of emerging market economies, COVID-19 infection rates have escalated. Another group of countries, including South Korea, China, New Zealand and much of Western Europe, have so far managed to get infection rates down and keep them there. In a third group of countries, infection rates had been at low levels but have since escalated in fresh outbreaks. This group includes Australia but also Japan and a range of countries in Eastern Europe. These differing experiences will necessarily shape both the initial contractions and the subsequent recoveries in each economy. But in most cases, we can see the same broad narrative. There is an initial phase of an extremely large and sudden contraction in activity, as governments impose lockdowns and other activity restrictions in order to control the virus, and people engage in voluntary social distancing in response to concerns about the virus. This phase has generally lasted a couple of months. As infection rates fall and activity restrictions are eased, activity begins to recover quite quickly over the course of the next few months. Graph 1 The phase of rapid recovery is usually only partial, however. With a few more months behind us, it has become clear that activity has not fully returned to pre-outbreak norms. This is apparent from data on the movement of people (Graph 2; Graph 1.2 in the SMP), and in more conventional economic indicators and surveys. Graph 2 There are a number of reasons why activity is unlikely to bounce back completely after lockdowns end. Firstly, some activity restrictions usually remain even after the most stringent lockdown measures are lifted. Secondly, some people continue to engage in some social distancing beyond what is mandated. Thirdly, and probably most importantly, the deficiency in demand and a general increase in uncertainty induces people and firms to be more cautious in their spending decisions. So demand remains weak for some time. This lingering effect of the pandemic on uncertainty and demand means that, beyond the first couple of months, recoveries will be protracted and uneven. It will take time to get back to the level of global GDP prevailing before the pandemic. Taking 2020 as a whole, global GDP is expected to contract by more than 4 per cent, before rising by nearly 6 per cent in 2021. If realised, this outcome would still leave GDP below where it would have been had the outbreak not occurred. The pattern is very similar for Australia's major trading partners, though the contraction occurred earlier and the recovery is expected to be a bit more vigorous in China than in our other major trading partners (Graph 3; Graph 1.7 in the SMP). Graph 3 In Australia, the story is fairly similar (Graph 4; Graph 6.1 in the SMP). We estimate that activity contracted severely in the June quarter of this year, but began to recover late in the quarter. The situation in Victoria will reduce growth in the September quarter and push out the recovery beyond that. That said, activity is expected to continue to recover in much of the country over the rest of this year and next. The recovery is expected to be slow and uneven, and GDP will probably take several years to return to the trend path expected prior to the virus outbreak. Graph 4 A contraction in demand of this size represents an enormous shock to the labour market. Employment declined by more than 850,000 in April and May. Although some people regained employment in June, the unemployment rate increased by more than 2 percentage points over these three months. The increase would have been much greater were it not for the JobKeeper program preserving many employment relationships over this period. We expect that employment and total hours worked will decline over the next few months, partly because of the increased activity restrictions in Victoria. Elsewhere, the recovery in employment and hours should continue, but there could be setbacks. Payroll data suggest that the recovery in employment began to falter in the second half of June and into July, even before the lockdown in Melbourne came into effect. In this baseline scenario, we expect the unemployment rate to continue to increase over the rest of this year (Graph 5; Graph 6.2 in the SMP); indeed, unemployment is expected to increase in all three scenarios. The current activity restrictions in Victoria will result in some further job losses there. In addition, an unusually large fraction of people did not actively look for work in April and May, because there are in many cases simply no suitable jobs to apply for during periods of activity restrictions. So they are recorded as having left the labour force, not as unemployed. Over time, and as job opportunities become more evident, we expect that many of these people will start actively looking for jobs again. This increase in labour force participation is expected to outpace any recovery in employment outside Victoria in the second half of this year. Graph 5 The main driver of the initial contraction has been consumption. Many categories of consumption were simply not permitted during the height of the lockdowns. Even now, some are still not permitted, such as overseas tourism. People substituted by spending on other things – in particular, they bought goods rather than services. But substitution can only go so far, so quickly. We estimate that household consumption declined over 10 per cent over the first half of the year. We expect consumption to recover some of this decline quite quickly; in fact, it already has. Part of this is a response to the expansion in consumption opportunities as businesses reopen. It is also made possible because there has been income support to help to sustain this. Although many people lost their jobs over recent months, government support has meant that total household income has not fallen in aggregate. This has been a surprising outcome of the current episode. On top of the income transfers, many households have added to their available cash flow by withdrawing from their superannuation (Graph 6; Graph 3.12 in the SMP). Graph 6 Closure of international borders to most movements of people is affecting Australia's international trade and will continue to do so over the forecast period. International tourism will be infeasible until borders reopen, and will probably only recover slowly. This will affect both services exports and imports; before the pandemic, tourism imports – spending by Australians travelling overseas – substantially exceeded tourism exports. Education exports are also an important component of Australia's international trade. This includes spending by foreign students when they are in Australia, as well as direct revenues such as university fees. Many students did manage to get to Australia before the borders closed. So, unlike tourism, this component of services exports will not fall to essentially zero, but it has fallen significantly. We project that education exports will remain broadly stable over the next year. This expectation is predicated on the assumption that allowances will be made for some international students to arrive for the start of the 2021 academic year. Business investment is likely to be weak in the near term and will take some time to recover. This is only partly a result of the activity restrictions. For example, construction activity was able to continue during Stage 3 restrictions. Site shutdowns in response to virus outbreaks have also been quite rare. So non-residential construction projects that were already underway have been mostly able to continue. However, the announced Stage 4 restrictions in Melbourne limit the number of workers on a site, and so will constrain commercial and residential construction activity there. The main reason for the weak investment outlook, though, is that many businesses across Australia have put investment plans on hold in response to the environment of weak demand and heightened uncertainty. This has been a particular issue for machinery and equipment investment, because this category of investment spending is more sensitive to demand conditions. Dwelling investment is also expected to be weak in the period ahead. This is partly a function of the mandated reductions in activity in Victoria over coming months, and weak incomes and employment, as well as more generalised uncertainty weighing on people's decisions to buy homes. Demand will also be reduced during the period that international borders are closed, because population growth will be significantly lower. The HomeBuilder policy is expected to provide some countervailing support in the near term, mostly for detached home building. Weak demand for housing is already affecting the market for rental housing. Many people changed their living arrangements in recent months to save money during the period of lockdown. The decline in international visitors and domestic business travellers, because of travel restrictions, has also encouraged some landlords to offer their short-term rental accommodation on the long-term market. That response increases the available rental stock. As a result, rental vacancy rates have increased significantly in Sydney and Melbourne (Graph 7; Graph 3.18 in the SMP). Many tenants have obtained discounts on their existing rental agreement. Advertised rents have also fallen of late. We expect that demand for rental housing will remain weak for a while yet. With international borders closed, immigration to Australia has essentially halted and so population growth will slow noticeably. Weak labour market conditions will also discourage some people, especially young people, from forming new households. Graph 7 The weak outlook for rents is one of the factors that is likely to weigh on inflation over the next couple of years. Temporary factors are driving large movements in inflation in the June and September quarters. Headline CPI declined by 2 per cent in the June quarter. This decline is entirely accounted for by two factors: the fall in petrol prices and the decision to make child care (and some preschool) free. Growth in some other prices, including groceries, was higher than it had been in some years. Large movements in prices in both directions, as well as some measurement challenges, make the underlying trend in inflation harder to discern. We can look through these effects as much as possible, by using various measures of underlying inflation. This suggests that the underlying trend declined to be closer to zero in the quarter rather than the large negative recorded in the headline CPI. Most of the decline in headline CPI will reverse in the September quarter. Petrol prices increased a little in recent months, and fees for child care and preschool are being progressively reintroduced. So there will be some further volatility in the headline inflation figures. This volatility will be less evident in the various underlying measures. Beyond the next quarter or so, we expect inflation to be low (Graph 8; Graph 6.5 in the SMP). Spare capacity in the economy and the resulting weak growth in labour costs are likely to put downward pressure on inflation for some time. We expect inflation to increase a little as the economy recovers. Unsurprisingly this pick-up is a bit faster in the upside scenario than the baseline. And in the downside scenario it can be expected to take quite a while before turning around. While the overall spare capacity in the economy is the main driver of the inflation outlook, some other factors will also be important. As well as the expected weakness in rents, weak demand for housing will affect prices of new homes, though changes in supply will also matter. Governments could also decide to reduce pressures on the cost of living by freezing or lowering administered prices, as we have already seen for child care and preschool. It is uncertain how all these forces will play out. Graph 8 The upside and downside scenarios The course of the virus is very uncertain, and so will be people's responses to it. Given this uncertainty, we have again presented the outlook in the form of three scenarios, complementing the baseline scenario I have just described with an upside and a downside scenario. The baseline scenario is based on the assumption that infection rates in Australia subside. The recent tightening of restrictions in Victoria is assumed to be successful and there are no new lockdowns imposed elsewhere. Restrictions are assumed to be eased progressively over the rest of the year. The upside scenario also assumes that infection rates fall quickly and stay low. The pace of decline in case numbers is assumed to be a bit faster than in the baseline, so the restrictions are eased a bit faster. This would be similar to the experience of some of the smaller states in recent months. People also take more comfort from this and confidence recovers faster than in the baseline scenario. Households are therefore willing to spend more of the savings they accumulated during the first half of this year, compared with what is assumed in the baseline scenario. The downside scenario assumes that infection rates continue to escalate around the world this year and next. Australia itself faces a series of outbreaks and periods of Stage 3 or 4 restrictions in some states. The result is further near-term weakness in activity. Confidence is damaged and so the recovery is much slower as well. The extent of the damage would depend on how widespread and long-lasting renewed restrictions need to be to get control over the spread of the virus. The other main point of variation between these three scenarios is how long Australia's international borders remain closed. Three months ago, we were assuming that travel restrictions would be lifted by the end of this year. Our current scenarios are based on an assumption that it is more likely that our borders will remain closed to most travellers until at least the middle of next year. Some longerterm visitors, such as those on student visas, are assumed to begin arriving early next year, subject to appropriate quarantine restrictions. But tourists and other short-term visitors will not be able to return until later. In the baseline and upside scenarios, we assume that the borders reopen in mid 2021. In the downside scenario, where the global spread of the virus does not subside as quickly, we assume the borders are closed for all of 2021. It is always possible to construct other scenarios. The near term would be stronger if there were a major medical breakthrough on treatments soon. An effective vaccine would take a bit longer to be distributed, so it would mainly affect outcomes next year and the year after. But it could also result in a stronger recovery than we have assumed even in the upside scenario presented here. A worse outcome than our downside could be conceivable if the virus cannot be contained and further waves of infection occur around the world for some years yet. There are also plenty of other risks that can be contemplated; we discuss some of these in the Statement. Geopolitical tensions were an issue even before the coronavirus outbreak, and could escalate further. The pandemic has also in some places exacerbated domestic political tensions. It is hard to know how these tensions will play out over the next couple of years. If they escalate, it is possible that some countries' recoveries will be derailed. Domestically, there are also a number of uncertainties that go beyond the direct effects of the virus and associated activity restrictions. For example, we have assumed that households and businesses are quite cautious in their use of the fiscal and other cash flow support they have been receiving. It is possible that people spend more out of that support than we are assuming. It is even possible that some people do more to make up for the consumption opportunities that were not available during periods of lockdown and other activity restrictions. On the downside, the longer the economy remains weak, the more the recovery will be impeded by scarring effects on workers, the destruction of business supply networks and other lingering damage. What has changed in the past three months The scenarios presented in the past few months. Statement incorporate several lessons from the experience of the First, the economic contractions induced by health-related restrictions on activity in the June quarter were very large. However, they were not quite as severe as initially expected. The peak-to-trough declines in output and hours worked have been smaller than we had expected in May. This seems to have been partly because the restrictions in Australia didn't amount to a complete lockdown, and partly because they were lifted a bit earlier than expected. Another reason for the smaller contraction was, as noted earlier, that fiscal transfers did a lot to replace lost income. This has helped sustain employment through periods of lockdown. It has also supported household consumption, which has recovered sooner than expected. A similar pattern has been evident in other advanced economies. Second, while the part of the contraction directly attributable to initial health measures turned out to be smaller, general uncertainty and responses to weak demand seem to have accounted for more of the downturn in output and the labour market than earlier envisaged. This has been evident in the industry pattern of employment effects, as well as the weakness in investment intentions both in Australia and abroad. After an initial rebound in payroll jobs in the most affected industries, the recovery in the labour market has been quite patchy. Consequently we now think that, even though the initial contraction was smaller, the subsequent recovery is likely to be more protracted and progress on reducing unemployment will be slower. Third, and related to the previous point, while the decline in total hours worked was smaller than we thought, it was tilted more to job losses rather than declines in average hours than expected (Graph 9; Graph 6.3 in the SMP). And more of the people who exited employment left the labour force entirely. This implies that there is more spare capacity in the labour market than a straight read of unemployment would suggest. Graph 9 Fourth, over the first half of the year, fiscal policy measures managed to keep aggregate household income broadly steady at the same time that household consumption contracted substantially. Some households have therefore built up buffers of savings – intentionally or otherwise – that they would not normally have accumulated. Similarly, recent withdrawals from superannuation could be used to tide some households over in a period of income loss. Household incomes are forecast to decline later in the year when JobKeeper starts to taper off and the mutual obligation conditions for JobSeeker are reimposed. But partly because of these accumulated savings, we do not expect this temporary setback to incomes to derail growth in household consumption. Fifth, the large persistent rise in case numbers in Victoria and the ensuing introduction of Stage 4 restrictions there were not anticipated. This is not exactly a lesson for our earlier forecasts, but it does show how quickly things can change in a pandemic. Policy and forecasts The Statement on Monetary Policy contains more detail on the outlook and other issues that I have not covered today. It represents the culmination of our analysis of the economy and financial markets over the past few months, and is the product of the hard work of many Bank staff. In my talk today I have focused on the Bank's outlook rather than all the other material presented in the or the details of the fiscal and monetary policy response. These have been discussed in Statement detail elsewhere. I would nonetheless like to conclude with a few brief remarks on how both fiscal and monetary policy have shaped our view of the economic outlook. The COVID-19 pandemic has been the most profound shock to the economy and society in many decades. All arms of public policy need to pull together to combat the spread of the virus and support the economy through the recovery. Monetary and fiscal policy are key parts of the response. The package of measures introduced by the Reserve Bank Board in mid March are intended to support the Australian economy by keeping funding costs low and credit available. The Board's assessment is that so far these measures are working as intended. Funding costs for banks, firms and households are all very low. Credit remains available and other policies have meant that borrowers in difficulty have been able to defer their repayments if needed. Likewise the transfers to households and businesses coming from fiscal policy have supported incomes during this difficult period and provide a platform for the recovery. The JobKeeper program and various support for businesses have also ensured that employment relationships have been preserved to date and viable businesses can tide themselves over the period of disruption. On Tuesday, the Board affirmed its commitment to do what it can to support jobs, incomes and businesses in Australia. It will maintain this accommodative approach for as long as this support is required, to help build the bridge to the recovery. Endnotes [*] My thanks to the many colleagues in Economic Group involved in putting these forecasts together, as well as colleagues from Financial Markets Group and Communications Division who also contribute to the . Monetary Policy Statement on The materials on this webpage are subject to copyright and their use is subject to the terms and conditions set out in the Copyright and Disclaimer Notice. © Reserve Bank of Australia, 2001–2020. All rights reserved. The Reserve Bank of Australia acknowledges the Aboriginal and Torres Strait Islander Peoples of Australia as the Traditional Custodians of this land, and recognises their continuing connection to Country. We pay our respects to their Elders, past, present and emerging. | reserve bank of australia | 2,020 | 8 |
Opening statement by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, online, 14 August 2020. | Philip Lowe: Opening statement to the House of Representatives Standing Committee on Economics Opening statement by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, online, 14 August 2020. * * * Much has changed in the world since we last met in February. We have experienced a global pandemic, the biggest peacetime contraction in the Australian economy in nearly a hundred years and extraordinary monetary and fiscal policy measures. This all means that many of the challenges we face today were hardly imaginable just six months ago. Economic forecasting is very difficult at a time like this, but the RBA released its regular economic update last Friday in the Statement on Monetary Policy. I will begin by highlighting some of the main points from this update and then turn to the policy response. We do not yet have the GDP data for the June quarter, but it will show the biggest economic contraction in many decades, likely to be around 7 per cent. If there is any good news to be found here, it is that this decline is not as large as initially feared. Similarly, while the labour market outcomes have been poor, they have not been as bad as expected. Hours worked were initially expected to fall by a staggering 20 per cent over the first half of this year. The actual fall has been around half of this, largely due to Australia’s initial success in containing the virus and the earlierthan-expected easing of some restrictions. Looking forward, there is a high degree of uncertainty about the outlook and our economic recovery depends upon how successful we are in containing the virus. In our baseline scenario, we are expecting the Australian economy to contract by around 6 per cent this year, and then grow by 5 per cent next year and 4 per cent in 2022. It is possible that we will do better than this if there is near-term success in containing the virus or there are medical breakthroughs. On the other hand, if we were to see further setbacks in containing the virus, the recovery would be delayed even further. Given this uncertain outlook, we should be prepared for a recovery that is uneven and bumpy. The recovery is also likely to be more drawn out than was initially expected despite the downturn being less severe than expected. There are a few factors at work here. The most obvious is the outbreak in Victoria. At a personal level this is very distressing, and on behalf of the staff of the RBA I extend best wishes to everybody in Victoria. And on the economic front, we expect the outbreak will reduce GDP growth in the September quarter by at least 2 percentage points. This will broadly offset the recovery that has been taking place in most other parts of the country. As a result, we are now not expecting a lift in economic growth until the December quarter. Another consideration is the growing impact of an extended period of weak aggregate demand. In the initial phase of the pandemic some firms were able to keep going because they had a pipeline of work to keep them busy – the construction industry is a good example. But with new contracts having been scarce over recent months, this pipeline is being emptied for many firms and they are having to scale back. Critical to reversing this is stronger growth in aggregate demand. A third consideration is that people’s attitudes to spending are changing because of the pandemic. It is probable that households and businesses will remain more cautious and that this will affect consumption and investment. How long this change might last is hard to tell, but we are unlikely to see a quick return to the previous patterns. 1/5 BIS central bankers' speeches Given these considerations, our baseline forecast is that the unemployment rate continues to increase, reaching around 10 per cent later this year. Unemployment would have been substantially higher if it were not for the JobKeeper and other income support programs. And, if we take into account people who are on zero hours, the true unemployment rate is higher than the published measure. We are expecting the published unemployment rate to decline gradually from 10 per cent, but to still be around 7 per cent in a few years’ time. As I will come back to later, addressing this should be high on our list of national priorities. In all three scenarios published in our latest update, inflation is likely to be very low. Inflation fell into negative territory in the June quarter for the first time since the early 1960s. While grocery prices and prices of some other items rose, this was more than offset by the decline in oil prices and governments’ decisions to make child care (and some pre-school) free. We are expecting inflation to return to positive territory in the current quarter, but to average between only 1 and 1½ per cent over the next few years. Wage growth is also expected to be low, averaging 1½ per cent over the next two years. I would now like to turn to the economic policy response. As the pandemic evolved in the early days of March, it became clear that a very significant monetary and fiscal response would be required. By virtue of my role as Governor of the RBA, I have been able to see first-hand how this support has been put in place. What struck me from the outset was the very strong sense of common mission from our political leaders, our regulators, our banks and the RBA itself. That common mission was to support the Australian economy through this difficult period. The level of cooperation and coordination was extraordinary and there was a real ‘Team Australia’ mindset. In my view, this reflects positively on both Australia’s political system and our institutions. From the outset, there was a strong sense that we needed to build a bridge to the other side, when the virus is contained. As things have turned out, that bridge has had to be longer and stronger than we might have hoped would be necessary. Even so, it has been the right strategy. At some point the virus will be contained and those foundations that have made Australia such a prosperous country will still be there. We will be better placed to build on those foundations if we have limited the damage to the fabric of our economy and our society while we are battling the pandemic. In terms of the RBA’s own response, that began with a cut in the cash rate at our regular meeting on 3 March. The Reserve Bank Board then held an extraordinary meeting just two weeks later, where it decided on a comprehensive package that included: a further reduction in the cash rate to 25 basis points the introduction of a target on three-year Australian Government bonds of 25 basis points a Term Funding Facility for the banking system under which funds can be provided for three years at 25 basis points the continued use of our open market operations to make sure that the financial system has a high level of liquidity the modification of the interest rate corridor system, with the rate paid on Exchange Settlement balances set at 10 basis points, rather than zero. This package is designed to keep funding costs low across the economy and support the provision of credit, especially to small and medium-sized businesses. To support these businesses, the Term Funding Facility provides banks with an additional five dollars of low-cost funding for every extra dollar of credit extended to them. Many other central banks have announced similar packages, although the Bank of Japan is the 2/5 BIS central bankers' speeches only other central bank with a yield target; in their case, it is a target for 10-year yields. In announcing our yield target, the Bank indicated that we are prepared to buy bonds in the secondary market in whatever quantity was needed to achieve the target. To date, overall bond purchases have totalled around $55 billion, with most of these bonds bought in March and April. These purchases have had the desired effect, lowering yields and they eased the market dislocation at the time. In the past week or so, we have again purchased bonds, buying around $6 billion. We have done this following a few weeks in which the yield on three-year bonds had been trading consistently a little above 25 basis points. The yield is now closer to 25 basis points and we are committed to maintaining the target. In taking the decision in March to target the three-year yield, the Board considered the possibility of instead undertaking a regular program of bond purchases – say buying a set dollar amount of bonds each week – as a number of other central banks have done. We chose the yield target for a couple of reasons. The first is that it is a more direct way of achieving our objective of low funding costs. A bond purchasing program would have also lowered bond yields, but it would have done this indirectly, and there would have been challenges in calibrating the required size of these purchases. Directly targeting a longer-term risk-free interest rate is also a natural extension of our target for the cash rate, which is the risk-free interest rate at the very start of the yield curve. The second reason is that this target reinforces the forward guidance regarding the cash rate. The Board has clearly indicated that it will not increase the cash rate until progress is being made towards full employment and it is confident that inflation will be sustainably within the 2– 3 per cent target range. Given the outlook I discussed earlier, these conditions are not likely to be met for at least three years. So it is highly likely that the cash rate will be at this level for some years and having a target for three-year yields of 25 basis points reinforces this message. So that is our rationale. We have not ruled out a separate bond buying program, or other adjustments to the mid-March package. But for the time being, the Board’s view is that the best course of action is to continue with the current package. The Board recognises that in the unique circumstances in which the country finds itself, the solutions to the challenges we face lie in areas other than monetary policy. Having said that, the mid-March package is providing material help now and it will continue to do so. Interest rates are lower than they have ever been before and the financial system is flush with liquidity. Also helping is the fact that the Australian financial system is in good shape. We went into the pandemic with strong balance sheets and high levels of capital in the Australian banking system. This means that our financial institutions are well placed to provide the credit that the economy will need. One monetary policy option that has been the subject of public discussion over recent months is the possibility of the RBA creating money to directly finance government spending. For some, this offers the possibility of a ‘free lunch’. The reality, though, is that there is no free lunch. There is no magic pudding. There is no way of putting aside the government’s budget constraint permanently. As I spoke about in a talk last month, it is certainly possible for a central bank to use monetary financing to affect when and how government spending is paid for. Depending upon how things are managed, it can be paid for through the inflation tax, by implicit taxes on the banking system and/or higher general taxes in the future. But it does have to be paid for at some point. 3/5 BIS central bankers' speeches I want to make it clear that monetary financing of the budget is not on the agenda in Australia. The separation of monetary policy and fiscal financing is part of Australia’s strong institutional framework and has served the country well. The Australian Government and the states and territories have ready access to the capital markets and they can borrow at historically low rates of interest. At a more practical level, I would like to mention a couple of other areas where the RBA has been providing assistance with Australia’s COVID-19 response. The first is as transactional banker for the Australian Government. Over recent months the RBA’s banking systems have been used to make record numbers of payments, processing the Government’s income support to households and businesses. We have done this with around 90 per cent of our staff working from home and it has been a great effort by the RBA’s banking and payments teams. The second is meeting the increased demand for banknotes. While COVID-19 has accelerated the shift to electronic payments, there has, paradoxically, also been record demand for banknotes. Some people seem to be wanting to keep some extra money at home. The result has been that the stock of banknotes on issue has increased from $83 billion in February to $94 billion today. We have met this extra demand despite our main storage vault being located in one of the coronavirus hotspots in Melbourne. I would like to close with some general comments about the economic policy response to the pandemic. While monetary policy has played an important role, it has been fiscal policy that has provided much of the support to the Australian economy. This is quite a change from how things have worked over recent decades and it is being accompanied by a significant increase in public borrowing as governments work to limit the hit to people’s incomes. This shift in fiscal policy is quite a shock for a country that has got used to low budget deficits and low levels of public debt. In that context, it is worth pointing out that: By borrowing today to support the economy we are avoiding an even bigger loss of output and jobs that would damage our economy and society for years to come, which would put ongoing strain on the budget. Australia’s public finances are in strong shape and public debt here is much lower than in most other countries. The overall national balance sheet is also in a strong position after decades of good economic performance. Government’s financing costs have never been lower, with interest rates being the lowest since Federation. This all means that the expected increase in public debt is entirely manageable and is affordable. It is the right thing to do to borrow today to help people, keep them in jobs and boost public investment at a time when private investment is very weak. There will always be debates about the precise nature of programs and about how much support should be provided, but the general strategy that we have is the right one. Looking forward, an important priority will be to boost jobs. Based on the forecast I discussed earlier, high unemployment is likely to be with us for some time, which should be a concern for us all. The Reserve Bank will do what it can with its policy instruments to support the journey back to full employment. Beyond that, government policies that support people’s incomes, that add to aggregate demand through direct government spending and that make it easier for firms to hire people all have important roles to play. We need to make sure that Australia is a great place for businesses to expand, invest, innovate and employ people. 4/5 BIS central bankers' speeches Thank you. My colleagues and I are here to answer your questions. 5/5 BIS central bankers' speeches | reserve bank of australia | 2,020 | 8 |
Speech by Mr Guy Debelle, Deputy Governor of the Reserve Bank of Australia, at the Australian Industry Group Virtual Conference, 22 September 2020. | 22/09/2020 The Australian Economy and Monetary Policy | Speeches | RBA Speech The Australian Economy and Monetary Policy Guy Debelle Deputy Governor Australian Industry Group Virtual Conference – 22 September 2020 My talk today will cover three topics. First I will provide a perspective on the historic decline in output that both the Australian and global economies have experienced and discuss the current state of the economy. Second I will explain how the monetary policy actions the Reserve Bank has taken are working to support the Australian economy, complementing the large fiscal response. Finally I will outline possibilities for further monetary policy action should the Reserve Bank Board decide that it is warranted. The Economic Impact of the Pandemic The pandemic has resulted in a historic decline in output in the Australian and global economy. Graph 1 shows the GDP outcomes for a range of economies. It is a truly daunting picture in terms of the size and the synchronised nature of the declines. https://www.rba.gov.au/speeches/2020/sp-dg-2020-09-22.html 1/13 22/09/2020 The Australian Economy and Monetary Policy | Speeches | RBA Graph 1 GDP Growth Quarterly contributions % % -5 -5 -10 -10 -15 -15 -20 -20 First-half 2020 March quarter 2020 June quarter 2020 -25 -30 -30 C hi Vi na et na Ta m So iw an ut h K H o on re g a Ko N ng or w Au ay st In ralia do ne Sw sia ed en Ja N p et an h U erl ni an te d ds St G ate er s m a Th ny ai la C nd an N ew ad Ze a a Si lan ng d ap Eu or ro e ar ea Ita l M al y ay si Fr a Ph anc U ni ilip e pi te n d Ki es ng do m Sp ai n In di a -25 Sources: ABS; RBA; Refinitiv What explains the large variation in outcomes across countries? Part of the explanation is the nature and management of the virus' impact. Some countries were affected more severely by the virus and had mobility restrictions for longer. There is a strong positive correlation between measures of mobility and GDP outcomes. Some part of the difference reflects the behavioural response of people beyond the direct effect of mobility restrictions. Those behavioural responses are having a significant impact on the shape of the economic recovery. A third source of variation is the share of the service sector of the economy, which has been most affected by shutdowns. That is evident in countries like France and Spain where tourism is a sizeable part of the economy. The notable exception is the Chinese economy. It experienced a 10 per cent decline in the March quarter of 2020 but reversed that decline in the second quarter such that output was actually a little higher than at the end of 2019. This reflects the earlier incidence of the virus and consequently the earlier relaxation of restrictions. There has also been substantial fiscal policy support in China, though not so much from monetary policy. The form of the fiscal support has been different to that in other countries. It has been directed at bolstering production rather than the income support that has comprised the bulk of the fiscal support in many other countries, including Australia. As a result, industrial production has recovered strongly whereas the rebound in retail spending has been considerably less (Graph 2). The strength of the industrial and construction sectors has seen strong demand for iron ore, with prices at multi-year highs. https://www.rba.gov.au/speeches/2020/sp-dg-2020-09-22.html 2/13 22/09/2020 The Australian Economy and Monetary Policy | Speeches | RBA Graph 2 China – Activity Indicators December 2019 = 100 index Industrial production Retail sales index D J F M A M J J A D J F M A M J J A Sources: CEIC Data; RBA Turning to Australia, GDP declined by 7 per cent in the June quarter. This is the largest peacetime economic contraction since the 1930s. While the decline was less than initially feared, it is still historically large. There are a number of aspects of the outcome that are worth noting: First, while GDP and employment recorded very large declines, household income actually rose. This is quite a remarkable and highly unusual outcome. Normally in recessions, household income falls along with the decline in output and employment. This time that hasn't happened because of the income support from the Government through JobKeeper and JobSeeker. In addition, household cash flows have been boosted by the superannuation withdrawals and lower interest rates, as well as the deferral of interest and rent payments (though in the latter case, they reduced income for other households). not The fact that household income rose in the quarter does mean that the stimulus was overdone. Absent the stimulus, the decline in GDP and employment would have been significantly larger and there would have been much greater financial hardship. That households saved a large amount of this income support means that their balance sheets are in a considerably better place than would normally be the case in a recession. They are better placed to support the recovery as it unfolds. The transfer from the strong balance sheet of the government to bolster the balance sheet of the household sector is an entirely appropriate and timely policy response. https://www.rba.gov.au/speeches/2020/sp-dg-2020-09-22.html 3/13 22/09/2020 The Australian Economy and Monetary Policy | Speeches | RBA Second, business incomes were also supported by the JobKeeper payments, as well as loan and rent deferrals. Nevertheless, business investment declined by 4 per cent in the quarter, as the large rise in uncertainty significantly curtailed investment plans. [1] The effect of the uncertainty has significantly outweighed the stimulatory effect of the decline in business borrowing costs. [2] The decline in investment would have been larger absent the effect of the instant asset write-off, which was evident in a pick-up in business spending on computer equipment and vehicles towards the end of the June quarter. Turning to the labour market, hours worked remains a useful way to gauge what is happening, given the impact of JobKeeper on other measures of the labour market. Hours worked declined by 10 per cent from peak to a trough around early May. Since then they have grown by around 6 per cent nationally, though that is being held back by the impact of the lockdown in Victoria. The unemployment rate in August was 6.8 per cent, which was better than expected. However, the recovery in the labour market is likely to be bumpy and uneven and we still expect the unemployment rate to rise from here. The CPI outcome for the June quarter was affected by a number of unusual developments. My colleague Luci Ellis talked about this in detail last month. [3] Inflation is being affected by some very large relative price movements. There were large declines in child care costs and petrol, both of which will be partly reversed in the current quarter, while some retail prices rose at a relatively rapid rate in the June quarter. I do not see there is any risk of a sustained rise in inflation while there remains considerable spare capacity in the economy. In particular, the high unemployment rate will mean that wage growth, which was not strong pre-pandemic, will remain subdued. As wage costs are a major factor affecting prices, inflation will remain contained for some time. Moreover, the declines in rents that were evident in the June quarter as a large amount of extra supply came into the rental market are also likely to persist and will also restrain inflation. We are now nearing the end of the September quarter. How is the Australian economy evolving after that large decline in output? Most indicators of activity and the labour market troughed in early May. Since then we have seen a recovery in a number of these indicators, though there has been substantial variation across the country. I will illustrate this using the payrolls data (Graph 3). https://www.rba.gov.au/speeches/2020/sp-dg-2020-09-22.html 4/13 22/09/2020 The Australian Economy and Monetary Policy | Speeches | RBA Graph 3 Payroll Jobs by State* Week ending 14 March 2020 = 100 index index WA NSW SA Qld Tas Vic M A M J J A M A M J J A M A M J J A * Excludes firms not reporting through single-touch payroll and self-employed persons Sources: ABS; RBA The strongest recovery has been in WA. Part of this reflects the turnaround in investment in the resources sector that was already in train before the onset of the pandemic. There has also been a sharp rebound in activity in the housing sector in WA boosted by the support from both the federal and state governments. The pick-up in WA has been such that some of the Bank's business liaison contacts are reporting that in some skill areas they are finding it hard to find labour, particularly with the border closures. At the other end of the scale is Victoria, where the impact of the lockdown is very evident. We estimate that the lockdown in Victoria has subtracted around 2 per cent from national GDP in the September quarter. Overall, the recovery has not been a rapid bounce but more of a slow grind. The virus is having its effect, particularly because of the lockdown in Victoria, but so too is the shortfall in demand that occurs in recessionary conditions. That shortfall in demand will be a significant brake on the recovery. Until households and businesses are confident about future demand and income, they will be reluctant to spend and invest. The Effect of Monetary Policy Actions Fiscal policy is having the largest impact in shaping the outcomes in the economy. But the monetary policy actions are also having a material influence. The monetary policy action taken by the Reserve https://www.rba.gov.au/speeches/2020/sp-dg-2020-09-22.html 5/13 22/09/2020 The Australian Economy and Monetary Policy | Speeches | RBA Bank since March has a number of elements which complement each other. They are aimed at supporting the recovery by lowering borrowing rates for households and business as well as the government and supporting the supply of credit. The various monetary policy actions have led to a significant increase in the size of the RBA's balance sheet from $170 billion in February to $300 billion currently. I will spell this out in more detail shortly. The consequent large amount of liquidity in the system is underpinning low money market rates for the financial system; the cash rate and bank bill swap rates (BBSW) are at historic lows (Graph 4). Given these rates underpin the whole spectrum of bank funding costs, funding costs have declined to historically low levels. These low funding costs have been passed through to record low borrowing costs for households and businesses. Graph 4 Australian Money Market Rates % % 3-month BBSW 2.0 2.0 Cash rate 1.5 1.5 1.0 1.0 0.5 0.5 0.0 0.0 Sources: ASX; RBA The cash rate target was reduced to 25 basis points. The traded cash rate sits below that at 13– 14 basis points given the abundance of liquidity in the system, reflected in the large rise in Exchange Settlement (ES) balances. [5] ES balances have risen to around $50 billion and were as high as $90 billion in recent months; considerably larger than the $2–3 billion that prevailed before the pandemic. The low level of the cash rate is anchored by the interest rate paid on banks' ES balances at the RBA, which is set at 10 basis points. The high level of ES balances is the result of a number of actions by the Reserve Bank. First, it reflects the large provision of liquidity in the early days of the pandemic through the Bank's daily market operations. [6] Second, it is a direct consequence of the Bank's purchases of government https://www.rba.gov.au/speeches/2020/sp-dg-2020-09-22.html 6/13 22/09/2020 The Australian Economy and Monetary Policy | Speeches | RBA bonds. When the Reserve Bank buys bonds in the secondary market, it directly boosts the banking system's deposits. Third, the funds provided under the Term Funding Facility (TFF) have substantially increased liquidity. These funds are lent by the RBA to the banking system for a term of three years and at a fixed rate of 25 basis points. The initial allowance of the TFF was 3 per cent of credit extended by the banking system or $84 billion. That allowance has been gradually taken up over the past six months, and particularly in recent weeks, such that take-up currently stands at $75 billion. Different types of institutions, whether large, medium-sized or small, have accessed similar shares of funding from the TFF. The Reserve Bank Board announced an extension of the TFF following its September meeting. This amounts to an additional 2 per cent of credit, and is available to be drawn until June 2021. [7] Why did the Board take this decision? Given the protracted nature of the recovery, the Board considered it appropriate to provide more funding and for a longer period to support the Australian economy in the recovery. The larger amount of funding available, at least 5 per cent of total credit, is a further easing in the stance of monetary policy. It will result in a further material expansion of the RBA's balance sheet for the next three years. What impact are we seeing from the take-up of the TFF? First, the TFF has lowered lending rates by lowering bank funding costs. The TFF funding is considerably cheaper than wholesale funding of similar maturity. Second, it is having a noticeable effect on the composition of bank funding. It is important to keep in mind that funding is fungible for banks. It is not possible to say to what purpose particular sources of funds are being put or which they are replacing. But the funding structure of the banking system has changed significantly over the past six months as a result of the TFF together with the increase in deposit funding. There has been a reduction in offshore wholesale funding, which is of a very similar size to the takeup of TFF funding (Graph 5). The amount of domestic wholesale funding is little changed. Banks have chosen to let their offshore funding roll off as it matures. https://www.rba.gov.au/speeches/2020/sp-dg-2020-09-22.html 7/13 22/09/2020 The Australian Economy and Monetary Policy | Speeches | RBA Graph 5 Wholesale Funding of Banks in Australia Amounts outstanding $b $b Offshore bonds Domestic bonds TFF Sources: Bloomberg; Private Placement Monitor; RBA The banks can use the TFF funds to expand their lending, to replace more expensive sources of funding or to buy other assets, including government debt. Funding is fungible, but we can see that all of these options are being taken up by banks. The final element of the Board's package is the target for the three-year Australian Government bond yield. This is a price-based target for bond purchases, rather than the quantitative target for bond purchases announced by many other central banks. You can think of it as an extension of the cash rate target, where the target is for three years rather than overnight. That increased horizon for the target is aligned with the Board's forward guidance, which I will come to shortly. In saying that it is a price-based target, it is important to remember that in maintaining the threeyear yield target the Bank is still buying the quantities of bonds required to achieve that. Those purchases have their effect on maintaining the three-year yield at the target but they also have the same portfolio substitution effect as the quantitative easing programs of other central banks. The three-year yield target is for the Australian Government bond nearest to a three-year maturity (Graph 6). Since the introduction of the target, that bond has been the April 2023 maturity. In a few weeks' time, it will switch to being the April 2024 maturity. There is a reasonable amount of substitutability between these two bonds as they are both in the three-year futures basket. We wouldn't want a dislocative jump as the target bond changes, and indeed we have seen the spread https://www.rba.gov.au/speeches/2020/sp-dg-2020-09-22.html 8/13 22/09/2020 The Australian Economy and Monetary Policy | Speeches | RBA between these two bonds narrow as the market has focused on the transition. The Bank has been purchasing both bonds in our operations in recent weeks to maintain the target. Graph 6 Australian Government Bond Yields % % Target introduced on 19 March 2020 0.75 0.75 0.50 0.50 April 2024 0.25 0.25 April 2023 0.00 J F M A M J J A S 0.00 Source: Yieldbroker It is worth reiterating that there are two related but separate motivations for the Bank's government bond purchases since March. The first is to achieve the Board's target for the three-year Australian Government bond yield. The second objective is to address dysfunction in the Australian and state government bond markets. The three-year yield declined reasonably quickly to the target so it didn't require large purchases to achieve the target. Rather, the bulk of the purchases in March and April was to address dysfunction in government bond markets. [8] The Bank purchased both Australian Government Securities (AGS) and semi-government securities (semis) out to a maturity of 10 years to help restore market function. Since the bond market has returned to functioning normally, purchases have been directed to maintaining the three-year target. The Bank continues to stand ready to purchase both AGS and semis to help support market functioning. I said earlier that the three-year yield target is closely aligned with the Board's guidance about the future direction of the cash rate target. The Board has consistently stated that it will not increase the cash rate target until progress is being made towards full employment and it is confident that inflation will be sustainably within the 2–3 per cent target band. In the August , the forecast was for the unemployment rate to rise to 10 per cent at the end of the Monetary Policy https://www.rba.gov.au/speeches/2020/sp-dg-2020-09-22.html Statement on 9/13 22/09/2020 The Australian Economy and Monetary Policy | Speeches | RBA year and (in the central scenario) to decline gradually to be 7 per cent by the end of 2022. While the recent labour market release indicates outcomes could be better than this, there would still need to be a significant further decline in the unemployment rate before the Australian labour market would be nearing full employment. Prior to the pandemic, the unemployment rate was around 5 per cent. That was not low enough to generate sufficient wage growth consistent with achieving the inflation target. Under the central scenario, it would be more than three years before sufficient progress was being made towards full employment to be confident that inflation will be sustainably within the target band. In this scenario, it is highly unlikely that the cash rate will be raised over that time horizon. This aligns with the target for the three-year bond yield of around 25 basis points. To summarise, the bond purchases and the TFF funding have resulted in a large expansion in the RBA balance sheet. The balance sheet has nearly doubled from $170 billion to $300 billion, which is a substantial easing in monetary policy. In many ways, these actions are as stimulatory as a quantitative easing program of the same size. They are providing substantial liquidity to Australian financial markets and underpinning the historically low level of interest rates. Other Options for Monetary Policy Given the outlook for inflation and employment is not consistent with the Bank's objectives over the period ahead, the Board continues to assess other policy options. The Governor talked about these options at the Anika Foundation event in July. One option considered is to buy bonds further out along the curve, supplementing the three-year yield target. Purchases would still be conducted to maintain the target for the three-year bond, but additional purchases could occur further out the curve on a regular basis. This would have the effect of further lowering government bond rates at longer maturities. Very few financial instruments in Australia price off these yields. This is in contrast to the US where the 10-year Treasury yield is a key pricing benchmark for mortgage rates. The Board has focussed on the three-year yield as the target, because Australian financial instruments price predominantly off the shorter end of the curve. These institutional differences across countries are important and affect the design and transmission of monetary policy actions. Bond purchases have a portfolio balance effect in addition to the interest rate effect. When a central bank buys government bonds, it is exchanging a shorter duration asset (cash) for longer duration one (the bond). This incentivises investors to switch into other assets, including potentially foreign assets, to get that duration exposure. This lowers interest rates on other financial assets and also can contribute to a lower exchange rate. It is difficult to separate the portfolio balance effect from the effect of lower government bond rates empirically. Nevertheless, additional bond purchases would have some effect in lowering longer-term interest rates. The current level of government bond rates is not a constraint on the fiscal decisions of the Australian and state governments. They all have strong balance sheets, with debt stocks that are low relative to other jurisdictions, even taking account of the current sizeable fiscal stimulus. The https://www.rba.gov.au/speeches/2020/sp-dg-2020-09-22.html 10/13 22/09/2020 The Australian Economy and Monetary Policy | Speeches | RBA increase in debt is definitely manageable. Moreover, there is not, in my judgement, a trade-off between debt and supporting the Australian economy in the current circumstance. Absent the fiscal stimulus, the economy would be significantly weaker and debt levels even higher. This is particularly so with interest rates at their historically low levels, where the growth benefit from the fiscal stimulus will improve the debt dynamics and help service the debt in the future. Foreign exchange intervention is another potential policy option. However, with the Australian dollar broadly aligned with its fundamentals, it is not clear this would be effective in the current circumstances. The Swiss experience over the past decade (ahead of the introduction of the ceiling on the Swiss franc) illustrates the issues that can arise in terms of the effectiveness of foreign exchange intervention when a currency is not far from its fundamental value. It is also important to remember that the exchange rate is a relative price. Part of the recent movements in the Australian dollar reflects the depreciation of the US dollar against other major currencies. It also reflects the high price of iron ore I mentioned earlier. The relatively better growth outcomes in Australia compared with other economies shown in Graph 1 are having an influence too. That said, a lower exchange rate would definitely be beneficial for the Australian economy, so we are continuing to watch developments in the foreign exchange market carefully. A third option is to lower the current structure of rates in the economy a little more without going into negative territory. The remuneration on ES balances is currently 10 basis points, the three-year yield target is at 25 basis points and the borrowing rate of the TFF is also 25 basis points. It is possible to further reduce these interest rates. A fourth option is negative rates. The Governor has talked about this before. [11] I will just make a few points here. The empirical evidence on negative rates is mixed. [12] In the short-term, they can contribute to a lower exchange rate. In the medium term, the effectiveness can wane including through the effect on the financial system. Negative rates can also encourage more saving as households look to preserve the value of their saving, particularly in an environment where they are already inclined to save rather than spend. That is, the income effect can be larger than the substitution effect. To date, those economies with negative policy rates have not lowered them further. Instead, they have eased monetary policy settings through other means. Conclusion The Australian and the global economies have undergone historic contractions as a result of the pandemic. We are now in a gradual and uneven recovery. The recovery is being supported by sizeable fiscal stimulus, particularly in terms of income support for households and business. Monetary policy is playing its role in supporting the economy. There has been a large expansion in the RBA balance sheet resulting from the Board's policy actions. This expansion comes from the TFF and the government bond purchases to achieve the yield target and address dysfunction in the bond market. This constitutes a substantial easing in monetary policy. These actions are underpinning the historically low interest rates for households and business as well as the government. https://www.rba.gov.au/speeches/2020/sp-dg-2020-09-22.html 11/13 22/09/2020 The Australian Economy and Monetary Policy | Speeches | RBA The Board decided to further expand and extend the size of the TFF at the September meeting, which will further increase the size of the Bank's balance sheet. As the outlook for the Australian economy unfolds, the Board will continue to assess the merits of the range of monetary options to best support the economic recovery. Endnotes This is very evident in the investment expectations measured in the ABS Capital Expenditure Survey. This is not a surprising outcome. Empirical macroeconomic models of business investment struggle to find much direct impact of borrowing rates on investment. Current and expected aggregate demand have the predominant influence. This is the case in the MARTIN model of the RBA, as well as much of the macroeconomic research on business investment. See Ballantyne A, T Cusbert, R Evans, R Guttmann, J Hambur, A Hamilton, E Kendall, R McCririck, G Nodari and D Rees (2019), ‘MARTIN Has Its Place: A Macroeconometric Model of the Australian Economy PDF ’, RBA Research Discussion Paper No 2019-07; Chirinko RS (1993), ‘Business Fixed Investment Spending: Modeling Strategies, Empirical Results, and Policy Implications’, , 31(4), pp 1875–1911; Caballero RJ (1999), ‘Aggregate Investment’, in JB Taylor and M Woodford (eds), : Volume 1B, Handbooks in Economics 15, Elsevier Science, Amsterdam, pp 813–862; and Cockerell L and S Pennings (2007), ‘Private Business Investment in Australia’, RBA Research Discussion Paper No 2007-09. Macroeconomics Journal of Economic Literature Handbook of Ellis L (2020), ‘The Economic Outlook’, Speech at the Australian Business Economists Lunchtime Briefing, online, 7 August. The payrolls data is one of a number of innovations that the ABS has introduced that has helped significantly in tracking the economy through this challenging episode. ES balances are the deposits the banking system holds at the RBA. The demand for liquidity in the Bank's daily market operations has declined since the early days of the pandemic. This reflects the fact that the system has abundant liquidity, and the growing take-up of the TFF. However, the TFF is not necessarily a complete substitute for the liquidity provided at the Bank's daily market operations, since the Bank's counterparties have different motivations for seeking funding at particular maturities. The Board also extended the drawdown deadline for the additional allowance available under the TFF until June 2021. The additional allowance incentivises banks to expand their lending to businesses. Banks obtain an additional $5 of TFF funding for every $1 they lend to SMEs, and an additional $1 of funding for every $1 they lend to large businesses. Again, given the substitutability between government bonds, it is not really possible to allocate the bonds purchased to each of these two motives. See Lowe P (2020), ‘COVID-19, the Labour Market and Public Sector Balance Sheets’, Address to the Anika Foundation, online, 21 July; and the Minutes of the Monetary Policy Meeting of the Reserve Bank Board on 7 July 2020. There is the possibility of a ratings downgrade from higher debt, but that really only has a political dimension not a financial dimension, as government bond rates would likely be little changed. In any case, a rating agency should not be the determinant of fiscal policy. Fiscal policy should be set to be the most beneficial for the Australian economy and people. See Lowe P (2019), ‘Unconventional Monetary Policy: Some Lessons From Overseas’, Address to Australian Business Economists Dinner, Sydney, 26 November; Lowe P (2020), ‘Opening Statement to the House of Representatives Standing Committee on Economics’, Canberra, 7 February; Minutes of the Monetary Policy Meeting of the Reserve https://www.rba.gov.au/speeches/2020/sp-dg-2020-09-22.html 12/13 22/09/2020 The Australian Economy and Monetary Policy | Speeches | RBA Bank Board on 7 July 2020; and Commonwealth (2020), ‘Reserve Bank of Australia Annual Report 2019’, House of Representatives Standing Committee on Economics public hearing, 14 August 2020, available at: <https://www.aph.gov.au/Parliamentary_Business/Committees/House/Economics/RBAReview20192/Public_Hearings>. ECB Economic See Boucinha M and L Burlon (2020), ‘Negative Rates and the Transmission of Monetary Policy’, , Issue 3/2020, available at <https://www.ecb.europa.eu/pub/economicbulletin/articles/2020/html/ecb.ebart202003_02~4768be84e7.en.html#toc1>; Arseneau D (2020), ‘How Would US Banks Fare in a Negative Interest Rate Environment?’, Finance and Economics Discussion Series 2017-030r1, Washington, Board of Governors of the Federal Reserve System, available at: <https://doi.org/10.17016/FEDS.2017.030r1>; Committee on the Global Financial System (2019), ‘Unconventional monetary policy tools: a cross-country analysis’, CGFS Paper No 63, available at: <https://www.bis.org/publ/cgfs63.htm>; Agarwal R and M Kimball (2019), ‘Enabling Deep Negative Rates to Fight Recessions: A Guide’, IMF Working Paper No 19/84, available at <https://www.imf.org/en/Publications/WP/Issues/2019/04/29/Enabling-Deep-Negative-Rates-A-Guide-46598>. Bulletin The materials on this webpage are subject to copyright and their use is subject to the terms and conditions set out in the Copyright and Disclaimer Notice. © Reserve Bank of Australia, 2001–2020. All rights reserved. The Reserve Bank of Australia acknowledges the Aboriginal and Torres Strait Islander Peoples of Australia as the Traditional Custodians of this land, and recognises their continuing connection to Country. We pay our respects to their Elders, past, present and emerging. https://www.rba.gov.au/speeches/2020/sp-dg-2020-09-22.html 13/13 | reserve bank of australia | 2,020 | 9 |
Address by Mr Philip Lowe, Governor of the Reserve Bank of Australia, at Citi's 12th Annual Australia and New Zealand Investment Conference, Sydney, 15 October 2020. | Speech The Recovery from a Very Uneven Recession Philip Lowe [ * ] Governor Citi’s 12th Annual Australia and New Zealand Investment Conference Sydney – 15 October 2020 It is a great pleasure to be able to join you today. It is especially good to be able to join you in person, rather than over the internet. This is the first time since February that I have been able to speak to a room of people. I hope this is another sign that the worst is behind us and that a recovery is under way. Today, I would like to talk about that recovery and four interrelated factors that will shape it. These are: (i) how successful we are in containing the virus; (ii) how effectively we deal with the shadow of the very uneven recession; (iii) how willing people and businesses are to draw on their accumulated financial buffers; and (iv) economic policy, including monetary policy. As we all know, the past seven months have been very difficult ones in the life of our nation. They are months that we will always remember. Our lives have been affected in ways that were barely imaginable at the start of the year. The economic policy response has also been on a scale that was barely imaginable back in January. At a high level, that response has had two parts. The first has been to build a bridge to the day that the pandemic is contained and to get as many people and businesses across that bridge as possible. And the second part has been to construct the road to the recovery as the economy opens up. This has been the right strategy. It has involved the government, the RBA, the regulators and the banks working closely together in the national interest. Thanks to this effort and the progress on the health front, a recovery is now under way and we can look forward to this continuing. This is good news, but the shape and nature of that recovery remains highly uncertain. Much depends upon how as a society we can live with the virus and the success of the scientists in terms of a vaccine, anti-viral treatments and rapid testing. There has been positive news on these fronts recently and we hope for more positive news, but success is not yet assured. So the single most important influence on the recovery is how successful we are in containing the virus. I would now like to turn to a second factor that will shape the recovery – that is the shadow cast by the very uneven nature of the recession that we have been living through. All recessions are uneven, but this one has been especially so. The government has wisely sought to even things out, but inevitably we are left with outcomes that are very uneven across the country. This unevenness is especially evident in the labour market, so this is where I would like to focus. This first graph shows the fall in employment that occurred between February and May for different age groups, and the recovery through to August (Graph 1). The picture is pretty clear. The job losses have been largest for young people, with around 500,000 people under 35 losing their jobs in the early stages of the pandemic, and around 300,000 still out of work in August. Graph 1 Employment by Age Change since February 2020 15–24 25–34 35–44 45–54 55–64 65+ -375 -300 -225 -150 To May -75 ’000 To August Sources: ABS; RBA This heavy burden partly reflects the uneven way the pandemic has affected different industries (Graph 2). The hospitality industry – in which many young people and women work – has been worst affected, with almost 300,000 job losses between February and May. There has been an encouraging recovery of late, and for this to be sustained our economy will need to open up further. In contrast, a number of other areas – including the finance industry, the public sector and mining – have been much less affected. Graph 2 Employment by Industry Change since February 2020 Public admin Finance Mining Retail Health Construction Arts & recreation Transport Professional Manufacturing Hospitality -300 -200 -100 To May To August ’000 Sources: ABS; RBA One consequence of these developments is that people who work in lower-paid occupations have, on average, been the hardest hit. This is evident in Graph 3, which shows that the decline in employment has been largest for occupations with the lowest hourly earnings, while employment has actually increased for occupations with the highest hourly earnings. The difference in experience is striking. Graph 3 Employment by Occupation Earnings* Change since February 2020 Highest Second Third Fourth Lowest -600 -400 -200 To May ’000 To August * The change in employment for each occupation has been ordered by the hourly earnings for those occupations in May 2018; the data have then been broken into five equal groups of occupations from highest to lowest earnings and added up within each group Sources: ABS; RBA The uneven effect of the pandemic is also evident in small businesses being harder hit, on average, than large businesses. As at mid September, the number of people on the payrolls of firms with at least 200 employees was down just 1 per cent on the level of mid March (Graph 4). In contrast, payrolls are down 7 per cent on average for firms with between 20 and 200 employees, with a similar decline for firms with fewer than 20 employees. Graph 4 Payroll Jobs by Employment Size* 14 March 2020 = 100 index index 100.0 100.0 200 or more employees 97.5 97.5 95.0 95.0 92.5 92.5 20–199 employees 90.0 90.0 87.5 M A M J J A S 87.5 * Excludes a small number of businesses reporting through single-touch payroll (STP) where employment size information was unavailable; excludes businesses not reporting through STP and self-employed persons Source: ABS This divergence in experience is also evident in the retail spending data (Graph 5). Spending at large firms is up considerably, but spending at small firms has only just returned to its level before the pandemic. Many retailers selling items such as home office equipment, electronics and groceries have done relatively well, but cinemas and many restaurants have had a very difficult time. So the experience has been very uneven. Graph 5 Retail Sales Current prices, year-to-latest three months % % Large firms Small firms -10 -10 -20 -20 Sources: ABS; RBA The pandemic has also hit our states and territories quite differently. In the first couple of months, all jurisdictions were affected broadly in the same way, with the number of payroll jobs falling between 7 and 9 per cent everywhere (Graph 6). Since then, labour market conditions have diverged very significantly. Graph 6 Payroll Jobs by Region* Change since mid March 2020 WA NT SA Qld NSW Australia ACT Tas Vic -10 -8 -6 To mid April * ** -4 -2 % To mid September** Excludes businesses not reporting through single-touch payroll and self-employed persons Average of weeks ending 12 and 19 September 2020 Sources: ABS; RBA The recovery has been strongest in Western Australia – so much so that in our business liaison we are hearing reports of some labour shortages. Consistent with the labour market data, retail spending, consumer confidence and house building have also picked up by more in Western Australia than elsewhere. At the other end of the distribution is Victoria, where the second wave has meant that the earlier recovery in jobs has been reversed, with the number of jobs there still down by 8 per cent from that in March. Retail spending in Victoria in August was also 11 per cent lower than at the start of the year – in contrast, spending in the rest of the country was up by 13 per cent. This uneven experience by age, industry, firm size and region will shape the recovery. Some parts of the country and some industries face very real challenges. At the same time, others now have new opportunities. The way business is done is also changing and it is possible that people and firms living through a pandemic become more risk averse, affecting their appetite to spend and invest. This all means that we are likely to see a period of heightened structural change in our economy. As a consequence of this and the recession we will see a pick-up in the number of business failures and households facing financial stress. How well we support those who are most affected while at the same time capitalising on the new opportunities will shape the recovery over the next few years. I would now like to move to the third factor that will shape the recovery: that is how willing people and businesses are to draw on their accumulated financial buffers to spend and invest over the months ahead. One of the many unique features of this recession is that it has been associated with a big increase in household saving. Normally in a recession, income falls and many people draw on their savings to get through the hard times. But in the June quarter, when fears about the pandemic were at their peak, the household saving rate surged to 20 per cent, the highest in almost 50 years (Graph 7). Graph 7 % Household Consumption and Income Nominal, year-ended growth % Disposable income Consumption -10 -10 % % Saving ratio -5 -5 Sources: ABS; RBA There are two factors at work here. The first is that Australians were more cautious and had fewer opportunities to spend, given that many services were simply unable to be offered. As these opportunities disappeared, households did adjust their spending patterns, spending more on electronics and exercise equipment and online. But this substitution was not enough to offset the very large drop in spending on services and there was a record decline in consumption in the June quarter. The second factor was the large boost to incomes from the various government support programs. Social assistance benefits, including the JobSeeker payment, increased by nearly $15 billion in the June quarter. In addition, businesses received more than $30 billion in JobKeeper payments to support the wages of their staff. These payments are equivalent to around 15 per cent of total household disposable income in a typical quarter. Many households have used this extra income and their increased savings to put their balance sheets on a firmer footing. Some of the money withdrawn from superannuation funds under the early release scheme – which is now equivalent to about an additional 10 per cent of quarterly household disposable income – has also been used to pay down debt and strengthen cash buffers. The impact of this can be seen in some of the banking data. Over recent months, there have been record rates of repayment on personal credit cards and other forms of personal debt (Graph 8). Interest-bearing credit card balances have fallen by 22 per cent since March and are now at their lowest level in around 15 years. Graph 8 Personal Credit Cards Net repayments* $b $b * Seasonally adjusted Source: RBA For many people with a mortgage, much of the extra savings and some of the superannuation withdrawals have been used to increase their balances in their offset accounts, with offset balances up 10 per cent since March. Other people have simply paid down principal directly. Combined, all forms of mortgage payments – including the additional balances in offset accounts – reached a record high over recent months, despite repayments being deferred on around 8 per cent of housing loans (Graph 9). Graph 9 Flows into Housing Loan and Offset Accounts* Share of disposable income % % Interest Principal Offset * Seasonally adjusted and break-adjusted; lighter bar is an estimate for the September quarter Sources: ABS; APRA; RBA The question that all this raises is: what are people going to do with this extra saving and improved debt situation? In aggregate, household income is likely to decline in the December quarter as the unemployment rate increases and government support becomes more targeted. In normal times, a decline in income would be expected to affect consumption, but these are not normal times. It is entirely possible that as restrictions ease, people will choose to draw on their accumulated buffers to sustain and increase their spending. Many businesses face a similar choice to households. Many have boosted their cash buffers over the past six months and face a decision about what to do with these: sit on these buffers in case something goes wrong, or use them for investment and expansion? The better outcome for the economy is for households and businesses to keep spending and investing. The key to this is confidence in the health situation and the future state of the economy. If people are nervous about the health situation or their job prospects, they are likely to sit on their savings. On the other hand, if they are confident that the virus can be contained and that they will have a job, they will be more willing to spend. This means that there are large payoffs to be had from ensuring public confidence in the capacity of the health system to respond. From this perspective alone, there are likely to be large returns from public investments in first-class testing, contact tracing and quarantine arrangements. These are essential, not only to open up our economy successfully but to also build the confidence that is required for people to spend and invest. Economic policy also has a critical role to play in reducing uncertainty about the future. So I would now like to turn to this issue. The policy response to the pandemic has been central to getting the Australian economy through the past six months in better shape than the economies of many other countries. In previous downturns, it was monetary policy that played the leading role, but this time it has been fiscal policy that has taken the lead. This switch is entirely appropriate given the pandemic and the low interest rate world that we are living in. The fiscal response has been crucial in helping build that bridge to the recovery that I spoke about earlier. The income support provided by the government has: assisted many people get through this difficult period; kept many businesses afloat; and reduced some of the unevenness of the pandemic. Fiscal policy has been supported in this effort by monetary policy and by the actions of the banks and the financial regulators. The recent Budget provided welcome further support to the economy. The various measures will provide ongoing support to disposable incomes and help boost aggregate demand. Policies of a structural nature will also help build the road to the recovery. I expect that this will help reinforce what I hope to be improving confidence on the health front. This fiscal support necessarily involves increased borrowing. For a country that became used to low budget deficits and low levels of public debt, this is quite a change. But it is a change that is entirely manageable and affordable and it is the right thing to do in the national interest. Debt across all levels of government in Australia, relative to the size of our economy, is much lower than in many other countries and it is likely to remain so (Graph 10). The national balance sheet is in a strong position and is able to provide the support that is now required. The Australian Government can borrow at the lowest rates ever and the demand from investors for government bonds remains very strong. The states and territories can also borrow at record low rates and have an important role to play in the national fiscal response. Graph 10 General Government Gross Debt 2019, per cent of GDP Japan Italy United States France Canada United Kingdom India Germany Malaysia China Australia South Korea Sweden Indonesia New Zealand % Source: IMF No doubt, there will be a point in the future when attention will need to return to the task of rebuilding our fiscal buffers to deal with the next downturn. This task will be easier when the additional government spending is temporary in nature. In any case, the best way to rebuild these buffers is through economic growth. This means that structural reforms that drive that growth need to remain on our national agenda. I would now like to turn to monetary policy, which has played an important supporting role. The package of measures announced in March – including the target for the yield on 3-year Australian Government bonds – has led to record low funding and borrowing costs, which have eased the burden of the pandemic for many people. The RBA's open market operations and the Term Funding Facility have both contributed to a plentiful supply of liquidity in the Australian financial system and this is supporting the supply of credit to households and businesses. This supply of credit will be important in the recovery phase. These measures to support the Australian economy have resulted in a very large increase in the RBA's balance sheet (Graph 11). Between 2016 and early this year, our balance sheet averaged around $170 billion. It is now almost double this at over $300 billion. Graph 11 Reserve Bank Balance Sheet Total assets, weekly $b $b Source: RBA At its September meeting, the Reserve Bank Board decided to expand the Term Funding Facility to provide authorised deposit-taking institutions (ADIs) with additional low-cost funding equivalent of 2 per cent of their total lending. The timing of this decision coincided with the approach of the deadline for final drawings under the initial allocations under this facility. As ADIs draw on the expanded facility there will be a further significant expansion of our balance sheet. This expanded facility should be seen as a further easing of monetary policy, although in a different way than in the past. At its most recent meeting, the Board continued to consider the case for additional monetary easing to support jobs and the overall economy. As part of this discussion we also considered the nature of our forward guidance regarding the cash rate. Before turning to the broader policy question, I would like to discuss how the Board's thinking on forward guidance has evolved. The Board agreed that it made sense for me to talk about this today, where more context can be provided, rather than make a change in the statement directly after the meeting. Over recent months, our communication has stated that the Board will ‘not increase the cash rate target until progress is being made towards full employment and it is confident that inflation will be sustainably within the 2–3 per cent target band’. It might seem strange to some that we are even talking about the day that interest rates increase, given that it is a long way off. But expectations about future interest rates affect people's decisions and asset pricing, so we seek to be as transparent as we reasonably can. In terms of inflation, our forward guidance has been forward looking – we have focused on the outlook for inflation, not just current inflation. This was a sensible approach when the inflation dynamics were relatively stable and well understood. In today's world, things are much less certain. So we will now be putting a greater weight on actual, not forecast, inflation in our decision-making. In terms of unemployment, we want to see more than just ‘progress towards full employment’. The Board views addressing the high rate of unemployment as an important national priority. Consistent with our mandate, we want to do what we can do, with the tools we have, to ensure that people have jobs. We want to see a return to labour market conditions that are consistent with inflation being sustainably within the 2 to 3 per cent target range. The Board will not be increasing the cash rate until actual inflation is sustainably within the target range. It is not enough for inflation to be forecast to be in the target range. While inflation can move up and down for a range of temporary reasons, achieving inflation consistent with the target is likely to require a return to a tight labour market. On our current outlook for the economy – which we will update in early November – this is still some years away. So we do not expect to be increasing the cash rate for at least three years. Turning to the broader policy question, we have been considering what more we can do to support jobs, incomes and businesses in Australia to help build that important road to the recovery. The options have been laid out in previous speeches by the Deputy Governor and myself and I don't plan to elaborate on these again today. [1] While the Board has not yet made any decisions, I thought it might be useful to close today by highlighting three of the many issues we are working through. The first is how much traction any further monetary easing might get in terms of better economic outcomes. When the pandemic was at its worst and there were severe restrictions on activity we judged that there was little to be gained from further monetary easing. The solutions to the problems the country faced lay elsewhere. As the economy opens up, though, it is reasonable to expect that further monetary easing would get more traction than was the case earlier. A second issue is the possible effect of further monetary easing on financial stability and longer-term macroeconomic stability. This is an issue that we have paid close attention to in the past when we were considering reducing interest rates in a relatively robust economic environment. It remains an important issue today, but the considerations have changed somewhat. To the extent that an easing of monetary policy helps people get jobs it will help private sector balance sheets and lessen the number of problem loans. In so doing, it can reduce financial stability risks. This benefit needs to be weighed against any additional risks as people take more investment risk in the search for yield. We also need to take into account the effect of low interest rates on people who rely on interest income. A third issue is what is happening internationally with monetary policy. Australia is a mid-sized open economy in an interconnected world, so what happens abroad has an impact here on both our exchange rate and our yield curve. In the past, the interest differentials provided a reasonable gauge to the relative stance of monetary policy across countries. Today, things are not so straightforward, with monetary policy also working through balance sheet expansion. As I noted earlier, our balance sheet has increased considerably since March, but larger increases have occurred in other countries. We are considering the implications of this as we work through our own options. So these are three of the complex issues we have been considering at our recent Board meetings. The Board will continue to review these and other issues at our upcoming meetings. We are committed to do what we reasonably can, with the tools we have, to support the recovery of the Australian economy. Thank you for listening. I look forward to your questions. Endnotes [*] I would like to thank Ellis Connolly for assistance in the preparation of this talk. See Debelle G (2020), ‘The Australian Economy and Monetary Policy’, Speech at the Australian Industry Group Virtual Conference, Online, 22 September; and Lowe P (2020), ‘COVID-19, the Labour Market and Public Sector Balance Sheets’, Address to the Anika Foundation, Online, 21 July. The materials on this webpage are subject to copyright and their use is subject to the terms and conditions set out in the Copyright and Disclaimer Notice. © Reserve Bank of Australia, 2001–2020. All rights reserved. The Reserve Bank of Australia acknowledges the Aboriginal and Torres Strait Islander Peoples of Australia as the Traditional Custodians of this land, and recognises their continuing connection to Country. We pay our respects to their Elders, past, present and emerging. | reserve bank of australia | 2,020 | 10 |
Address by Mr Christopher Kent, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to the IFR Australia DCM Roundtable Webinar, online, 20 October 2020. | Speech The Stance of Monetary Policy in a World of Numerous Tools Christopher Kent [ * ] Assistant Governor (Financial Markets) Address to the IFR Australia DCM Roundtable Webinar Online – 20 October 2020 Introduction In a world of unconventional policies, assessing the stance of monetary policy is not as straight forward as it once was. It used to be that looking at the Board's cash rate target, and coming to a view on its likely path (for example by using overnight indexed swap (OIS) market prices), provided a reasonable summary of the stance of monetary policy. If the cash rate target was lowered, the traded cash rate would decline to that lower rate and policy had clearly moved to a more expansionary footing. The mechanics of the first stage of monetary transmission was also well understood. [1] The cash rate anchored very short term interest rates. Along with expectations of the future evolution of the cash rate, this influenced rates out along the (risk-free) yield curve. This in turn affected rates on corporate bonds, mortgages and other financial products that reference different points along the yield curve. Key asset prices – such as the exchange rate and equity prices – also reacted to changes in the yield curve. So using the cash rate target as a summary statistic was a reasonable way to think about the stance of policy, and the transmission mechanism to financial prices was clear. However, this all became more complex after 19 March this year, when the Reserve Bank introduced a new package of policy measures. Some of these were within the realm of conventional monetary policy tools, but others were unconventional. In particular, the Board: reduced the cash rate target to 0.25 per cent, and provided forward guidance indicating that the cash rate would not be increased until the Board was confident of meeting its employment and inflation objectives set a target for the three-year Australian Government bond yield of around 0.25 per cent, to be achieved by purchasing government bonds in the secondary market. Purchases would also be conducted as required to address dislocation affecting government bond markets introduced the Term Funding Facility (TFF), providing three-year secured funding to banks at 0.25 per cent and announced that the Bank would continue to provide liquidity to Australian financial markets by conducting repo operations at terms of up to six months in its daily market operations. It's clear that this package of policy measures represented a significant easing in the stance of monetary policy. The aim has been to lower funding costs across the economy and support the provision of credit, and it has broadly worked as expected. At the same time, however, it's no longer possible to summarise the stance of policy by reference to the cash rate target alone. Other elements of the policy package have to be taken into account. These other elements affect the transmission mechanism in various ways. Today I'm going to discuss these channels and how they work. This will also clarify how we can assess the stance of monetary policy. I find it helpful to split our policy tools into two broad groups as follows: First, there are interest rate tools, which are primarily focused on achieving a particular interest rate, such as the cash rate target, forward guidance and the bond yield target. These are relatively straight forward to assess, but the obvious point is that we need to look at more than just the current cash rate target. Second, there are tools that operate by providing liquidity or longer-term funding. These also affect various interest rates, but in somewhat less obvious ways. Moreover, these tools contribute to growth in the RBA's balance sheet, and result in important compositional changes in terms of the type and maturity of instruments held on our balance sheet. [2] Hence, examining the balance sheet is a complementary way of assessing the stance of monetary policy. I'll consider each of these types of policy tools in turn. Interest Rate Tools – It's not just the Cash Rate Target that Matters The reduction in the cash rate target, by 50 basis points to 25 basis points in March, pulled down the short end of the yield curve. That was straightforward. More novel was the use of forward guidance and the three-year yield target. The Board wants to see labour market conditions that are consistent with inflation being sustainably in the 2 to 3 per cent target range. And it will not increase the cash rate until actual inflation is sustainably in the target range. [3] This forward guidance has contributed to interest rates being lower than otherwise, as rates across the economy depend, among other things, on expectations of future cash rates. This effect is being reinforced by the Bank's three-year yield target. By committing to keep the threeyear Australian Government bond yield at around 0.25 per cent, we have been directly affecting the interest rate at this point on the yield curve. The effect of the resulting changes in the short end of the yield curve on other financial market rates and prices is standard. Lower risk-free interest rates pull down interest rates for other financial products throughout the economy. In addition, lower returns on Australian dollar assets contribute to a lower exchange rate than otherwise. Also, the actual cash rate has moved to be below the cash rate target, driven by those parts of the package that are contributing to a rise in liquidity and funding provided to the banks. [4] I'll turn to each of these elements as I discuss the balance sheet tools we have been using. Balance Sheet Tools Liquidity provision In March, during the early days of the pandemic and following the sharp rise in financial market volatility, the Reserve Bank increased the supply of liquidity to the banking system via our normal daily open market operations (OMO). The provision of large amounts of short-term liquidity to the banking system is a long-standing tool of central banks used during periods of financial dislocation. The purchases of government bonds and the take-up of the TFF contributed to a further significant rise in liquidity in the banking system. As expected, the actual cash rate – which is the rate banks charge to lend out funds to other banks overnight – declined below the cash rate target (Graph 1). It settled at around 13 basis points, which is just above the 10 basis points that banks receive on surplus Exchange Settlement (ES) balances in their accounts at the Reserve Bank. The decline in the cash rate to be below the target was a natural consequence of the expansion of the Reserve Bank's balance sheet. Graph 1 It's worth noting that this need not have been the case. Instead, the Bank could have sterilised the liquidity impact of bond purchases and the TFF by draining surplus ES balances (for example, by using term deposits). But by not sterilising the effect of these policy tools, the Bank has provided more monetary stimulus than otherwise. This extra liquidity also underpinned lower interest rates in other short-term money markets. This includes the bank bill market, which is a key benchmark affecting banks' funding costs. Because banks are generally flush with cash, they don't need to compete very hard to raise short-term funds. In fact, since mid April banks have been able to borrow funds for terms of three months at or below the (expected) cash rate (Graph 2). This is the lowest spread in at least two decades. Graph 2 Government bond purchases As well as supporting the three-year yield target, bond purchases have added directly to banks' ES balances, and so contributed to low money market rates. This effect will be in play for a while, given that the bonds purchased will contribute to the Reserve Bank balance sheet for some time. So while bond purchases under the Bank's yield target are clearly an interest rate tool, they also share some of the aspects of balance sheet tools. The Term Funding Facility The TFF provides low-cost funding to banks for a period of up to three years. Competitive pressures in lending markets mean that reductions in funding costs associated with the TFF have been passed through to business and household borrowers. [6] But the TFF has lowered a broader range of interest rates in the economy and put more money into the hands of borrowers and investors. To understand how that has occurred it's helpful to consider what the banks could do with money from the TFF. They have three broad options: write new loans to households or businesses; purchase securities such as government or corporate bonds; or replace other forms of funding, such as bank bonds. I'll consider each in turn. First, banks may choose to use money from the TFF to write new loans to households or businesses (with the latter particularly attractive given that it will contribute to an additional allowance under the TFF). To do so, banks first need to attract new borrowers, so they have an incentive to pass on the lower cost of funding offered by the TFF to those borrowers. This was clearly evident in the mortgage market, where banks have competed for new high-quality borrowers with a reduction in rates, as well as offers of cash back to borrowers for refinancing an existing loan previously held with another lender. Moreover, banks announced sizeable declines in interest rates on fixed rate business and housing loans shortly after our package of measures was announced. Second, if a bank uses money from the TFF to buy a bond issued by a government or a private business this has a very similar effect, but via capital markets instead of the loan market. The act of bidding for a bond drives its price up and its yield down. Buying the bond also extends a form of credit to the issuer if it is purchased in the primary market. Or, the bank can buy the bond from an existing investor, who is then likely to recycle those funds by buying another asset. Via this chain, the TFF can work to drive down the yields on a range of assets, public and private. Third, a bank can use money from the TFF to repay their maturing debt. This also has the effect of lowering the yield on Australian dollar assets. For example, in normal circumstances a bank would typically issue a new bond to repay an existing, maturing bond. And investors holding the maturing bank bond would normally use the proceeds to invest in a new bank bond. If, instead, a bank uses money from the TFF to repay that bond, and so does not issue a new one, then investors are left with cash but no new bank bond to buy. So they have to find something else in which to invest. The resulting adjustments in the market will help to drive up the price and lower the yield on the asset or assets in question. So in each case, the use of TFF funds results in lower interest rates in the economy. And in the case where the TFF is used to buy a bond or make a loan, it also results in new funding finding its way to a borrower or an investor. That is, there is a quantity effect as well as an interest rate effect, whereby an expansion in the Reserve Bank's balance sheet can lead to additional funding ending up with households, businesses or governments. A Useful Summary Metric: The Balance Sheet Pulling this together, it's clear that assessing the stance of monetary policy is very different in a world of unconventional monetary policy. One useful way to deal with the new complexity is to recognise that many of these new tools will lead to changes in the size, composition and maturity of the central bank balance sheet. So balance sheet metrics – which are affected by our efforts to influence a wide range of interest rates in the economy – can provide useful additional insights into the stance of policy. Most obviously, the provision of liquidity, purchasing of government bonds, and funding provided under the TFF, involve expanding the size of the Reserve Bank's balance sheet (Graph 3). Generally, an increase in balance sheet size under the new policy measures means that the Reserve Bank has acquired an asset from the private sector (for some time), and in so doing provided some form of monetary stimulus. This form of stimulus has clearly been evident through this year. It was also evident during the run-up in the Bank's balance sheet during the global financial crisis (GFC) when the Reserve Bank satisfied the sharp increase in demand for liquidity during that period of extreme uncertainty. Graph 3 The composition of the balance sheet also reveals how the various monetary policy tools are being used. In the early stages of the pandemic, liquidity was supplied via OMOs and hence the domestic repo market, while the foreign exchange swap book was allowed to run off (Graph 4). There was also a sizeable increase attributable to the Bank's purchases of government bonds. More recently the TFF has played an increasing role; most of banks' initial allowances were drawn down by the 30 September deadline for that part of the facility. At the same time, short-term repos have been rolling off. This change in the composition of the RBA's balance sheet is clearly evident in the large rise in the average residual maturity of the assets held by the Bank. This is consistent with the need for monetary policy support to be provided for some time given the economic outlook and the prospect of an extended period of high unemployment. Graph 4 This perspective of balance sheet size and composition is useful for comparing our current suite of policy measures with the stimulus undertaken during the GFC. The reduction in the cash rate target was much larger during the GFC – 400 basis points compared with a reduction of 50 basis points this year. Of course that reflects the fact that more recently the cash rate has been close to its effective lower bound. In both cases, the initial expansion in the balance sheet was in the order of 5 per cent of GDP. But in the current episode, the nature of the expansion has been quite different compared with the GFC. During the GFC the main focus of active balance sheet expansion (which is evident in Graph 4) was on satisfying the precautionary demand for short-term liquidity, while a deprecation in the Australian dollar also boosted the value of the Bank's foreign reserve assets. Satisfying precautionary demand was also important in the early stages of the pandemic, but subsequently the mix of assets shifted to longer-term repos (via the TFF) as well as government bonds. Consequently, the breadth and the durability of the easing in financial conditions associated with these balance sheet tools has been greater now than was the case during the GFC. Conclusion The Bank is using a number of monetary policy tools as part of the package of measures adopted to support the economy through the pandemic. This means that the task of assessing the stance of monetary policy is very different and more complex than it used to be. Some of the tools influence interest rates directly in a way that gives us greater control over a wider range of rates than previously. In particular, forward guidance and the three-year yield target have supported historically low borrowing rates at this maturity. Other elements of the package affect interest rates indirectly, and are harder to assess. But, the extent of stimulus from these sources can be gauged in the first instance by considering their effect on the RBA balance sheet, hence my use of the term ‘balance sheet’ tools. A key example of this has been the TFF, which was recently expanded by $57 billion to around $200 billion. We expect that much of this extra funding will be drawn upon in time, for the simple reason that it will be profitable for banks to do so. When this happens a new, long-lived asset will be added to the Reserve Bank's balance sheet. The banks will use the funds to write loans to businesses and households, buy securities, or repay debt, all of which will serve to lower interest rates in the economy and extend funding to the private and indeed the public sector. Endnotes [*] I thank Chris Becker and Richard Finlay for invaluable assistance in preparing this material. For a more detailed discussion, see Becker C and S Woon (2018), ‘A Case Study of Monetary Policy Implementation on 3 August 2016’. Available at https://www.rba.gov.au/education/resources/presentations/. Also see Domestic Markets Department (2019), ‘The Framework for Monetary Policy Implementation in Australia’, RBA Bulletin, June, viewed 19 October 2020. Available at <https://www.rba.gov.au/publications/bulletin/2019/jun/the-framework-formonetary-policy-implementation-in-australia.html>. As I'll make clearer below, the bond yield target is focused on a achieving a particular interest rate but it also has aspects of a balance sheet tool. See Lowe P (2020), ‘The Recovery from a Very Uneven Recession’, Address to Citi's 12th Annual Australia and New Zealand Investment Conference, Online, 15 October. For further details see Kent C (2020), ‘The Reserve Bank's Operations – Liquidity, Market Function and Funding’, Address to KangaNews, Online, 27 July. While the Bank has not actively sterilised its bond purchases or TFF funding, it allowed its portfolio of short-term foreign exchange swaps, which were previously used for domestic liquidity management purposes, to run off. See RBA (2020), Statement on Monetary Policy, August. The story is similar for a maturing bank bond that was issued offshore in foreign currency: in this case the Australian bank would have exchanged the foreign currency raised when the bond was issued for AUD in the foreign exchange swap market, with the FX swap transaction unwinding when the bond matures. If the bank bond is not rolled over, the provider of AUD in the FX swap will be left with those AUD at bond maturity, and will need to find a new investment to place the funds into, putting downward pressure on the relevant AUD interest rate. Note that part of the sharp increase in assets in late 2008 was due to valuation effects on the Bank's foreign reserve assets associated with the sharp depreciation of the Australian dollar. The more gradual increase in the balance sheet up to 2007 reflected the fact that the Australian government was running successive budget surpluses and the funds resulting from that were held as deposits at the RBA. To sterilise the impact on liquidity the central bank built up its FX swap portfolio given that the government bond market was relatively small and illiquid at that time. The creation of the Future Fund meant that government deposits at the RBA fell sharply in 2007 and the swap book was quickly unwound. The noticeable rise in the Bank's balance sheet in late 2013 was due to the introduction of same-day settlement of direct entry payments, which required the RBA to implement a system of overnight liquidity using open repos remunerated at the cash rate target. For further details see RBA annual reports from the time, available at <https://www.rba.gov.au/publications/annual-reports/>, and also Debelle G (2008), ‘Market Operations in the Past Year’, Speech at the 2008 FTA Congress, Melbourne, 31 October. The materials on this webpage are subject to copyright and their use is subject to the terms and conditions set out in the Copyright and Disclaimer Notice. © Reserve Bank of Australia, 2001–2020. All rights reserved. The Reserve Bank of Australia acknowledges the Aboriginal and Torres Strait Islander Peoples of Australia as the Traditional Custodians of this land, and recognises their continuing connection to Country. We pay our respects to their Elders, past, present and emerging. | reserve bank of australia | 2,020 | 10 |
Speech by Mr Guy Debelle, Deputy Governor of the Reserve Bank of Australia, at the FX Week Australia Webinar, virtual, 22 October 2020. | Guy Debelle: The global foreign exchange committee and the FX global code Speech by Mr Guy Debelle, Deputy Governor of the Reserve Bank of Australia, at the FX Week Australia Webinar, virtual, 22 October 2020. * * * Thank you to FX Week for organising this event. Today, I will provide you with an update on the recent issues that the Global Foreign Exchange Committee (GFXC) has been considering as well as the state of play in the review of the FX Global Code. Conditions in Foreign Exchange markets The GFXC has met three times this year and each meeting we draw on the insights of FX market functioning from the 20 member Foreign Exchange Committees.1 This encompasses advanced and emerging economy FX markets and views from all parts of the market: sell-side, buy-side, non-banks and platforms. In FX markets, the experience following the outbreak of Covid-19 earlier this year was similar to what has occurred in previous market crises: spreads widened, volatility increased sharply, liquidity deteriorated for both spot and swap markets and funding costs surged in many currencies. These abrupt changes in market conditions can prompt rapid shifts in the structure of the market, such as the methods by which market participants execute their trades. For example, there was a reduction in the share of trade internalisation used by sell-side market participants and a greater share of activity migrated to the primary venues. However, one notable feature of this latest crisis was both how sharply market conditions deteriorated and how quickly they recovered. The actions by central banks and governments around the globe doubtless contributed to this rebound. By and large, conditions have continued to improve in recent months. Many indicators of liquidity are now approaching more normal levels, although the depth of market does remain noticeably below pre-pandemic levels. Conditions are more diverse in emerging market currencies, where more idiosyncratic factors tend to be in play, but overall, conditions have also generally improved in these markets but to a lesser extent. In periods of volatility, it is inevitable that there will be a greater focus on benchmark fixes. Large changes in asset prices and currencies generally mean that investors have greater-than-normal rebalancing flows when managing their portfolios. This was certainly the case at the height of market volatility in March. Ordinarily, a lot of these rebalancing flows will go through the market at times that match benchmark fixings. The GFXC drew attention to the possible consequences of these flows ahead of March quarter-end,2 cautioning market participants to always be mindful of the impact of their transactions and to clearly understand how their orders are being handled. Subsequent liaison suggested that market participants were attentive to the potential impacts. In some markets, participants looked to bring the timing of their flows forward of month-end. But while the fixings have generally proceeded smoothly, there have been occasions this year where the London 4pm fix has been associated with heightened volatility. This has prompted discussions – including amongst the GFXC and its member committees – about the fixing process. The GFXC is regularly engaging with the administrator of the W M/R fixes to relay any feedback from the committee and its members. I am encouraged by the increased engagement by them with market participants on the issues. At the same time, it remains as important as ever for users of the 4pm fix and other benchmarks 1/4 BIS central bankers' speeches to regularly assess whether executing at those times suits their requirements. Operation of FX markets More broadly, the Covid lockdowns presented major operational challenges to FX market participants. These challenges were exacerbated by the market volatility, but even as market conditions stabilised, many of the operational challenges remained. However, the FX industry generally has been able to meet these challenges. A recent report issued by the GFXC summarised the experiences of both buy-side and sell-side market participants throughout this time.3 Broadly speaking, electronic trading proved effective and reliable. It is likely that the Covid period will have only furthered the industry’s shift toward electronic trading. This includes the greater use of execution algorithms in many markets. From the GFXC’s perspective, the recent period has highlighted the importance of having common standards of industry practice. The abrupt change in market conditions that we witnessed this year also underscored the importance of transparency. As spreads widened, trade sizes were reduced and ‘last look’ rejection rates rose, clients needed to understand the implications of this for their activities. Review of the FX Global Code While the Code has certainly proven its value since it was introduced, the FX market is constantly evolving. When the Code was launched in 2017, the GFXC committed to undertaking a review of the Code every three years to ensure that its guidance remains appropriate and is contributing to an effectively functioning market. Wide-ranging feedback obtained from market participants last year confirmed that the Code does remain fit for purpose. Nevertheless, there were a few key areas where closer review was warranted. I would like to provide an update on some of those focus areas today. Originally, we had intended to conclude the review of the Code by this December, but following the outbreak of Covid, we needed to pause our work for several months. That work has now been resumed and is on track for completion by mid 2021. The first focus area for the GFXC is getting greater adherence and commitment to the Code from the buy-side. Certainly, a lot of progress has been made over the past three years. For example, of the top 30 asset managers globally, more than half have now signed Statements of Commitment to the Code, including Blackrock, Fidelity, SSGA. There is, however, scope for further progress. In our liaison with the industry, several possible reasons have been suggested for the slower rate of take up from buy-side. Firstly, the Code has 55 principles and there is a perception that many of them are only relevant to the sell-side. Secondly, the buy-side hasn’t had the same incentive to sign up to the Code as the sell-side. The sell-side has faced pressure from their regulators and their customers to demonstrate their commitment. Peer pressure has also played a role there as well. Finally, with constrained resources, many buy-side have other priorities to focus on. To overcome some of these issues, one question that has been asked is whether a buy-side and simpler version of the Code could be developed. However, in considering this issue at its recent meeting, the GFXC’s firm conclusion was that a single Code remains the best way of ensuring there is a common market standard that constitutes good practice. The diversity and increasing complexity of the FX market means that it is not always possible to assign clear roles to market participants, such as liquidity providers and consumers. Relatedly, some buy-side firms will have a larger and more complex involvement with the FX market than many sell-side banks. 2/4 BIS central bankers' speeches From the outset, the GFXC has emphasised that the Code should be applied by each market participant in a manner that is proportionate to the nature of their engagement in the market. It was envisaged that the larger, more complex and sophisticated an institution’s FX activities are, that institution should have undertaken a more comprehensive and detailed internal exercise to ensure its adherence to the Code’s principles. The GFXC will develop additional guidance to assist firms in identifying those principles of the Code that are the most appropriate for them to evaluate when aligning their practices with the Code. This will complement the existing material that is already available on the GFXC’s website, including case studies of a variety of buy-side firms that have aligned their practices to the Code.4 Another priority for the Code review is to provide further guidance around certain trading practices, in particular last look and pre-hedging. It is not necessarily the case that the GFXC will amend the existing principles of the Code dealing with these practices. This may happen, but we are certainly aiming to provide guidance material that provides greater clarity about how these practices are used and what the relevant considerations are for market participants. There will always be some controversy attached to these practices, so it is important that they are transparent and well understood. One important means for providing transparency in the FX market is the disclosures made by sell-side participants. In the GFXC’s surveys of the industry, many market participants – especially from the buy-side – still consider the disclosures around certain trading practices to be poor. And it is the areas of pre-hedging and last look that are generally of most concern. More broadly, the aim of the GFXC has been to ensure that market participants have easily accessible and understandable information on how their trades are handled, allowing them to make informed decisions. While there has been progress in this area, the Committee’s view is that the availability and adequacy of some elements of disclosures remains an issue. The disclosures have to be readable and have meaningful content. In part, it can be the greater volume of disclosure information that is being made available is itself proving challenging for market participants to comprehend and evaluate. Several different sets of disclosures can be produced by the one entity, with some publically available and others provided bilaterally, depending on the intended purpose of the material. Across counterparties, disclosure information is often provided in an inconsistent manner with varied levels of detail. Disclosure documents are also reviewed and updated at different times by different counterparties, and there is no central repository of multiple firms’ disclosures. The GFXC is aiming to develop solutions that will address issues in comparing information across different disclosure documents and facilitate access to disclosure information. The GFXC is also considering reviewing the Code’s principles in light of the ongoing adoption o f algorithmic execution (‘algos’) in the FX market. It is estimated that between 10 and 20 per cent of FX spot trading globally is accounted for by execution algos. Usage of these algos can improve market functioning but they also introduce risks. So as elsewhere, the issue is how well understood these things are by market participants and whether the disclosures made by providers are adequate. Disclosures surrounding algos are often high-level. While there may be legitimate reasons why providers don’t disclose certain things (such as intellectual property), it’s nevertheless important that users have sufficient information to facilitate comparability amongst these instruments. Another area where the FX market has continued to evolve is the increased usage of anonymous trading. As part of its Code review, the GFXC has a workstream looking at this aspect of the market, the roles played by venue providers and prime brokers, and whether the 3/4 BIS central bankers' speeches issues that can arise with this form of trading are adequately addressed in the Code’s principles. FX Settlement risk One aspect of the market that the GFXC has been focussing on its recent meetings is settlement risk. When conducting their triennial survey of the global FX market last year, the Bank for International Settlements expanded the scope of their survey to include data on settlement methods.5 The BIS data suggested that the amount of trades being settled without payment-versus-payment (PvP) protection remains very significant and has increased. There could be several reasons for this trend and further work is being done within the industry to understand the drivers. Part of the explanation is that the overall share of activity has increased in currencies that are not settled through CLS – the main means for obtaining PvP protection. In CLS currencies, it is possible that greater rates of internalisation by market-makers means that settlement risk is being mitigated without needing to use PvP services such as CLS. Many central banks conduct regular six-monthly surveys of activity in their markets – a slimmeddown version of the BIS triennial – and these central banks are enhancing their regular surveys to also capture data on settlement methods, so that we can better monitor what is going on. The importance of this issue – and the potential size of the risks involved – mean that settlement risk needs to remain a focus for the industry. Consistent with that, the GFXC concluded that it was appropriate to strengthen the Code’s guidance in this area. As part of the current review of the Code, we will be looking to further emphasise the need for market participants to sufficiently monitor and manage their settlement risks. This not only includes the credit risks associated with non-PvP settlement, but other elements of the settlement process as well. At its last meeting, the GFXC discussed the potential for ‘strategic fails’ in FX settlements, the incentives that can give rise to such fails and the adverse consequences for the broader market. Recent issues in the Turkish lira highlighted the importance of market participants making the maximum effort to complete their settlements to avoid exacerbating liquidity strains or otherwise disrupting the market. The guidance in the Code will also be strengthened to address this issue. Conclusion To conclude, the GFXC is aiming to complete the review of the FX Global Code by mid next year. Reflecting the feedback from market participants that it broadly remains fit for purpose, the changes to the Code will not be significant. Where appropriate they reflect the ongoing evolution of the FX market. Besides that, the GFXC continues to discuss the functioning of the FX market, including around benchmarks, with a particular focus on FX settlement risk. 1 <www.globalfxc.org/agendas.htm> 2 <www.globalfxc.org/press/p200326.htm> 3 <www.globalfxc.org/docs/operational-challenges-facing-fx-industry-covid19.pdf> 4 <www.globalfxc.org/case_studies.htm?m=71%7C438> 5 See <www.bis.org/statistics/rpfx19.htm> and <www.bis.org/publ/qtrpdf/r_qt1912x.htm>. 4/4 BIS central bankers' speeches | reserve bank of australia | 2,020 | 10 |
Address by Ms Michele Bullock, Assistant Governor (Financial System) of the Reserve Bank of Australia, to Ayr Chamber of Commerce Event, online, 27 October 2020. | reserve bank of australia | 2,020 | 11 |
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Speech by Mr Philip Lowe, Governor of the Reserve Bank of Australia, Sydney, 3 November 2020. | Philip Lowe: Today's monetary policy decision Speech by Mr Philip Lowe, Governor of the Reserve Bank of Australia, Sydney, 3 November 2020. * * * Good afternoon. The Reserve Bank Board met this morning. It decided on a package of further measures to support the Australian economy as it recovers from COVID-19. Given the significance of this package, I wanted to explain in person what we are doing and why we are doing it and to answer your questions. At its core, today’s decision reflects the Reserve Bank’s commitment to do what we reasonably can, with the tools that we have, to support the recovery of the Australian economy. The Board views addressing the high rate of unemployment as a national priority and it wants to do what it can to support job creation. Importantly, today’s decision complements government efforts to support the Australian economy and to lower unemployment. When the virus first arrived on our shores, economic policy quickly turned to building a bridge to the recovery. This was the right strategy and this bridge has made a major difference to people’s lives, helping many people and businesses get through a very difficult period. This bridge was constructed through close co-operation by governments across Australia, the Reserve Bank, the financial regulators and Australia’s financial institutions. For the Reserve Bank’s part, we have kept borrowing costs low and the financial system very liquid and supported the supply of credit to the economy. This broad economic policy response and Australia’s progress on the health front have meant that the Australian economy is in a better shape than many others. While Australians have experienced a severe recession, it has not been as bad as was earlier expected or experienced in many other countries. In light of this experience, we have recently updated our economic outlook, with the full details to be published on Friday. These updated forecasts will contain an upgrade to the near-term economic outlook, although there are a number of factors weighing on the medium-term outlook, including lower population growth. On balance, both the recent household spending and employment data have been a little stronger than we were expecting. It now appears probable that GDP increased solidly in the September quarter despite the lockdown in Victoria. And growth over the year to June 2021 is expected to be close to 6 per cent compared with an expectation of 4 per cent growth when we reviewed our forecasts three months ago. The fiscal support, including through the Budget, has played an important role here. The unemployment rate is also now expected to peak at a lower rate than previously – at a little below 8 per cent, rather than the 10 per cent expected three months ago. This upgrade to the near-term outlook is clearly welcome news. At the same time though, we need to recognise that the pandemic has inflicted significant damage on our economy. It will take time to repair that damage and it is highly likely that the recovery will be uneven and drawn out. In particular, we face the prospect of a long period of higher unemployment and underemployment than we have become used to. In the RBA’s central scenario, job creation is slow over coming months and the unemployment rate is still around 6 per cent at the end of 2022. One consequence of this is that wages growth and inflation are both likely to stay very low. In each of the next two years, we are expecting annual wages growth of less than 2 per cent. And inflation, in underlying terms, is expected to be just 1 per cent next year and 1½ per cent in 2022. 1/5 BIS central bankers' speeches Given this outlook, the Board judged that it is appropriate to take further steps today to support the economy. Unemployment is a major economic and social problem that damages the fabric of our society. So, it is important that it is addressed. The Board recognises that, in the context of the pandemic, the responsibility for job creation falls mainly on the shoulders of business and government. But the Reserve Bank can, and will, make a contribution too. Today’s policy package does that and it builds on the contributions from our policy measures earlier in the year. Today’s package has three elements. These are: first, a reduction in the cash rate target, the three-year yield target and the interest rate on new drawings under the Term Funding Facility to 10 basis points, from the current 25 basis points. second, a reduction in the interest rate on Exchange Settlement balances to zero from the current 10 basis points. and third, the introduction of a program of government bond purchases. In particular, we are intending to buy $100 billion of government bonds over the next six months, purchasing bonds issued by the Australian Government as well as by the states and territories. Together, these three elements represent a significant package. The lower interest rates and our plan to buy $100 billion of government bonds over the next six months will help people get jobs and support the recovery of the Australian economy. The package combines the price-based target at the shorter part of the yield curve that has been in place since March with a quantity target at the longer part of the yield curve. In doing so, it will lower the whole structure of interest rates in Australia. This lower structure of interest rates will work to support the economy through the normal transmission mechanisms, including lower borrowing costs, a lower exchange rate than otherwise and higher asset prices. To be clear, the inflation target remains the cornerstone of Australia’s monetary framework. Even so, the priority over the next couple of years is jobs, with inflation risks remaining low. The RBA has a broad legislative mandate for price stability, full employment and the economic welfare of the Australian people. Today’s decision reflects that broad mandate. The Board expects that this new lower level of interest rates will be in place for an extended period. The Board will not increase the cash rate until actual inflation is sustainably within the target range. It is not enough for inflation to be forecast to be in the target range. For inflation to be sustainably within the target range, wage growth will have to be materially higher than it is currently. This will require a lower rate of unemployment and a return to a tight labour market. On the current outlook, it will take some years to get there. Given this, the Board is not expecting to increase the cash rate for at least three years. It remains the case that prior to any increase in the cash rate target, the Board intends to remove the three-year yield target. I would now like to provide some further details of the bond purchase program. At the start, it is important to point out that all purchases will be made in the secondary market through an open auction process. The RBA will not be buying bonds directly from governments. We plan to hold auctions three times a week: on Mondays, Wednesdays and Thursdays, with the first auction being on this Thursday. On Mondays and Thursdays we plan to purchase bonds issued by the Australian Government (AGS) and on Wednesdays we plan to purchase bonds issued by the states and territories (semis). We will focus on buying bonds with maturities of around five to 10 years, but may also buy bonds outside this range, depending upon market conditions. To assist with the smooth running of the 2/5 BIS central bankers' speeches auctions, we plan to buy AGS with five to seven-year maturities on Mondays and AGS with seven to 10-year maturities on Thursdays. For semis, we plan to alternate weekly between the five to seven and seven to 10-year securities, subject to market conditions. We will be purchasing fixed-rate nominal bonds only, as these are the benchmark fixed-income securities in Australia and they underpin the pricing of many other assets. Inflation-indexed bonds are not part of the program. The initial auctions for AGS will be for around $2 billion and the initial auctions for semis will be around $1 billion. This means that we expect to purchase around $5 billion per week. We will closely monitor the impact of our purchases on market functioning and are prepared to adjust the size and timing of the auctions if necessary. If the size of these initial auctions is maintained, 80 per cent of the bonds purchased would be AGS and 20 per cent would be semis. In allocating our bond purchases across the various states and territories we will be guided by the stock of debt outstanding and relative market pricing. These bond purchases mean that the RBA is now conducting quantitative easing, or QE, similar to that of many other central banks. I want to point out, though, that there has already been a very substantial increase in the size of our balance sheet as a result of our earlier measures. Once these additional bond purchases are completed mid next year, our balance sheet would have nearly tripled since the beginning of 2020, provided that the funds currently available under the Term Funding Facility are drawn upon. I also want to point out that this bond purchase program is separate from any bond purchases that we undertake to support the three-year yield target. We remain committed to buying bonds in whatever quantity is needed to support that target. Any bonds purchased in support of the threeyear yield target will be separate from the $100 billion. I would now like to address four specific questions that I know some people would have. I will then answer questions more broadly. These four specific questions are: 1. Why make this change now? 2. Is the RBA now financing the government? 3. Why have a price and a quantity target? 4. With interest rates so low, is the RBA now out of fire power? Why make these changes now? This is an understandable question, especially given that we are easing monetary policy further today at the same time as we are upgrading the near-term outlook for the economy. Apart from the general case for further monetary easing that I have already spoken about, there are a couple of other factors that have influenced the timing. The first is that over recent months we have learnt more about the pandemic and its economic impact. As the months have passed, it has become increasingly apparent that there will be longlasting effects, including high unemployment. While the outlook does remain uncertain, we do have a somewhat clearer picture of the future state of the labour market. A sharp bounce-back in jobs is unlikely and it will take time to return to where we were before the pandemic. We have responded to this clearer picture today. The second factor is that monetary easing is likely to get more traction today than it would have when widespread restrictions were in place. In earlier months, the usual transmission 3/5 BIS central bankers' speeches mechanisms were not working as normal and the challenges facing the country were best addressed by other policy tools. However, as restrictions are eased and people have more opportunities to spend, our judgement is that further monetary easing now provides additional support to other policies, including the fiscal initiatives and the RBA’s earlier monetary policy package. In reaching today’s decision, the Board also considered the effects on medium-term financial and macro stability as well as the impact on savers. The Board recognises that low rates can encourage some additional risk-taking, as investors search for yield. It also recognises that low deposit rates can create difficulties for some people. These issues will need to be closely watched over the months ahead. But the Board judged that the bigger risk at the moment was the threat to our economy and to balance sheets from an extended period of high unemployment. Today’s decision will lessen that risk. Is the RBA now financing the government? The answer is a simple no. Today’s decision does not change the long-standing separation of monetary policy and fiscal financing in Australia. The RBA is not financing government spending. I want to highlight the important distinction between providing finance and affecting the cost of that finance. The RBA is not providing finance to the government, but our actions are lowering the cost of government finance. I should point that our actions are also lowering the cost of finance for all other borrowers in Australia, whether they are a household buying a home or a business wanting to expand. This lower cost of finance for everybody is supporting the recovery from the pandemic. It is important to point out that the bonds purchased by the RBA will have to be repaid by the government at maturity. They will have to be repaid in exactly the same way as would occur if the bonds were held by others. The same is true for the ongoing coupon payments on the bonds. The fact that the RBA is holding some bonds makes no difference to the financial obligations of the government, other than through a lower cost of finance. The Australian Government and the states and territories continue to fund themselves in the market, as they should. Raising funds in the market is an important discipline and movements in market prices can contain valuable information. Recent bond auctions have been heavily oversubscribed, even though the size of these auctions has been a record high. There is strong demand by domestic and global investors for bonds issued by the Australian Government and by the states and territories. I expect that this will remain the case. Why have a price and a quantity target? As part of the RBA’s March package, we announced a price target for the yield on the three-year Australian Government bond, rather than a quantity of bonds to purchase. We viewed the yield target as the more direct way of achieving our objective of low funding costs. The target also reinforced our forward guidance regarding the cash rate. Given that we expected the cash rate to remain low for some years, we judged it appropriate to target a three-year yield and stand behind that target with our balance sheet. These arguments for a yield target remain valid and so we are continuing with the three-year yield target. We considered targeting a longer yield – say five years – but decided against this. This was on the basis that the yield target is most effective when it is consistent with our forward guidance on the cash rate. As I said earlier, we expect the cash rate to be at its current level for at least three years. Beyond that, we have less confidence. I certainly hope that the economy will be sufficiently strong sometime over the next five years to warrant an increase in the cash rate. So three years, not five years, is the appropriate maturity for the yield target. 4/5 BIS central bankers' speeches Today’s decision supplements this price target with a quantity target further out along the yield curve. This quantity target is similar to the approach adopted by many other central banks, which have responded to the pandemic with government bond buying programs. The evidence is that these programs have lowered government bond yields in other countries. One result of this is that Australia has had higher long-term bond yields than elsewhere, even though the setting of the short-term policy rate is similar across countries. These higher bond yields have added to the attractiveness of Australian dollar assets and this has put some upward pressure on the exchange rate. There has also been an accumulation of evidence that central bank balance sheet expansion has a stimulatory effect beyond that resulting from lower bond yields. When the central bank buys assets, investors in the private sector adjust their portfolios, buying different assets with the proceeds of their bond sales. This portfolio rebalancing can affect the price of other assets and international capital flows, as well as the exchange rate. Given these considerations, the Board judged it was now appropriate to combine the three-year yield target with QE further out along the yield curve. Is the RBA now out of firepower? The short answer here again is no. The Reserve Bank is not out of firepower. We have additional monetary policy options and we are prepared to use them if the circumstances require. In terms of interest rates, I think we have gone as far as it makes sense to do so in the current environment. There has been no change to the Board’s view that there is little to be gained from lowering the policy rate into negative territory. While a negative rate might lead to a helpful depreciation of the Australian dollar, it could impair the supply of credit to the economy and lead some people to save more, rather than spend more. Given this assessment, the Board continues to view a negative policy rate in Australia as extraordinarily unlikely. But monetary policy is now about more than just short-term interest rates – we have returned to a world in which quantities matter too. In this world, it is certainly possible for us to increase the size of our bond purchases. Given this, we will continue to closely monitor the economic situation and the impact of our purchases on market functioning. If we need to do more, we can and we will. The RBA also has a range of tools to support the proper functioning of markets and address market dysfunction were that to occur. These tools include further liquidity provision, asset purchases and transactions in the foreign exchange market. So it would be incorrect to conclude that we are out of firepower. That brings me to the end of the four questions I posed. I am now happy to answer any other questions that you might have. Thank you. 5/5 BIS central bankers' speeches | reserve bank of australia | 2,020 | 11 |
Address by Mr Philip Lowe, Governor of the Reserve Bank of Australia, at the Committee for Economic Development of Australia Annual Dinner, Sydney, 16 November 2020. | Speech Covid, Our Changing Economy and Monetary Policy Philip Lowe [ * ] Governor Committee for Economic Development of Australia Annual Dinner Address Sydney – 16 November 2020 Thank you very much for the invitation to speak at CEDA's annual dinner. After so many webinars and Zoom meetings, it is great to be able to be here in person. 2020 has been a year like no other and one we will never forget – a global pandemic, the closure of our borders, the biggest economic downturn in nearly a century, a very large budget deficit, interest rates down to zero and QE by the RBA. None of this was expected at the start of this year. Unfortunately, it guarantees that 2020 will be a year that is talked about for decades to come. Yet through these difficult times, the underlying strengths of the Australian economy and people have been on display. Our economy has performed better than many others in challenging circumstances. We have had more success in containing the virus than many other countries. Australia's public institutions have worked effectively and constructively together. Our public sector balance sheets are strong and have been used to good effect to cushion the shock. Our financial institutions have also helped people and businesses manage their mortgages and their debts. And Australians across the country have reacted sensibly and worked together to contain the virus. So, even though we have had our challenges and setbacks, we do have a lot to be thankful for. Notwithstanding this, a year like the one we are living through will inevitably leave some marks on our economy and on economic policy, including on monetary policy. Tonight I would like to talk about some of these. In terms of the economy, I am going to touch on five areas where the pandemic is leaving a mark. The recession and the labour market The first is that it has brought an end to Australia's nearly three decade-long run without a recession. This was an impressive record and it is one that will not easily be broken by us or by others. We are now, though, having to adjust to a new reality. The level of output in Australia fell by a record 7 per cent in the June quarter and over 2020, we are expecting GDP to decline by around 4 per cent (Graph 1). In the RBA's central scenario, we are expecting growth of 5 per cent next year and 4 per cent over 2022. These are fast growth rates, but because of the size of the fall in the first half of this year it will take until the end of 2021 for us to reach the level of output at the end of last year. Graph 1 GDP Central Scenario December 2019 = 100 index Forecast index Sources: ABS; RBA This downturn has taken a heavy toll on our labour market. Hours worked in Australia fell 10 per cent between March and May and the unemployment rate has risen to 6.9 per cent, with underemployment even higher. We are expecting the unemployment rate to rise further over coming months to a little below 8 per cent. In our central scenario, we expect it then to start gradually declining, but still be a little above 6 per cent at the end of 2022 (Graph 2). Graph 2 Unemployment Rate Central Scenario % Forecast % Sources: ABS; RBA One consequence of this higher unemployment is that wage and price pressures are likely to remain subdued. In each of the next two years, we are expecting annual wages growth of less than 2 per cent. And inflation, in underlying terms, is expected to be just 1 per cent next year and 1½ per cent in 2022. It is certainly possible that the economy will do better than this baseline scenario. The recent data have been better than expected and the easing of restrictions has lifted spirits. Further good news on a vaccine and rapid testing would also help. There is a lot of stimulus in the system, balance sheets are generally in good shape and governments are providing substantial incentives for firms to invest and employ people. So if we do get further good news on the health front, we could have a rapid rebound. At the same time, it is still possible that we experience further outbreaks. And the hoped-for medical advances may be delayed and could face production and distribution challenges slowing their rollout. This means that there are downside scenarios too. So there is still considerable uncertainty about the outlook. It does, though, seem highly probable that one of the marks the pandemic will leave is an extended period of higher unemployment than we have become used to. Addressing this is an important national priority. Lower population growth A second area where the pandemic has left a mark is the sharp decline in population growth. Over the past two decades, Australia's population grew at an average annual rate of 1½ per cent (Graph 3). But in 2020/21, it is expected to increase by just 0.2 per cent. This will be the slowest rate of increase since 1916, when many Australians left our shores to fight in the First World War. Graph 3 Population Growth % % Projection -2 -2 Sources: ABS; Australian Treasury; RBA The fast population growth of recent decades has been a major factor shaping our economy. It has underpinned our relatively fast growth in GDP compared with other advanced economies. It also slowed the ageing of the population, given that the new arrivals have been fairly young. The large number of students coming to Australia has also boosted our education sector. And the effects of fast population growth have also been felt in our housing market and in pressure on some of our infrastructure. So the effects have been widespread. Looking to the future, it remains hard to predict when the borders will open again and when they do, what the rate of new arrivals will be. If population growth is to be noticeably slower in a post-COVID world, the trajectory for our economy will look different too. A changed property market A third area where the pandemic is having a marked effect is on our property market. It is a complex picture here, with the market simultaneously adjusting to: a recession; lower population growth; record low interest rates; substantial government incentives to support residential construction; and changes to the way that people work, shop and live. So there are a lot of moving pieces at present and the effects are very uneven across different types of property and across the country. The effects of the pandemic are most obvious in the market for retail properties in our CBDs, where vacancy rates have increased sharply (Graph 4). Not surprisingly, rents and the capital values of these properties have both fallen. There has also been an impact on the CBD office market, as people work from home. The national office vacancy rate has increased sharply this year and further increases are expected (Graph 5). But even here, there is considerable variation across our cities, with the biggest increase in CBD office vacancies in Sydney and Melbourne. In contrast, the markets for industrial property have been stronger, with increased demand for warehousing and distribution facilities as people increasingly shop online. Graph 4 Retail Vacancy Rates* By property type % % CBD retail 10.0 10.0 7.5 7.5 5.0 5.0 Regional** 2.5 2.5 0.0 * ** Vacancy rates for specialty stores Centres anchored by department stores Source: JLL Research 0.0 Graph 5 Office Vacancy Rate* National CBD market % % * Excluding Hobart and Darwin Source: JLL Research The residential market is also a mixed picture. Our biggest cities have been more affected than others by the slowdown in population growth. They have also been more directly affected by the virus. As a result, prices in Sydney and Melbourne have fallen over recent months, while they have risen in most other cities. It is also noteworthy that in some states, the markets in our regional towns and cities have been stronger than those in the capital cities. For example, while prices have fallen in Sydney they have increased in regional NSW (Graph 6). Many regional centres have been less affected by the virus and some are experiencing increased demand as people work remotely and look for property outside the big cities. Graph 6 Housing Price Growth Six-month-ended annualised % % New South Wales Capital city Regional -10 % -10 % Victoria -10 -10 -20 -20 Sources: CoreLogic; RBA Within the capital cities, the markets for houses and apartments are also performing quite differently. In most cities – especially Sydney and Melbourne – rents for apartments are falling, while rents for houses are generally rising (Graph 7). The apartment markets are more affected by the lower population growth and fewer foreign students and by young adults staying at home with their parents. There has also been an increase in demand for houses as people work from home. Graph 7 Advertised Rents Growth Six-month-ended annualised % Houses Sydney % Melbourne -10 -10 Apartments and townhouses Brisbane % % Perth -10 -10 -20 -20 Sources: CoreLogic; RBA As I said, it is a complex picture and the full effects of the pandemic will take time to be evident in our property market. To date, the demand from investors in residential property has been subdued, but it is possible that low interest rates will change this. This is one of the many areas that we will be watching carefully in the period ahead. Attitudes to risk The fourth area where the pandemic is likely to leave a mark is on our attitude to risk. While it is not possible to be definitive here, I expect that for a time, people will be more cautious in their borrowing and spending decisions. As we all know, 2020 has been a sobering year. Given this, it is probable that some people will want bigger buffers in future in case things go wrong. They might also be less inclined to lever up and be more cautious in taking on debt. At the same time, though, it is important that we guard against becoming too risk averse. Over the past decade or so, there have been signs that our economy was becoming less dynamic. An increase in risk aversion would reinforce this trend. We all know that businesses need to take risks to innovate and grow. I understand that in an uncertain world, it can be hard to take on risk and there can be a natural tendency to avoid new risks. But, if businesses are to seize the opportunities that are out there to grow and to increase Australia's productive capital base, some degree of risk-taking is necessary. Another area we will be watching carefully is how people adjust their portfolios as they search for yield in a low interest rate environment. Some people will no doubt move out along the risk spectrum. As they do so, the additional investment risks will need to be understood and managed. Productivity and the digitalisation of our economy A fifth area where the pandemic is leaving a mark is in the digitalisation of our economy. In some areas, progress that otherwise would have taken years has been made in a matter of months. The combination of necessity, new technologies and the easing of regulations has made a real difference. Digitalisation is not only helping Australians deal with the pandemic, but it will also boost productivity and can help drive future economic growth. Examples of this include the uptake of telehealth and the availability of electronic prescriptions. Companies can also now hold AGMs virtually and more legal documents can be executed electronically. Many people are also benefiting from not having to travel as much for work and for meetings. For some, the time that they would otherwise have spent sitting in cars or on public transport and planes can now be used for more productive or rewarding activities. There has also been very rapid growth in online retailing, with many people shopping online for the first time (Graph 8). Reflecting this, online retail sales have increased by 80 per cent since the start of the year. Graph 8 Online Share of Retail Sales % % Sources: ABS; RBA The shift to doing things differently is also evident in the payments data, where there has been a marked increase in the use of electronic forms of payment. One side effect of this is that the use of banknotes for transactions has declined considerably, with the value of cash withdrawals falling by 17 per cent this year (Graph 9). Graph 9 Total Value of Cash Withdrawals* Monthly, seasonally adjusted** $b $b * ** Includes ATM withdrawals, debit card cash-outs and credit and charge card advances; excludes over-the-counter withdrawals Series break between February 2018 and May 2018 due to changes in collection and reporting methodology Source: RBA This acceleration in the shift to a more digital economy is prompting firms to innovate and to find new ways of doing things. They are having to compete to come up with new products and new ways of delivering them. This innovation and competition will have a positive payoff for our economy. It will take time to realise the full benefits, but as businesses are re-engineered to become more digital we will all see the benefits in terms of higher productivity. Economic policy On that positive note, I would now like to turn to economic policy, where there have been major changes too. On the fiscal front, fiscal policy has taken on a greater role in macroeconomic stabilisation than was the case prior to the pandemic. This is entirely appropriate and reflects both the size and nature of the shock that we have experienced and the limits on monetary policy in a low interest rate world. This change has been accompanied by a shift in the government's broader fiscal strategy. The first stage of the revised strategy is to support the economy and jobs and promote economic growth until the recovery is assured. This focus will remain in place until the unemployment rate is comfortably below 6 per cent. This is a form of forward guidance familiar to central banks. In the longer run, the strategy will shift to stabilising and reducing debt as a share of GDP. Doing this will provide greater flexibility to respond to future shocks, wherever they come from. The key here is to ensure a strongly growing economy, so we need to focus on the reforms and innovations that will deliver this. There have also been changes on the monetary policy front. I would like to highlight four. The first is the nature of the RBA's own forward guidance. In the past, our forward guidance about interest rates was forward looking – we have focused on the outlook, or forecast, for inflation. This was a sensible approach when the inflation dynamics were stable and predictable. But the combination of globalisation and technology and now the pandemic have changed these dynamics. Labour markets are working differently than they used to and wage and inflation dynamics have changed. This has made relying on forecasts more difficult. Given this, we have now moved to place much more weight on actual outcomes, rather than forecast outcomes, in our decision-making and in our forward guidance. As an example of this, in our communication after the most recent Board meeting we said ‘the Board will not increase the cash rate until actual inflation is sustainably within the 2 to 3 per cent target range. For this to occur, wages growth will have to be materially higher than it is currently. This will require significant gains in employment and a return to a tight labour market.’ This forward guidance is in contrast to the earlier approach, which emphasised our expectation of future inflation. A second and related change has been a shift in the relative weight given to jobs and inflation in our communication. The mandate of the Reserve Bank of Australia was established by Parliament back in 1959 and the central elements have remained unchanged since then. Our mandate is to promote price stability, full employment and the economic welfare of the Australian people. This mandate is broader than that given to most other central banks, with Australia not swinging with the fashion over recent decades to adopt a singular focus on inflation. My view is that this broader mandate has served the country well and that it is especially relevant in today's world. In particular, the challenge facing Australia over the next few years is much more likely to be the creation of jobs, rather than controlling inflation pressures. So that is our focus too. The Board wants to do what it can, with the tools that it has, to support the national effort to reduce unemployment. This does not mean that we are backing away from the inflation target. As Australia's central bank, we will continue to provide a strong nominal anchor through the 2 to 3 per cent medium-term flexible inflation target. We remain committed to achieving this target. The best way to do this is through reducing the spare capacity that currently exists in the economy. And this starts with getting people back into jobs. If this can be done we will get closer to both full employment and the inflation target and enhance the economic welfare of the Australian people. The third change to monetary policy is a strengthening in the gravitational pull of low global interest rates. A decade ago, world real interest rates fell sharply in the aftermath of the global financial crisis. Around the world, people wanted to save more and invest less. The inevitable result was that the return to savers fell. Given that Australia is part of the interconnected global financial system, we felt the effects of this here too. Even so, our interest rates did not fall as far as they did elsewhere due the combination of the resources boom, our relatively strong economy and higher levels of investment in Australia. This year, the pandemic has brought another major shock, with investment intentions falling further. As a result, global interest rates and the return to savers have also declined. The gravitational pull of this on our own interest rates has been very strong. The RBA has responded to this, with the policy rate now essentially zero in Australia, as it is in many other countries. If we had sought to ignore this gravitational pull, there would have been obvious implications for our exchange rate and our economy. If our interest rates were higher than in the major countries there would be stronger inflows into Australian dollar assets and this would put upward pressure on our exchange rate. In turn, this would make it harder to make the needed progress on jobs. Over the medium term, I do expect to see a time when Australia's strong economic conditions once again justify higher interest rates. But today, during a global pandemic when a lot of people have lost their jobs and many businesses are struggling, is not the time for that. The fourth and final change on the monetary front is the return to a world in which quantities, not just prices, matter. Over recent decades, monetary policy has been about the price of money, or the short-term interest rate. Little attention was paid to the quantity of money. This has now changed, with the RBA now undertaking QE, or quantitative easing, as many other central banks are also doing. Quantities and prices are obviously connected, so QE works partly through affecting the price of money, including long-term risk-free interest rates. But there are other effects too. When the central bank increases the quantity of money and buys assets, liquidity in the financial system is increased and investors in the private sector need to purchase other assets with the proceeds of the bonds they sell to the central bank. These portfolio adjustments can affect the price of other assets and international capital flows, as well as the exchange rate. We are still learning about how strong and durable these transmission mechanisms are, and we will learn more over coming months as we implement our own $100 billion QE program. To conclude, 2020 has been a year of great change and disruption. We are all talking about issues that few of us even contemplated at the start of the year. Australia is managing well in these challenging circumstances and I expect it to continue to do so. The pandemic has been difficult for many people and businesses, but we are now on the road to recovery. As we travel along that road we will see some changes in our economy and there will be new opportunities as well. As we make that journey, economic policy will also continue to adjust to our changing circumstances. Thank you for listening. I look forward to your questions. Endnotes [*] I would like to thank Ellis Connolly for assistance in preparing this talk. See Kennedy S (2020), ‘Policy and The Evolution of Uncertainty’, speech at the Australian Business Economists, 5 November. The materials on this webpage are subject to copyright and their use is subject to the terms and conditions set out in the Copyright and Disclaimer Notice. © Reserve Bank of Australia, 2001–2020. All rights reserved. The Reserve Bank of Australia acknowledges the Aboriginal and Torres Strait Islander Peoples of Australia as the Traditional Custodians of this land, and recognises their continuing connection to Country. We pay our respects to their Elders, past, present and emerging. | reserve bank of australia | 2,020 | 11 |
Remarks by Mr Christopher Kent, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, at the Australian Securitisation Forum Virtual Symposium, Sydney, 17 November 2020. | Christopher Kent: Benchmark reforms Remarks by Mr Christopher Kent, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, at the Australian Securitisation Forum Virtual Symposium, Sydney, 17 November 2020. * * * Introduction Thank you for the opportunity to speak at the ASF Symposium again this year. Benchmark reform is a critical issue to all of us since it will help to underpin the healthy functioning of financial markets. Much work has already been done in this area, but much remains to be done in the year ahead as we look to transition away from LIBOR. I’ll spend a bit of time reviewing the work ahead of us. A key aspect of this is the adoption of fallbacks. While these are an important part of the LIBOR transition, they also should be in place for a much wider range of financial contracts, including those that reference BBSW. The end of LIBOR The end of LIBOR is a certainty. It is critical that Australian institutions – both sell-side and buyside – are ready for this by no later than the end of 2021. Institutions need to have done one of two things. They can transition away from LIBOR by using alternative reference rates. Or, for contracts where that’s not possible, they can ensure that robust fallback provisions are in place. Doing either one will provide certainty about the replacement rate when LIBOR ends. Institutions that continue using LIBOR beyond the end of next year face significant legal, operational and reputational risks. When LIBOR ends, any firms with contracts still referencing LIBOR – and without fallbacks in place – will face contractual disputes, litigation and frustration. There is the potential for this to lead to a firm facing financial and operational disruptions. Any such firms then risk disrupting financial markets more generally. So we all need to get our respective houses in order. The state of readiness for the LIBOR transition is something that the RBA, ASIC and APRA are all watching closely. ASIC and APRA have supervisory responsibilities in this area and associated powers to pursue if needed. Our current assessment is that Australian firms have made progress on the LIBOR transition to date. There is, however, variation across firms and continued focus and effort is needed in the year and a bit that remains. The Financial Stability Board (FSB) has recently published a Global Transition Roadmap for LIBOR putting a timeline on the steps involved that you should be aiming to meet.1 In particular: By now you should have identified and assessed all existing LIBOR exposures and agreed on a plan to transition before the end of 2021. By the end of this year, financial institutions should be offering non-LIBOR linked loans to their customers. By 25 January 2021, firms should be adhering to the ISDA IBOR fallbacks protocol. (I’ll talk more about that in a moment.) By mid next year, firms should have established formal plans to amend legacy contracts where this can be done. They also need to have implemented the necessary changes to 1/4 BIS central bankers' speeches their systems and processes to enable transition to robust alternative rates. If you follow these steps in a timely manner, your institution will be ready for the end of LIBOR. ASIC, APRA and the RBA have published a more detailed checklist of the range of things you need to make sure you cover in your transition plans.2 Fallbacks are important for LIBOR and beyond Fallbacks will play an important role in the orderly transition away from LIBOR. These will be necessary in the cases where transition to alternative reference rates for legacy contracts is not feasible. This is why ISDA’s recent publication of fallback provisions for LIBOR is such welcome news. These fallbacks will automatically be included in new contracts as part of ISDA definitions from 25 January 2021. And there’s an associated ISDA protocol to incorporate the fallbacks in existing contracts.3 Robust fallbacks will significantly reduce the risks of contractual disputes, litigation and frustration for firms when LIBOR ends. Accordingly, ASIC, APRA and the Reserve Bank are strongly encouraging Australian financial institutions and corporations that use derivatives contracts referencing LIBOR to review and, wherever practical, adhere to the ISDA protocol by its effective date.4 The Reserve Bank has already adhered to the ISDA protocol, as have some of our major Australian financial institutions. Again, it is our strong expectation that, wherever practical, Australian institutions will adhere to the ISDA protocol. But the need for robust fallbacks goes beyond contracts that reference LIBOR. This includes contracts that reference other benchmarks, such as BBSW. Fallbacks provide important insurance. And if there’s one thing that LIBOR has shown us, it’s that we shouldn’t take existing benchmarks for granted. So the global central banking and financial supervisory community has been promoting the adoption of robust fallback provisions as part of the broader program of global benchmark reform. This is why the Reserve Bank worked with ISDA as fallback provisions for credit benchmark rates were being developed. We needed to ensure that our local credit-based benchmark, BBSW, was included in the ISDA fallbacks and protocol. In time, the Reserve Bank will require securities that reference BBSW to include the relevant ISDA fallback provisions in order to be eligible as collateral in our market operations. I know that there is a lot of good work already underway in industry towards developing market conventions in this area – including by the ASF. In the period ahead, we will be seeking views from market participants on how and when we are going to implement this new eligibility requirement for our market operations. BBSW in the context of global benchmark reform Australia’s local credit-based benchmark BBSW remains robust. A lot of work has gone into strengthening the methodology underlying its calculation and the supporting infrastructure and market practices. This has allowed Australia to pursue a multiple-rate approach for our local reference rates. This means that, unlike for LIBOR, regulators in Australia aren’t advocating a wholesale transition to referencing the risk-free rate, which in Australia’s case is the cash rate, also known as AONIA. 2/4 BIS central bankers' speeches Instead, we expect market participants to choose robust reference rates that best suit each of their products and situations, taking into account their own and their clients’ needs or hedging strategies: In some cases, referencing the cash rate will make sense. Floating rate notes issued by governments, non-financial corporations and securitisation trusts are possible examples. But in other cases, a credit-based benchmark, like BBSW will continue to make sense. Floating rate notes and corporate loans issued by banks are examples of this. But as I’ve said before, not all BBSW tenors are as robust as others.5 In particular, the 1month BBSW is largely a buy-back market. Accordingly, it is less liquid than other tenors. So users of 1-month BBSW should be considering using alternative benchmarks given the lack of liquidity in this market. It’s also worth noting that for some products, approaches adopted widely by market participants offshore will have an important bearing on the reference rates we are likely to end up using here. So regardless of the robustness of BBSW, we can expect to see a shift towards referencing risk-free rates in Australia for some products if that is the trend adopted offshore. The risk-free rate in Australia Before I conclude, I want to make a few comments on Australia’s risk-free rate, which again is the cash rate. The RBA is the administrator of the cash rate benchmark. Accordingly, we’ve made sure that the procedures underpinning the cash rate are robust. The details of these procedures are available on our website.6 These ensure that the cash rate will continue to be published, even in circumstances when there are insufficient transactions in the market on a given day to calculate the cash rate based on those transactions. These procedures have been put to the test in recent months, as activity in the cash market has on a number of occasions declined below the relevant thresholds. In most cases, the cash rate has been determined as the last published rate based on sufficient transaction volumes. But the procedures also allow for the cash rate to be determined by the RBA in its expert judgement and based on market conditions. So this has ensured that the cash rate continues to reflect the interest rate relevant to unsecured overnight funds. In short, the Reserve Bank can assure you of the robustness of the cash rate as a benchmark. Thank you for your attention. I look forward to your questions. 1 See FSB (2020), ‘Global Transition Roadmap for LIBOR’, 16 October. Available at <www.fsb.org/2020/10/global- transition-roadmap-for-libor/>. 2 See RBA, APRA and ASIC (2020), ‘Regulators Release Feedback on Financial Institutions’ Preparation for LIBOR Transition’, Media Release No. 2020–12, 8 April. Available at <www.rba.gov.au/media-releases/2020/mr20–12.html>. 3 See ISDA (2020), ‘SDA Board Statement on the IBOR Fallbacks Supplement and Protocol’, Press Release, 9 October. 4 See RBA, APRA and ASIC (2020), ‘Regulators urge Australian institutions to adhere to the ISDA IBOR Fallbacks Protocol and Supplement’, Media Release No. 2020–25, 13 October. Available at <www.rba.gov.au/mediareleases/2020/mr-20–25.html>. The Financial Stability Board also released a statement strongly encouraging widespread and early adherence to the protocol. See FSB (2020), ‘FSB encourages broad and timely adherence to the ISDA IBOR Fallbacks Protocol’, Press Release, 9 October. 5 See Kent (2019), ‘Bonds and Benchmarks’, Speech at KangaNews DCM Summit, webcast, 19 March. 3/4 BIS central bankers' speeches 6 See RBA (2020), ‘Cash Rate Procedures Manual’, 17 June, rba.gov.au site. Available at <www.rba.gov.au/mkt- operations/resources/cash-rate-methodology/cash-rate-procedures-manual.html>. 4/4 BIS central bankers' speeches | reserve bank of australia | 2,020 | 11 |
Speech by Mr Guy Debelle, Deputy Governor of the Reserve Bank of Australia, at the Australian Business Economists Webinar, online, 24 November 2020. | 11/24/2020 Monetary Policy in 2020 | Speeches | RBA Speech Monetary Policy in 2020 Guy Debelle [ * ] Deputy Governor Australian Business Economists Webinar Online – 24 November 2020 I spoke at the ABE annual event 2 years ago in December 2018. [1] In that speech, I talked about the lessons and questions from the global financial crisis that had occurred 10 years earlier. Today, the global economy has experienced another crisis, but one which has taken a very different form. The source of the crisis this time has been a health event rather than a financial one. The contraction in output in the global economy and in the Australian economy has been considerably larger and more synchronised than in 2008/09. But some of the lessons we learned from the financial crisis have helped to lessen the impact this time around and will help in speeding the recovery that is underway. The lessons that I highlighted in 2018 were: 1. Leverage matters. The regulatory response since 2008 has been aimed at addressing the leverage in the core of the financial system 2. Timely policy responses are effective. In a crisis, go fast and go hard. Don't die wondering 3. Plumbing can sometimes really matter. Keep the credit pipes flowing 4. Targeted policy responses are effective. These lessons are evident today. The importance of a timely policy response is particularly evident. The size and rapidity of the fiscal and monetary policy responses have been unprecedented. The fiscal stimulus provided has been the largest outside wartime in many countries. This is true in Australia, where the federal government's budget deficit in 2020/21 is expected to be 11 per cent of GDP, having been near balance at the beginning of this year (Graph 1). The state governments have also provided stimulus, with their budget deficits around 4 per cent of GDP. https://www.rba.gov.au/speeches/2020/sp-dg-2020-11-24.html 1/14 11/24/2020 Monetary Policy in 2020 | Speeches | RBA Graph 1 Australian Government Financial Balance* Per cent of GDP % % -10 -10 2020/21 Budget forecast -20 -20 -30 1903 / 04 23 / 24 43 / 44 63 / 64 83 / 84 -30 03 / 04 2023 / 24 * Experimental historical series before 1971 then the underlying cash deficit after; additional structural break in 1962 Sources: ABS; Australian Treasury; Barnard (1986); Butlin On the monetary front, policy rates have been reduced where that was possible, often to their effective lower bound. Central bank balance sheets have expanded significantly. While the stimulus has been provided in large scale, some aspects of the policy response have been targeted at particularly affected sectors of the economy. In line with the fourth lesson, these targeted measures have been designed to taper as conditions improve or to serve as a backstop should conditions deteriorate. There was one lesson from the crisis I didn't talk about 2 years ago that is relevant to today: be careful of removing the stimulus too early. A number of European countries learned this lesson to their cost after the global financial crisis. That leverage matters is evident in the post-financial crisis reforms to the financial system. The Australian and global banking systems came into the current episode in a good position. Banks are holding more capital and have much stronger liquidity positions. Banks were at the centre of the financial crisis in 2007. In contrast, banks were not a catalyst to the financial tumult back in March. Banks have strong balance sheets that are able to support the economy through the downturn and into the recovery. Examples of this are in the ability to offer loan deferrals as well as the capacity to make provisions for future loan losses without compromising capital. Banks with strong balance https://www.rba.gov.au/speeches/2020/sp-dg-2020-11-24.html 2/14 11/24/2020 Monetary Policy in 2020 | Speeches | RBA sheets can lend to businesses and households to support the economic recovery, rather than being concerned with restoring balance sheets as has been the case in previous cycles. The strong capital buffers of the banks are there to be used, not preserved. This point has been clearly stated by APRA. This leads to the third lesson: keep the credit flowing. The actions of central banks to stabilise dislocated markets also had that as one of the primary motivations. In many countries, including Australia, central bank bond purchases helped stabilise government bond markets that serve as the key pricing benchmark for the financial system. This was particularly so in the US, where the Treasury market is a pivotal foundation of global financial markets. The one question I posed at the end of my 2018 speech was how much debt is enough and how much is too much. I said that the question remained generally unresolved. But in the case of public debt in Australia, there is a very clear answer. In Australia, public debt is very manageable. Public sector debt remains low as a share of GDP for the Australian Government as well as the states and territories, even after the sizeable stimulus that is being implemented. Australian governments have been able to provide the substantial and very necessary fiscal support to the economy. It is also important to ask: what is the alternative? Absent the fiscal support, the Australian economy would be much weaker with the consequent economic and social damage. This would have materially worsened the fiscal position. I don't see there is a trade-off between fiscal sustainability and fiscal support in the current circumstance. The cost of borrowing is at historically low levels for Australian governments. Borrowing costs are likely to remain very low for quite some time, and almost certainly until the economy is considerably stronger. This means that the debt dynamics for the Australian Government and the states and territories are absolutely sustainable. Monetary Policy Actions In the rest of my talk today I will summarise the policy actions that the RBA has taken since March to support the Australian economy. I will describe how they have been transmitted to the economy and financial markets so far. First I will recap the actions the Board has taken to date. In mid March, as the impact of the virus and the health policy actions on the Australian economy became evident, the Board put in place a comprehensive package: a reduction in the cash rate target to 25 basis points, having already reduced the cash rate to 50 basis points at the earlier March Board meeting the introduction of a target on the 3-year Australian Government bond of around 25 basis points. The Bank also would purchase bonds to address market dysfunction a Term Funding Facility (TFF) for the banking system under which funds can be provided for 3 years at 25 basis points https://www.rba.gov.au/speeches/2020/sp-dg-2020-11-24.html 3/14 11/24/2020 Monetary Policy in 2020 | Speeches | RBA the continued use of the RBA's open market operations to make sure that the financial system had a high level of liquidity. The RBA had already been expanding its liquidity provision prior to this Board meeting to address the growing dislocation in financial markets the modification of the interest rate corridor system, with the rate paid on Exchange Settlement (ES) balances set at 10 basis points. In September, as the deadline for drawings on the initial allowances under the TFF approached, the Board decided to expand the TFF to provide additional low-cost funding equivalent to 2 per cent of lending in the banking system. Then at the November Board meeting, the Board decided on a further package of measures to support the economy: a reduction in the cash rate target, the 3-year yield target and the interest rate on new drawings under the TFF to 10 basis points, from 25 basis points a reduction in the interest rate on ES balances from 10 basis points to zero the introduction of a program of government bond purchases, focusing on the 5–10 year segment of the yield curve. The RBA will buy $100 billion of government bonds over 6 months in the secondary market, purchasing bonds issued by the Australian Government (AGS) as well as by the states and territories (semis). Transmission of Monetary Policy The motivation for these policy actions is to provide support for the Australian economy. It is complementary to the necessary and welcome significant fiscal stimulus provided by the Australian Government and the states and territories. Its aim has been to deliver low borrowing costs for households, businesses and the government. These low borrowing costs are a necessary precondition to support investment and spending as confidence in the health and economic outlook improves. In addition, the monetary response boosts the cash flow of households and corporate borrowers by lowering their debt-servicing costs, which more than offsets the effect of the reduction in interest income on deposits. Asset prices are also supported, which bolsters balance sheets of households. Finally, the lower structure of interest rates leads to a lower exchange rate than otherwise. All of these channels of transmission boost aggregate demand in the economy and hence employment. I will now step through in more detail how these policy actions have been transmitted through financial markets to the Australian economy. First the reduction in the cash rate target and the remuneration on ES balances has seen all shortterm interest rates decline to historically low levels. [3] This decline has been further accentuated by the large amount of liquidity in the financial system as a result of the Bank's policy actions. https://www.rba.gov.au/speeches/2020/sp-dg-2020-11-24.html 4/14 11/24/2020 Monetary Policy in 2020 | Speeches | RBA The large increase in liquidity was initially provided in response to the heightened demand at the Bank's daily open market operations. Subsequently this has been bolstered as authorised deposittaking institutions (ADIs) have drawn on their allocations to the TFF. Given the ample liquidity in the system, including the significant take-up of the TFF, [4] as those earlier liquidity injections in March and April matured, they have generally not been rolled over. As a result, the size of the RBA's repo book from our regular market operations has shrunk considerably. But the total of repos under the TFF and daily market operations remains very large, generating a large amount of system liquidity (Graph 2). Graph 2 Monetary Policy Operations Value outstanding on settlement basis $b Liquidity Operations* $b TFF M A M J J A S O N * Liquidity injections net of drains and maturities; contracted in OMOs, FX swaps and short-dated bond purchases Source: RBA The liquidity in the system has been further increased by the Bank's bond purchases. When the Bank buys bonds, there is an increase in ES balances as the Bank credits the ES accounts of the counterparties that it buys the bonds from. The large rise in ES balances has seen the cash rate fall to be close to the interest rate on ES balances. Up to October, the cash rate was trading for a number of months around 13 basis points, a little above the ES rate of 10 basis points. The small difference between the two reflects transaction costs and a small credit premium. Now that the ES rate has been reduced to zero, the cash rate is currently around 5 basis points. Overnight indexed swap (OIS) rates have declined in line with the https://www.rba.gov.au/speeches/2020/sp-dg-2020-11-24.html 5/14 11/24/2020 Monetary Policy in 2020 | Speeches | RBA cash rate and are around 4 basis points for the foreseeable future, reflecting the market's expectations that the ES rate and the cash rate will not be increased over that horizon, consistent with the Bank's forward guidance. The combination of the low cash rate, low OIS rates and the ample supply of liquidity and funding in the banking system has seen Bank Bill Swap Rates (BBSW) decline to low single digits (Graph 3). The cash rate and BBSW are critical pricing benchmarks for many borrowing rates in the economy for both households and businesses. Graph 3 Money Market Rates % % BBSW 0.75 0.75 0.50 0.50 0.25 0.25 Cash Rate Expected Cash Rate 0.00 M J S D M J S D 0.00 Sources: Bloomberg; RBA The final monetary policy driver of borrowing rates in the economy is the 3-year bond yield target. The Bank has chosen to focus on the 3-year bond yield target for a couple of reasons. It influences many borrowing rates across the economy, given that borrowing rates in Australia are variable or fixed for short horizons, compared with other countries such as the US, where the 10-year government bond rate is a more important pricing benchmark. Secondly, the 3-year horizon is aligned with the forward guidance on the cash rate. The Board has stated that it will not increase the cash rate until actual inflation is sustainably within the target range of 2–3 per cent. Given the outlook for the labour market and the economy, the Board does not expect to increase the cash rate for at least 3 years. The combination of ample system liquidity, the low cash rate and ES rate, the 3-year yield target and the expectation that policy rates will remain low for at least 3 years are underpinning low borrowing https://www.rba.gov.au/speeches/2020/sp-dg-2020-11-24.html 6/14 11/24/2020 Monetary Policy in 2020 | Speeches | RBA rates across the economy. How has this being passed through to borrowing rates for businesses and households? There was a step down in business borrowing rates following the policy package in March (Graph 4). They have declined further since. Corporate bond yields have declined as credit spreads have reverted to pre-pandemic levels and the risk-free benchmark curve has declined. There has been subdued bond issuance by banks because of the significant increase in funding from deposits and the TFF. This has contributed to a further compression of corporate spreads as fixed income investors look for other bonds to buy. Graph 4 Business – Variable Lending Rates* Average interest rate on credit outstanding % % Small business Medium business Large business J A S O N D J F M A M J J A S O * Data cover financial institutions with $2 billion or more in business credit Sources: APRA; RBA After the surge in drawdowns of credit lines in March and April for precautionary reasons, business credit has declined as these credit lines have been repaid. Despite the low cost of borrowing, demand for new business loans is subdued. When businesses become more confident about future prospects, the low cost of borrowing will support their decision to invest. Turning to mortgage rates, there was a marked decline in fixed rates in March. The decline in standard variable rates has been less. [7] However, the average mortgage rates paid by households has continued to decline as households have continued to refinance and take advantage of the lower https://www.rba.gov.au/speeches/2020/sp-dg-2020-11-24.html 7/14 11/24/2020 Monetary Policy in 2020 | Speeches | RBA mortgage rates on offer (Graph 5). This is shown in the decline in new loan rates, which are still noticeably below the average rate paid. We expect the steady decline in the average mortgage interest rate paid by households to continue for a while yet. Graph 5 Housing Interest Rates % % Standard variable rates* Variable – existing loans** Variable – new loans** Fixed*** * Average of the major banks ** Series breaks in July 2019, thereafter, data based on EFS collection *** 3-year advertised rates for owner-occupiers Sources: APRA; Banks’ websites; CANSTAR; RBA Securitisation System These declines in mortgage rates have boosted the cash flows of households with mortgages. The early superannuation withdrawals also provided a sizeable boost to cash flows. At the same time, household incomes have been boosted by the support through the JobSeeker and JobKeeper programs. These have all contributed to a very large increase in household savings, further bolstered by the constraints on household spending through the period. As a result, there have been large increases in offset accounts and redraw facilities for those with mortgages. This boost to household saving and cash flows will help support consumption in the recovery. The transmission of lower mortgage rates to household borrowing has differed between owner occupiers and investors. Credit growth to owner occupiers is around 5 per cent, supported by federal and state government incentives for new building (Graph 6). Investor lending had been declining, in part reflecting expectations of lower returns given weaker rental demand. https://www.rba.gov.au/speeches/2020/sp-dg-2020-11-24.html 8/14 11/24/2020 Monetary Policy in 2020 | Speeches | RBA Graph 6 Housing Credit Growth* % Owner-occupier % Investor Six-month-ended annualised % % Monthly 0.5 0.5 0.0 0.0 -0.5 -0.5 * Seasonally adjusted and break-adjusted Sources: APRA; RBA The decline in the cash rate and the increased liquidity in the financial system has led to a decline in deposit rates. Those who benefit most from lower mortgage rates tend to be younger, while those who depend on interest income are generally aged over 65. Back when the cash rate was at 1.5 per cent, around 5 per cent of these older households were earning more than one-fifth of their income from interest. Hence the effect of monetary easing falls unevenly across the community, although so does the incidence of unemployment. That said, the impact on the household sector in aggregate is clearly positive. While a low interest rate environment can put pressure on banks' net interest margins, the return on equity of the Australian banking system remains robust. Moreover, it is important to remember that there would be an even bigger effect on bank profitability from increased loan losses that would occur if the economy were weaker. Bond Purchases Turning to bond purchases by the RBA, they are comprised of three elements (Graph 7): purchases to maintain the 3-year yield target purchases to address market dysfunction https://www.rba.gov.au/speeches/2020/sp-dg-2020-11-24.html 9/14 11/24/2020 Monetary Policy in 2020 | Speeches | RBA since November, the $100 billion bond purchase program. Graph 7 Government Issuance and RBA Purchases Cumulative $b $b AGS issuance Semis issuance RBA semis purchases RBA AGS purchases M A M J J A S O N M A M J J A S O N Sources: Bloomberg; RBA; Yieldbroker In March and April, the Bank bought bonds across the maturity spectrum out to 10 years to address the dysfunction in government bond markets. We purchased both AGS and semis. Since early May, we have not needed to do any more purchases to address dysfunction, but the Bank stands ready to resume these purchases should dysfunction return. We have also purchased bonds to maintain the 3-year target as required. Up until mid October, the target bond was the April 2023 maturity. Now the bond with maturity closest to 3 years is the April 2024. Since early November, we have purchased $5 billion of the April 2024 bond to meet the objective of maintaining the 3-year yield around 10 basis points. In November, the Board announced a quantity bond purchase program that is complementary to the 3-year yield target. Why did the Board decide to do this? Longer-term Australian government bond yields were higher than those in other advanced countries. This provided some evidence that the size of central bank bond purchase programs was affecting longer-term yields beyond the anchoring effect of the Bank's 3-year yield target. This in turn was contributing to a higher exchange rate. Why didn't the Board extend the yield target to a longer horizon? First, the yield target reinforces the Board's forward guidance on the cash rate. Three years is a reasonable horizon over which we have https://www.rba.gov.au/speeches/2020/sp-dg-2020-11-24.html 10/14 11/24/2020 Monetary Policy in 2020 | Speeches | RBA some confidence about the economic outlook. Beyond that, the economic outlook is considerably less certain and with it, our confidence about the settings of monetary policy. Second, further out along the yield curve other factors also start to have a greater influence, particularly global developments. The recent volatility in longer-term bond yields resulting from news about potential vaccines is a case in point. What has been the impact of the expectation and announcement of the November package? Recent movements in bond yields and the exchange rate provide some evidence. Since mid September, there were increased market expectations of a further decline in the cash rate, ES rate and the 3-year bond yield target. There were also expectations that the Bank would announce a quantity target for bond purchases. As a result, there was a decline in yields at the front end of the curve. There was also a decline in longer-term yields that was larger than the decline in shorter-term yields. The spread between Australian Government bonds and those of other advanced economies narrowed (Graph 8). This provides some evidence that the quantity of bond purchases has an influence above and beyond the price, particularly in terms of net demand, that is how much the central bank buys relative to issuance. Finally, the spread of semis to AGS also declined. Between then and early November, the exchange rate depreciated by around 5 per cent in tradeweighted terms and against the US dollar. It is reasonable to attribute the bulk of this depreciation to the growing expectation of the package announced in November. Longer-term yields have risen a little since the November Board meeting as has the exchange rate, largely due to the news about vaccines. But I would argue they are both lower than they would be absent the November policy package. https://www.rba.gov.au/speeches/2020/sp-dg-2020-11-24.html 11/14 11/24/2020 Monetary Policy in 2020 | Speeches | RBA Graph 8 10-year Australian Government Bond Spreads Australian yield minus select international bond yields bps bps UK Canada NZ US -50 -50 -100 -100 J F M A M J J A S O N D Sources: Bloomberg; Yieldbroker Let me remind you briefly about how the bond purchases occur. The bond purchase program comprises $80 billion of AGS and $20 billion of semis. Any purchases to maintain the 3-year yield target will be in addition to this. The Bank buys bonds in the secondary market. We announce our intentions at 11.15 am on Mondays and Thursdays for the Australian Government bond auctions, both for the 3-year target and the AGS bond purchase program (though this does not completely preclude purchasing bonds for the 3-year target on other days if necessary), and on Wednesdays for the semis bond purchase program. The bond purchase program comprises bonds beyond the 3-year yield target up to the longest maturity in the 10-year futures basket. We alternate purchases between the shorter and longer end of that maturity spectrum. The semis are purchased across 3 auctions with the aim of buying broadly in line with the size of their respective bond programs. In the afternoon, we take bids in a 5-minute window on the auction platform. We accept the bids that are cheapest relative to the mid-market price for the relevant bond. This determines the final composition of the bonds we purchase each auction, with the caveat that for the states we aim to achieve an overall allocation across the purchase program broadly consistent with the size of their bond programs. We aim to exclude bond lines from the weekly auctions that are being tapped in the same week or are recently issued new bonds. The results of the bond auctions are published very shortly after they are completed. The Bank is carefully monitoring the impact of its bond purchases on the market. We are alert to any sign of dysfunction in the market, and are prepared to adjust the program if necessary. https://www.rba.gov.au/speeches/2020/sp-dg-2020-11-24.html 12/14 11/24/2020 Monetary Policy in 2020 | Speeches | RBA Conclusion To conclude, the RBA has implemented a comprehensive package of measures over the course of 2020. This package has materially lowered the structure of interest rates in the Australian financial system. It has lowered borrowing costs for households, businesses and the government. The decline in interest rates across the yield curve has lowered the exchange rate, relative to what it otherwise would be. This package of monetary stimulus is complementing the significant fiscal stimulus. It has boosted the cash flow of households and businesses, as the effect of lower borrowing rates has more than offset the impact of lower deposit rates. This directly supports spending in the economy, as does the lower exchange rate. The lower borrowing rates will encourage businesses and households to borrow, invest and spend when they are confident about their future prospects. While the news about vaccines should help bolster that confidence, the recovery will be uneven. It is likely to be some time before the vaccines will be widely available and distributed. That said, the fiscal and monetary support will boost spending in the economy. This will increase employment and, in time, reduce unemployment. A materially lower unemployment rate is clearly desirable in itself, but will also be necessary before we will see sustainably higher wages growth and inflation. Endnotes [*] Thanks to Ellis Connolly for his assistance. Debelle G (2018), ‘Lessons and Questions from the GFC’, Address to the Australian Business Economists Annual Dinner', 6 December. Logan L (2020), ‘Treasury Market Liquidity and Early Lessons from the Pandemic Shock’, remarks at BrookingsChicago Booth Task Force on Financial Stability meeting, panel on market liquidity, 23 October. Available at <https://www.newyorkfed.org/newsevents/speeches/2020/log201023>. Fleming M and F Ruela (2020), ‘Treasury Market Liquidity during the COVID-19 Crisis’, Liberty Street Economics, Federal Reserve Bank of New York, April. Available at <https://libertystreeteconomics.newyorkfed.org/2020/04/treasury-market-liquidity-during-the-covid-19crisis.html>. Debelle G (2020), ‘The Reserve Bank's Policy Actions and Balance Sheet’, Address to the Economic Society of Australia, 30 June. See Debelle G (2020), ‘The Reserve Bank's Policy Actions and Balance Sheet’, Address to the Economic Society of Australia, online, 30 June; and Kent C (2020), ‘The Reserve Bank's Operations – Liquidity, Market Function and Funding’, Address to KangaNews, online, 27 July. The initial allowance under the TFF of $84 billion was almost entirely drawn on by the end of September. Banks serve as the intermediaries in the RBA's bond-buying auctions. Other holders of bonds can sell them to the banks who can on-sell them to the RBA. The low money market rates are also seen in the interest rates on Treasury Notes, which are in the single digits. Kohler M (2020), ‘New Financial Statistics: The Value of Sound Data in Troubled Times’, Address to the Australian Financial Markets Association, online, 17 September. https://www.rba.gov.au/speeches/2020/sp-dg-2020-11-24.html 13/14 11/24/2020 Monetary Policy in 2020 | Speeches | RBA The 3 auction groups are NSW and Victoria; Queensland and WA; SA, Tasmania, ACT and Northern Territory. The results of the most recent bond auction are published at: Reserve Bank Purchases of Government Securities Auction Results. The RBA publishes its purchases of government securities in Statistical Table A3 (see the worksheets titled ‘Bond Purchase Program’ and ‘Long-Dated Open Mkt Operations’). The RBA publishes its holdings of AGS and semis in Statistical Table A3.1. The materials on this webpage are subject to copyright and their use is subject to the terms and conditions set out in the Copyright and Disclaimer Notice. © Reserve Bank of Australia, 2001–2020. All rights reserved. The Reserve Bank of Australia acknowledges the Aboriginal and Torres Strait Islander Peoples of Australia as the Traditional Custodians of this land, and recognises their continuing connection to Country. We pay our respects to their Elders, past, present and emerging. https://www.rba.gov.au/speeches/2020/sp-dg-2020-11-24.html 14/14 | reserve bank of australia | 2,020 | 11 |
Opening statement by Mr Philip Lowe, Governor of the Reserve Bank of Australia, at the House of Representatives Standing Committee on Economics, Canberra, 2 December 2020. | Philip Lowe: Recent economic developments and outlook Opening statement by Mr Philip Lowe, Governor of the Reserve Bank of Australia, at the House of Representatives Standing Committee on Economics, Canberra, 2 December 2020. * * * We welcome the opportunity for this additional hearing of the House Economics Committee. A lot has happened since the previous hearing, including further significant policy measures by the RBA. This morning, I would like to explain why we took these additional measures and how they will help the recovery. To provide some context, I will begin with a summary of recent economic developments and the economic outlook. Economic developments and outlook This year has been an extremely difficult one for many people and businesses. But we have now turned the corner and a recovery is underway. Since we last met, the economic news has, on balance, been better than we were expecting. Over recent months, the number of people with a job has risen significantly and the peak in the unemployment rate is now likely to be between 7 and 8 per cent, rather than close to 10 per cent. Retail spending has also continued to increase, with consumers adjusting their spending patterns to the realities of a COVID-19 world. Business and consumer confidence has also lifted and housing markets have generally proved resilient. Given these developments, we are now expecting GDP growth to be solidly positive in both the September and December quarters. And then, next year, our central scenario is for the economy to grow by 5 per cent and then 4 per cent over 2022. These figures, though, cannot hide the reality that the recovery will be uneven and bumpy and that it will be drawn out. Some parts of the economy are doing quite well, but others are in considerable difficulty. And even with the overall economy now growing solidly, it will not be until the end of 2021 that we again reach the level of output recorded at the end of 2019. The effects of this loss of output and income are all too obvious in the labour market. The unemployment rate currently stands at 7 per cent and we are expecting it to be still above 6 per cent in two years’ time. Underemployment is higher still, with many people working on reduced hours. One consequence of higher unemployment is that wage and price pressures are likely to remain subdued. In each of the next 2 years, we are expecting annual wages growth of less than 2 per cent. And inflation, in underlying terms, is expected to be just 1 per cent next year and 1½ per cent in 2022. It is certainly possible that the economy will do better than our central scenario. This scenario does not envisage a vaccine being widely available to most Australians until late next year at the earliest. It also assumes that significant restrictions on international travel are still in place at the end of 2021. Recent medical breakthroughs give us some hope that things will work out better than this. If so, confidence would lift and there would be a further easing of restrictions. The result would be an upside surprise to growth and jobs, especially given the significant policy stimulus that is already in place, the generally strong balance sheets and the substantial government incentives for businesses to employ people and invest. But it is also possible that things could go the other way. Europe provides a salutary reminder of this. It was just 3 months ago that many commentators were remarking on the robust bounceback in Europe. Now, the European economy is expected to contract again in the December 1/4 BIS central bankers' speeches quarter as countries struggle to contain the virus. Similarly, in the United States the outlook is clouded by the sharp increase in case numbers there. Fortunately, here in Australia, we look to be on a different path, but there is no guarantee that we will remain so. This inevitably means that there is still a high degree of uncertainty about the outlook. What has become clearer, though, as time has passed is that Australia is likely to experience a run of years with unemployment too high and wage increases and inflation too low, leaving us short of our goals. In the current environment, addressing the high rate of unemployment is a priority for the Reserve Bank Board. We are intent on doing what we can, with the tools that we have, to help here. This brings me to our recent monetary policy decisions. Recent monetary policy measures Since the previous hearing in August, significant policy announcements were made following the Board’s meetings in September, October and November. We made no further changes at our meeting yesterday. In September, the Board increased the size of the Term Funding Facility and allowed authorised deposit-taking institutions (ADIs) more time to draw on this facility. Institutions can now access funds up to the equivalent of 5 per cent of their total loans, with additional funds available if an ADI increases its lending to businesses, especially small and medium-sized businesses. In October, we changed the nature of our forward guidance about the cash rate. The focus is now on actual outcomes for inflation and unemployment, rather than forecast outcomes. This shift reflects the changing price dynamics in our economy due to globalisation and technology, and now the pandemic. The Board will now want to see evidence that inflation is consistent with the target before it increases the cash rate. It is not enough for inflation to be forecast to be consistent with the target. In November, we announced another major policy package, including: reductions in the cash rate target, the 3-year Australian Government bond yield target and the interest rate on new drawings under the Term Funding Facility to 0.1 per cent a reduction in the interest rate on Exchange Settlement balances at the RBA to zero the introduction of a quantitative bond purchase program, under which the RBA will buy $100 billion of government bonds over the next 6 months. As part of this program we are buying bonds issued by the Australian Government and the states and territories. These decisions, together with those made by the Board earlier in the year, will support the recovery of the Australian economy. They will keep funding costs low for households, businesses and governments. They are also complementary to the significant fiscal stimulus by the Australian Government and the states and territories. This fiscal stimulus has played a critical role in helping the economy through the pandemic and it has preserved hundreds of thousands of jobs. For our part, the RBA’s recent measures will support the economy through a number of channels. Lower borrowing costs free up cash flow for both households and businesses, some of which will be spent. Lower interest rates also support asset prices, which boost balance sheets and consumption and investment. And a lower structure of interest rates leads to a lower value of the Australian dollar than would otherwise be the case. The end result is a stronger economy and more jobs. 2/4 BIS central bankers' speeches The decision to implement a bond buying program as part of the November policy package followed a careful review of the international experience. When we met last time, I said that my judgement was that a price-based target (i.e., a yield target) was preferable to a quantity-based target. That remains my view, but it doesn’t need to be an either/or choice and we can’t ignore what is happening overseas. As other central banks have bought government bonds under quantitative easing programs they pushed down the yields on those bonds. In turn, this put downward pressure on the value of their currencies. As a result, here in Australia we found ourselves in the position of having relatively high longer-term bond yields compared with other countries, despite the short-term policy rate being similar across countries. These relatively high bond yields were putting unhelpful upward pressure on the value of our own currency. Given monetary policy developments overseas and the strong gravitational pull of very low global interest rates, the Board judged that it was now appropriate to combine the 3-year yield target with a quantity target for bond purchases. This judgement was reinforced by the outlook for unemployment and inflation that I discussed earlier. As the Deputy Governor outlined in a speech last week, the movement in market prices in response to this package was broadly as we expected. The Board will continue to review the details of this package at our future meetings. We are prepared to do more, if that is required. Having said that, we are still of the view that a negative policy interest rate in Australia is extraordinarily unlikely, with any benefits being outweighed by the costs. The Board recognises that its decisions have an uneven effect across the community. How any given Australian is affected depends very much on their own financial situation. As we have discussed at previous hearings, people who rely on interest as a significant source of income find this a difficult time. People with more diversified sources of income and assets, including a home, tend to be in a better position. And those people who benefit most from monetary stimulus are those who get a job or retain a job because of this stimulus. The benefits here are wider, though, than just those to the individual. When more people who want jobs have one, the whole community benefits too. This is not just in terms of stronger household income growth but in an improvement in a wide range of social indicators as well. In making its decisions, the Reserve Bank Board is looking at this whole picture. Consistent with the mandate given to it by Parliament, the Board is seeking to maximise the collective welfare of the Australian people. As we do this, we are also paying close attention to asset prices and trends in household debt. At previous hearings we have discussed the effect of low interest rates on housing prices, the incentive to borrow, and medium-term economic and financial stability. These remain issues that we are continuing to monitor. But in the current environment, the bigger stability risk is a protracted period of high unemployment, rather than excess borrowing. When people don’t have jobs, their spending is curtailed and they have difficulty servicing their debts. It is also worth noting that over the past 6 months, many households have improved their finances and paid down debt. It is possible that this attitude to debt will change again, but it is also possible that people will continue to take a more cautious approach to borrowing than they did before the pandemic. So this is something to keep an eye on. But for the time being, the priority is employment. This brings me to the end of my prepared remarks. Guy and I look forward to answering your questions. Thank you. 3/4 BIS central bankers' speeches 4/4 BIS central bankers' speeches | reserve bank of australia | 2,020 | 12 |
Address by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to the Australian Payments Network, online, 7 December 2020. | Philip Lowe: Innovation and regulation in the Australian payments system Address by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to the Australian Payments Network, online, 7 December 2020. * * * I would like to thank my colleagues in Payments Policy Department for assistance in the preparation of this talk. Introduction Thank you for the invitation to join you today. It is very good to see the tradition of AusPayNet’s annual summit continue, even if it is taking a different form this year. As we all know, the world of payments has become an area of excitement: it brings together two things that people have a fascination with – money and technology. The pace of change is rapid and the payments landscape is complex and evolving quickly. New technologies are creating new ways of moving money around and new business models are emerging. There are also new players, including the big techs and the fintechs. And blockchain and distributed-ledger technologies are opening up new possibilities. This innovation is raising many issues for both the payments industry and for regulators. This morning I would like to discuss some of these issues and their implications for the regulatory framework. I will then discuss some of the Payments System Board’s preliminary views from its Review of Retail Payments Regulation. Innovation The Payments System Board has a long standing interest in promoting innovation in the Australian payments system. Those of you who have followed our work over the years will recall that back in June 2012 the Board released a report titled ‘Strategic Review of Innovation in the Payments System’. In promoting innovation we have employed a mix of strategies. We have used a combination of: i. suasion and pressure on industry participants to do better ii. regulation to promote competition and access iii. using our position to help overcome coordination problems, which can act as a barrier to innovation in a network with many participants iv. helping the industry establish benchmarks that can be aspired to collectively. I will leave it to others to judge the success of this mix of strategies. But from my vantage point, Australians enjoy an efficient and dynamic payments system. There are still gaps that need addressing, but by global standards we have done pretty well. Australians were early and rapid adopters of tap-and-go payments and increasingly are using digital wallets. We have a very good fast payments system, which after a slow start, is seeing continuing strong volume growth. And there is a roadmap for the development of new payment capabilities using this fast payments infrastructure. I would though like to draw your attention to two areas where we would like to see more progress. The first is the move to electronic invoicing and the ability to link e-invoices to payments as a way to improve the efficiency of business processes. The second is improvements to the speed, cost and transparency of cross-border retail payments and international money transfers. We are 1/6 BIS central bankers' speeches looking forward to progress on both fronts. Against the backdrop of this generally positive picture, the Payments System Board recognises that the structure of payment systems is changing. In some cases it is now better to think of a payments ecosystem, rather than a payments system. In this ecosystem, the payment chains can be longer and there are more entities involved and new technologies used. This more complex and dynamic environment is opening up new opportunities for innovation as well as new competition issues to consider. One of the factors driving innovation is the increasing interest of technology-focused businesses in payments. These businesses include the fintechs and the large multinational technology companies, often known as the ‘big techs’. They are a source of innovation and are playing a role in the development of digital wallets. These wallets are being used more frequently and I expect this trend has a long way to go. Another trend is the increasing use of payments within an app. Big techs are playing important roles on both fronts. This influence of the big techs is perhaps most evident in China, with Ant Group (owners of Alipay) and Tencent (WeChat Pay) having developed new payments infrastructure that has led to fundamental changes in how retail payments are made in China. In Australia and many other countries, Google, Apple, Facebook and Amazon are increasingly incorporating payments functionality into their service offerings. Mobile wallets such as Apple Pay and Google Pay are the most prominent examples of this in Australia. In some other countries the big techs are also offering person-to-person transfers and consumer credit products. Facebook also announced its Libra project. The Apple Pay and Google Pay wallets illustrate some of the new and complex issues that are arising. These wallets are clearly valued by consumers and they will reduce industry-wide fraud costs through the use of biometric authentication (e.g. fingerprint or facial recognition). The tokenisation of the customer’s card number is also a step forward. So these wallets are a good innovation. At the same time, though, they are raising new competition issues. One of these relates to the restriction that Apple, unlike Google, places on access to the nearfield communication (NFC) technology on its devices. Many argue that this restriction limits the ability of other wallet providers to compete on these devices and that this could increase costs. This issue has recently attracted the attention of policymakers in several countries. For example, in 2019 the German parliament passed a law requiring device manufacturers to provide third parties with access to technologies (such as NFC) that support payments services. And the European Commission announced in June that it would commence a formal antitrust investigation into Apple’s restriction of third-party NFC access on the iOS platform and in September announced that it will also consider legislation on third-party access. This issue has also been raised in submissions to our review of payments system regulation, and we are watching developments in Europe and elsewhere closely. Another issue being raised by these wallets is the value of information and data, and again we observe Google and Apple taking different approaches. Google states that it may collect information on transactions made using Google Pay, which can be used as part of providing or marketing other Google services to users. In contrast, Apple states that it does not collect transaction information that can be tied back to an individual Apple Pay user. There are also different approaches to charging transaction fees. Apple charges a fee to issuers when a transaction is made with the Apple Wallet but a similar fee is not charged by Google when transactions are made with Google Pay. It is certainly possible that these different approaches to the use of data on the one hand and access and fees on the other are linked. So there are issues to consider here too. Beyond the issues raised by digital wallets, there are other competition issues raised by the 2/6 BIS central bankers' speeches involvement of the big tech companies in payments. These companies are mostly platform businesses that facilitate interactions between different types of users of their platform. They have very large user bases, benefiting from strong network effects that can make it hard for competitors. Data analysis is part of their DNA and they have become increasingly effective at commercialising the value of data they collect and analyse. Providing additional services, such as payments, also reduces the need for users to ‘leave’ the platform. So there are complex issues to be worked through here. One of these is the terms of access to the platform and whether the platform requires that payments be processed by the platform’s own payment system. One specific issue that is raised by both digital wallets and the big techs is the nature of the protections that apply to any funds held within any new payment systems, and outside the formal banking sector. For confidence in the system and for the protection of individuals and businesses it is important that strong arrangements are in place. In this regard, I welcome the Government’s announcement that it will accept the Council of Financial Regulators’ proposed reforms of regulatory arrangements for so-called stored-value facilities. Under the proposals, APRA and ASIC will be the primary regulators, with requirements tailored to the nature of the facility. It would be possible, for example, to ‘designate’ a provider of a stored-value facility as being subject to APRA prudential supervision on the basis of financial safety considerations. This could become relevant if the technology companies were to launch new payment and other products that held significant customer funds. Internationally, this and related issues came to prominence following Facebook’s announcement that it was developing a global stablecoin (originally called Libra, but recently rebranded as Diem). Since the original announcement, the Libra Association (now the Diem Association) has also announced plans to launch some single-currency stablecoins intended for use in consumer digital wallets. In April, the Association applied to FINMA (the Swiss financial regulator) for a payment system licence. This initiative has raised concerns from governments and regulators in many jurisdictions regarding a wide range of issues including consumer protection, financial stability, money laundering and privacy. The Swiss authorities have established a regulatory college to coordinate with other countries. The RBA is participating in this college on behalf of Australia’s Council of Financial Regulators. FINMA has indicated that Diem will be subject to the principle of ‘same risks, same rules’ – that is, if Diem poses bank-like risks it will be subject to bank-like regulatory requirements. It remains to be seen how this and other similar initiatives progress. As I said at the outset, the world of payments is becoming more complex and raising new issues for industry participants and regulators to deal with. This means that it is timely to consider how the payments system should be regulated and the Payments System Board welcomes the Government’s review of the regulatory architecture. The legislation governing the Reserve Bank’s regulatory responsibilities was put in place over 20 years ago. This legislation gives the Bank specific powers in relation to payment systems and participants in those systems. While the powers are quite broad, in practice the Bank has the ability to regulate only a fairly limited range of entities. As I mentioned earlier, these regulatory powers have been used in conjunction with our ability to persuade and to help solve coordination problems in networks. As part of the Government’s review it is worth considering what the right balance is here and whether the regulatory arrangements could be modified to better address the complexities of our modern payments ecosystem. An update on the Review of Retail Payments Regulation At the same time that we have been considering these broad issues, the Payments System 3/6 BIS central bankers' speeches Board has been conducting its periodic Review of Retail Payments Regulation in Australia. This review was temporarily put on hold during the pandemic but has now restarted. I would like to use this opportunity to provide you with a sense of our thinking on three important issues: 1. interchange fee regulation 2. dual-network debit cards and least-cost routing 3. ‘buy now, pay later’ (BNPL) no-surcharge rules. I want to stress that we have not yet reached any final conclusions and the Bank’s staff will be meeting with industry participants over the next few months to discuss these and other issues. If, at the conclusion of the review, we are to make changes to the standards it is our intention to consult on these by mid 2021. Interchange fee regulation The Board’s view is that interchange fees should generally be as low as possible, especially in mature payments systems. While these fees might arguably play a role in establishing new payment methods, once a payment system is well established these fees increase the cost of payments for merchants and they can distort payment choices. So the direction of change in these fees over the medium term should be down, and not up. Having said that, at the current point in time the Board does not see a strong case for a significant revision of the interchange framework in Australia. The current interchange standards have been in effect for only 3½ years and submissions to the review did not point to strong arguments for major changes. The standards appear to be working well and frequent regulatory change can carry costs. It is also relevant that the average level of interchange rates in Australia is quite low by international standards, particularly the 8 cents benchmark for debit card payments. Credit card interchange fees are also lower than in most countries. One exception is the lower credit card interchange fees in Europe. The Board is watching the European experience closely and expects that, over time, a stronger case will emerge for lower credit card interchange fees in Australia. There is one aspect of the interchange regulations where the Board is considering a change as part of the review – that is the cap on the fees that can be applied to any particular category within a scheme’s schedule of debit card interchange fees. Currently a 20 basis point cap applies when a fee is expressed in percentage terms and a cap of 15 cents applies when the fee is expressed in terms of cents. The Board sees a case to lower this 15 cents cap. This case has emerged as there has been an increasing tendency for interchange fees on transactions to be set at the 15 cents cap, particularly on transactions that are less at risk of being routed to another scheme. At the same time, the international schemes are setting much lower strategic rates for some merchants, particularly larger ones, in response to least-cost routing. This is resulting in large differences in interchange fees being paid on similar transactions, with unreasonably high interchange fees on some low-value transactions, especially at smaller merchants. For example, a 15 cent interchange fee on a $5 transaction is equivalent to an interchange rate of 300 basis points, which is far higher than would apply to that transaction if a credit card had been used. Over the coming months, Bank staff will be seeking further information from the industry on this issue as the Board considers a lower cap. Dual-network debit cards and least-cost routing The second issue is dual-network debit cards and least-cost routing. The Board has long held the position that merchants should have the freedom and the capability to route debit card transactions through the lower-cost network. The Government and a wide 4/6 BIS central bankers' speeches range of stakeholders have a similar view. It is understandable why: this choice promotes competition and helps keep downward pressure on the cost of goods and services for consumers. Over recent years, the Board has discussed the right balance between regulation and suasion to achieve this outcome. Its judgement has been that the best approach was for the industry itself to support least-cost routing, pushed along by pressure from the RBA. While progress has been slower than we would have liked, the slow progress by the major banks did create competitive openings for other players, which led to some innovation. The major banks now also all offer least-cost routing, with some making it the default offering for small and medium-sized businesses. So there has been significant progress. The Board is not convinced that a better outcome would have been achieved through regulation. The concept of least-cost routing is most applicable when a physical card is used and where that card has two networks on it. One recent trend that we have observed is that some issuers have sought to move away from dual-network debit cards to issue single-network cards, with no eftpos functionality. This may be partly in response to financial incentives from the international schemes and possibly the additional costs to issuers from supporting two networks on a card. Notwithstanding this trend, the Board’s view is that it is in the public interest for dual-network cards to continue and to be the main form of debit card issued in Australia. It is also important that acquirers and other payment providers offer or support least-cost routing and that the schemes do not act in a way that inappropriately discourages merchants from adopting leastcost routing. The Board is again considering the best balance between regulation and suasion to achieve these outcomes. Consistent with its earlier approach, its preference is for the industry to deliver these outcomes without regulation. To help achieve this, the Board is considering setting out some formal expectations in this area. If these expectations are not met, the Board would then consider regulation. To be clear, the Board sees a strong case for all larger issuers of debit cards to issue cards with two networks on them. At the same time, it recognises that there can be additional costs of supporting two networks, which can make it harder for new entrants and small institutions to be competitive. So it may not be appropriate to expect very small issuers to issue such cards. Over the months ahead, the Bank will be consulting with small authorised deposit-taking institutions and the schemes to get a clearer picture of the costs and their implications for determining any regulatory expectations. The Board also expects that in the point-of-sale or ‘device-present’ environment all acquirers should provide merchants with the ability to implement least-cost routing for contactless transactions, possibly on an ‘opt-out' basis. In the online or ‘device-not-present’ environment, it is not yet clear how least-cost routing should operate and what expectations on its provision might be appropriate. In this environment, there is scope for consumers to make more active choices, there are various technical challenges to least-cost routing and there can be more providers in the payments chain. So the idea of how least-cost routing might apply in the online world will be explored by the Bank’s staff over coming months. Buy now, pay later no-surcharge rules The third issue that I’d like to cover is the no-surcharge rules of buy now, pay later providers. The Board’s long standing view is that the right of merchants to apply a surcharge promotes payments system competition and keeps downward pressure on payments costs for 5/6 BIS central bankers' speeches businesses. This is especially so when merchants consider that it is near essential to take a particular payment method for them to be competitive. The Board also recognises that it is possible that no-surcharge rules can play a role in the development of new payment methods. While new payment methods can be developed without them, these rules can, under some circumstances, make it easier to build up a network and thereby promote innovation and entry. The Board’s preliminary view is that the BNPL operators in Australia have not yet reached the point where it is clear that the costs arising from the no-surcharge rule outweigh the potential benefits in terms of innovation. So consistent with its philosophy of only regulating when it is clear that doing so is in the public interest, the Board is unlikely to conclude that the BNPL operators should be required to remove their no-surcharge rules right now. Even the largest BNPL providers still account for a small proportion of total consumer payments in Australia, notwithstanding their rapid growth. New business models are also emerging, including some that facilitate payments using virtual cards issued under the designated card schemes that are subject to the existing surcharging framework. In addition, the increasing array of BNPL providers is resulting in competitive pressure that could put downward pressure on merchant costs. The Board expects that over time a public policy case is likely to emerge for the removal of the no-surcharge rules in at least some BNPL arrangements. Some of the BNPL operators are growing rapidly and becoming widely adopted by merchants, particularly in certain sectors. As part of the Bank’s ongoing consideration of this issue, Bank staff will be discussing with industry participants possible criteria or thresholds for determining when no-surcharge rules should no longer be allowed. If the point is reached where the Board’s view is that the public interest would be served by the removal of a no-surcharge rule, the Board’s preference would be to reach a voluntary agreement with the relevant provider. This would be similar to the approach adopted with American Express and PayPal. In the event that this were not possible, the Bank would discuss with the Australian Government the best way to address the issue. More broadly, as I discussed above, the current Treasury review of the regulatory architecture provides an opportunity to look holistically at this issue and whether the existing legislation and regulatory provisions could be amended to better reflect our modern and dynamic payments ecosystems. Conclusion So that is a quick review of some of the issues that the Payments System Board and the RBA staff have been focusing on recently. It is clear that payments is an increasingly exciting area and that significant innovation is occurring. This presents opportunities to deliver improved services to end users of the payments system as well as raising new questions for policymakers. The Bank very much appreciates the ongoing engagement we have with the industry as we jointly work towards better outcomes for the Australian community. Thank you. 6/6 BIS central bankers' speeches | reserve bank of australia | 2,020 | 12 |
Address by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to the National Press Club of Australia, Canberra, 3 February 2021. | Philip Lowe: The year ahead Address by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to the National Press Club of Australia, Canberra, 3 February 2021. * * * Thank you for the invitation to address the National Press Club. This is the third time I have had the privilege of doing so, but it is the first time here in Canberra. The world has changed tremendously since my previous address in February last year: a pandemic, the biggest contraction in output in generations, the closure of our borders, a very large fiscal stimulus, near zero interest rates and quantitative easing. All that in just a year and none of it was predicted. It was therefore with some trepidation that I titled my remarks today, ‘The Year Ahead’. I did so, though, because at the start of a new year, I thought it important to explain how we are thinking about the Australian economy and monetary policy over the year ahead. Before I do this, I would like to offer 3 observations on the year we have just been through. The first is that Australians respond well in a crisis. The second is that the economic downturn was not as deep as was initially feared and the bounce-back has been earlier and stronger than we were expecting. And the third is that as we start 2021, there is still quite a way to go before we reach our goals of full employment and inflation consistent with the target. I would like to elaborate on each of these observations as they are relevant to the future. The national response First, our national response. As a community, we have pulled together in the common good and been prepared to do what has been necessary to contain the virus. Our public administration and health systems have worked well in the public interest. Governments responded quickly to the pandemic and decisive fiscal and monetary policy responses have helped many people. Our banks also worked with their customers to help them meet their obligations. Because of these collective efforts Australia is in a much better place than most other countries. This is true for both the economy and the health situation. An earlier and stronger bounce-back My second observation is that despite the pandemic having very significant economic costs, the downturn was not as deep as we had feared and the recovery has started earlier and has been stronger than we were expecting. Employment growth has been strong, as have retail sales and new house building. Across many indicators, including GDP, the outcomes have been better than our central forecasts and often better than our upside scenarios as well. As an illustration, in August our central forecast was that the unemployment rate would end 2020 at close to 10 per cent and still be above 7 per cent at the end of 2022 (Graph 1). In our upside scenario, the unemployment rate was expected to end 2020 a little lower than 10 per cent, but still be around 7 per cent later this year. Thankfully, the actual outcome for the unemployment rate has been much better than this, with the peak now looking to be behind us and the unemployment rate ending 2020 at 6.6 per cent. Graph 1 1/7 BIS central bankers' speeches It is reasonable to ask: what explains these better-than-expected outcomes? There are 3 factors that I would like to point to. The first is the success that Australia has had in containing the virus. That success has meant that the restrictions on activity have been less disruptive than we feared. It has allowed more of us to get back to work sooner and it has reduced some of the economic scarring from the pandemic. As is increasingly clear from experience both here and overseas, the health of the population and the health of the economy are inextricably linked. The second factor is the very significant fiscal policy support in Australia, which as measured by the change in the aggregate budget position is almost 15 per cent of GDP (Graph 2). Most of this support has been delivered by the Australian Government, but the states and territories have also played a role too. This support has been more substantial than was assumed in August and has made a real difference. It has provided a welcome boost to incomes and jobs and helped front load the recovery by creating incentives for people to bring forward spending. There has also been a positive interaction with the better health outcomes, which have allowed the policy support to gain more traction than would otherwise have been the case. Graph 2 The third factor is that Australians adapted and innovated. When the virus first came to our shores, many people hunkered down, but as the days wore on, households and businesses adjusted and changed what they do and how they do it. This resilience has helped keep the economy going and kept people in jobs. Many firms changed their business models, moved online, used new technologies and reconfigured their supply lines. Households adjusted too, with spending patterns changing very significantly. Some of the spending that would normally have been done on travel and entertainment has been redirected to other areas, including electrical goods, homewares and home renovations. Online spending also surged, increasing by 70 per cent over the past year (Graph 3). These changes in our spending patterns have been challenging for many businesses, but the ability and willingness of Australians to keep spending has helped the overall economy. Graph 3 Still quite a way to go My third observation is that despite the positive economic news over recent months, we still have quite a way to go. There is still very substantial spare capacity in the Australian economy. The unemployment rate is higher today than it has been for almost 2 decades and many people can’t get the hours of work they want. And in terms of output, we remain well behind where we thought we would be when I spoke here in February last year (Graph 4). When the National Accounts are published for the December quarter, they are likely to show that the level of GDP is 4 per cent lower than where we thought it would be a year ago. This is a big gap. Graph 4 2/7 BIS central bankers' speeches On the nominal side of the economy, there is also a fair way to go. In underlying terms, inflation is running at 1¼ per cent, well below the medium-term target of 2–3 per cent. And wage growth is the lowest in decades, with the Wage Price Index increasing by just 1.4 per cent over the past year (Graph 5). Given the spare capacity that currently exists, these low rates of inflation and wage increases are likely to be with us for some time. Graph 5 The year ahead This brings me to the year ahead. In my view, we can draw some comfort from the year just passed. Our ability to pull together and the earlier-than-expected bounce-back are both positive developments and provide a basis for confidence about the future. Yet even so, the path ahead is likely to be bumpy and uneven and it will be some time before we are back to full employment and have inflation back to the target. As was the case in 2020, much depends upon the path of the pandemic. The development of vaccines in record time is clearly good news. It has reduced one of the big uncertainties and could provide the foundation for a vigorous and sustainable recovery in the global economy. But this outcome is not assured – the global rollout of the vaccines faces challenges and there are a range of other uncertainties about the global economy, including trade tensions. We hope for the best here, but we also need to be prepared for further setbacks in what remains a highly uncertain world. The RBA will be releasing a full set of updated economic forecasts on Friday. Today, I can provide the key numbers. In preparing these forecasts we have assumed a rollout of the vaccines in Australia in line with current government guidance and that international travel remains highly restricted for the rest of this year. Our central scenario is for the upswing in the Australian economy to continue, with above-trend growth over the next couple of years (Graph 6). GDP is expected to increase by 3½ per cent over both this year and 2022. Given the recovery we have seen so far, we are expecting the level of GDP to return to its end-2019 level by the middle of this year, which is 6 to 12 months earlier than we previously expected. Graph 6 Notwithstanding this recovery, we are not expecting the level of GDP to return to its previous trend over our forecast period. This is largely because of lower population growth. When we prepared the forecasts a year ago, we were expecting the population to grow by 1.6 per cent per year over 2020 and 2021. The actual outcome is likely to be around 0.2 per cent in 2021, the lowest since World War I (Graph 7). This slower population growth has a direct effect on the size of our economy and means that we will not get back to the previous trend any time soon. In per capita terms, we expect more, but not all, of the lost ground to be made up. Graph 7 In the labour market, we are expecting the rate of unemployment to continue to decline. In the central scenario, it is expected to reach 6 per cent by the end of this year and around 5¼ per cent by mid 2023 (Graph 8). Job vacancies, job ads and business hiring intentions are at 3/7 BIS central bankers' speeches high levels, which suggests continuing solid employment growth over the next few months. Beyond that, some slowing in employment growth is expected when the JobKeeper program comes to an end in March. Graph 8 Given this outlook, wages growth and inflation are forecast to remain subdued. In the central scenario, wages growth is forecast to pick up from its current low rate, but to do so only very gradually and still be below 2 per cent at the end of next year. Consistent with this, and the ongoing spare capacity in the economy, inflation in underlying terms is also forecast to stay below 2 per cent over the next couple of years: the central forecast for 2021 is 1¼ per cent and for 2022 it is 1½ per cent (Graph 9). In headline terms, inflation is expected to spike to around 3 per cent in the June quarter, largely reflecting swings in the prices of child care and some other administered prices, but then to return to below 2 per cent by the end of this year. Graph 9 So that is the broad outline of the central scenario. We will also be publishing downside and upside scenarios, as we did last year. The downside scenario is one in which there is a combination of further sporadic domestic outbreaks, a delay in the rollout of vaccines and a worsening global outlook. The upside involves further good news on the health front, with a strong pick-up in consumer and business confidence propelling a stronger self-sustaining recovery, especially given the large amount of monetary and fiscal stimulus that is in place. In the downside scenario, further progress in reducing unemployment is delayed and there is a little pick-up wage growth and inflation from current levels. In the upside scenario, the unemployment rate falls faster to be a bit below 5 per cent in the second half of next year. I would like to highlight 2 specific issues that have a bearing on the forecasts. The first is how households respond over coming months to the tapering of the fiscal and other support measures. Unusually for an economic downturn, growth in household income has been quite strong, largely reflecting the support provided by fiscal policy (Graph 10). Much of this extra income has been saved, with the household saving rate surging to 22 per cent in the June quarter. This largely reflects the limited spending opportunities during the lockdowns, but it is also a response to the uncertainty that people felt about the future. These extra savings have strengthened household balance sheets and mean that many people now have bigger financial buffers than they had previously. Graph 10 The question is what comes next. Over the next 6 months, aggregate household income is expected to decline as the pandemic support payments unwind. Normally, when income falls, so too does consumption. But we are not in normal times. The extra savings over the past 6 months and the bigger financial buffers can support future spending – people will have more freedom to spend as restrictions are eased and be more willing to spend as uncertainty recedes. So we are expecting the recovery in consumer spending to continue. 4/7 BIS central bankers' speeches But there are risks to the forecasts in both directions here. On the downside, further bad news on the health front could see additional restrictions on activity and a renewed desire to save. And on the upside, positive news on health and jobs could see people seek to catch up on spending and run down their extra saving buffers quickly. So we are watching this area carefully. One other important factor bearing on household spending is the housing market. When I spoke here last year I discussed how falling housing prices was one of the factors that had contributed to sluggish growth in 2019. The dynamics in the housing market now look to be in a different phase, with prices rising across most of the country recently (Graph 11). It remains to be seen how long this will continue, but sustainable increases in asset prices support household balance sheets and encourage spending through positive wealth effects. Higher housing prices can also encourage additional residential construction. But as housing prices rise again, we will be monitoring lending standards closely. We would be concerned if there were to be a deterioration in these standards, but there are few signs of this at the moment. Graph 11 The second specific issue I want to highlight is the outlook for investment. Prior to the pandemic, there were concerns about the protracted period of low levels of nonmining business investment (Graph 12). Not surprisingly, when the pandemic hit, investment fell further. Faced with a more uncertain environment and a drop in demand, many firms deferred investment plans and sought to de-risk their balance sheets. Spending on non-residential construction has been particularly affected. On a more positive note, there has been a welcome offsetting pick-up in public investment, which is playing a strong counter cyclical role. We are yet to see the same signs of a recovery in private investment that we have witnessed in household spending. Investment is nonetheless expected to pick up as uncertainty recedes and demand increases. An increase in private business investment is not only needed to support the economic recovery but also to build the productive capital stock that is needed for our future. So this too is an issue we are watching carefully. Graph 12 Monetary policy I would now like to turn to monetary policy. At our meeting yesterday, the Reserve Bank Board reviewed the monetary policy measures announced last year and the outlook for the year ahead. I would like to share the conclusions of this review with you. The first conclusion is that last year’s monetary policy package is working broadly as expected and is supporting the economy. Together, the bond purchases, the Term Funding Facility, the 3year yield target and the record low cash rate have kept funding costs low for all borrowers and helped ensure that the banking system is able to provide the credit that is needed for the recovery. They have also resulted in a lower value of the Australian dollar than otherwise. Combined, the various measures have resulted in the RBA’s balance sheet increasing from around $180 billion to $330 billion and a further substantial increase is in prospect (Graph 13). Graph 13 5/7 BIS central bankers' speeches The second conclusion is that very significant monetary support will need to be maintained for some time to come. It is going to be some years before the goals for inflation and unemployment are achieved. So it is premature to be considering withdrawal of the monetary stimulus. The third conclusion is that we will continue to purchase bonds issued by the Australian Government and the states and territories at the completion of the current $100 billion program in mid April. In reaching this conclusion, the Board considered 3 factors: 1. the effectiveness of the bond purchases; 2. the decisions of other central banks; and 3. most importantly, the outlook for inflation and jobs. With 3 months experience now, it is clear that the bond purchase program has helped to lower interest rates and has meant that the Australian dollar is lower than it otherwise would have been. So, it has worked. Australia’s government bond markets also continue to function well and the available evidence is that further purchases would not be a source of market dysfunction. In terms of other central banks, most have recently announced extensions of their bond purchase programs, many running until at least the end of this year. Given this, if we were to cease bond purchases in April, it is likely that there would be unwelcome upward pressure on the exchange rate. And, third, in terms of the most important consideration – the outlooks for inflation and jobs – we remain well short of our goals, as I have already discussed. Given these considerations and the fact that the cash rate is at its effective lower bound, the Board decided to purchase an additional $100 billion of government bonds at the completion of the current program in mid April. These additional purchases will be at the rate of $5 billion a week, which is unchanged from the current program. They will ensure a continuation of the RBA’s monetary support for the Australian economy. The fourth conclusion is that the Term Funding Facility will be maintained as it is. Banks are able to draw on the facility up until end June, which means they will have the benefit of low-cost funding out to mid 2024. The Board would consider extending this facility if there were a marked deterioration in funding and credit conditions in the Australian financial system. At the moment, there are no signs of this. Fifth, the 3-year yield target for Australian Government bonds will be maintained. This target has helped anchor the Australian yield curve and reinforced our forward guidance regarding the cash rate. Later in the year, the Board will need to consider whether to shift the focus of the yield target from the April 2024 bond to November 2024 bond. In considering this issue the Board will be giving close attention to the flow of economic data and the outlooks for inflation and jobs. It has made no decision yet. The final conclusion is that the cash rate will be maintained at 10 basis points for as long as is necessary (Graph 14). The Board has no appetite to go into negative territory and has done as much as it reasonably can with interest rates. Before increasing the cash rate, the Board wants to see inflation sustainably within the 2 to 3 per cent target range. Meeting this condition will require a tighter labour market and stronger wages growth than we are currently forecasting. It is difficult to determine exactly when this condition might be met but, based on the outlook I have discussed today, we do not expect it to be before 2024, and it is possible that it will be later than this. So the message is: interest rates are going to be low for quite a while yet. The Reserve 6/7 BIS central bankers' speeches Bank is committed to provide the support the economy needs as its recovers from the pandemic. Graph 14 On that note, I wish you all the best for the year ahead. Thank you for listening and I look forward to answering your questions. 7/7 BIS central bankers' speeches | reserve bank of australia | 2,021 | 2 |
Address by Mr Christopher Kent, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, at the Australian Corporate Treasury Association FX Roundtable, webinar, 17 February 2021. | Speech FX Markets Around the Turn of the Year Christopher Kent [ * ] Assistant Governor (Financial Markets) Australian Corporate Treasury Association FX Roundtable Webinar – 17 February 2021 Introduction Today I will discuss some recent developments in the foreign exchange market, and provide some views on the role of the Reserve Bank's various policy measures. I will also briefly discuss a modest change to the way the Bank will be using foreign exchange swaps to manage our foreign exchange needs. A novel development in the market for Australian dollar swaps Typically, Australian banks pay a small premium to swap foreign currency into Australian dollars. This premium is also referred to as the basis, which is the difference between the implied cost of obtaining Australian dollars in the FX swap market and the cost of obtaining Australian dollars onshore. Most of the time the basis is positive, but over the course of 2020 the basis declined and became negative at shorter tenors, with a very noticeable decline around the turn of the year (Graph 1). I thought it was worth explaining what's happened in this market. Graph 1 But first, it's helpful to understand why the Australian banks have typically paid a premium in this market. They obtain foreign currency by issuing debt offshore – including via bonds denominated in US dollars. They do this to help diversify their funding sources. It allows them access to deep, liquid foreign capital markets. They then swap this foreign currency into Australian dollars in order to fund their Australian dollar assets, including the loans they make to households and businesses. The demand for Australian dollars in the swap market by the Australian banks is the flipside to the demand from other entities to swap Australian dollars into US dollars, much of which relates to their own hedging needs. This includes foreign entities issuing Kangaroo bonds in Australian dollars to fund their assets offshore and Australian investors who hedge their foreign currency assets. [1] While the flows are large in both directions, demand and supply are brought in balance in the swap market with those demanding Australian dollars typically paying a small premium. However, over the past year there have been some sizeable changes in the market for Australian dollar swaps. The Reserve Bank's policy actions have played a part here by providing plenty of Australian dollar liquidity. For example, to date the Reserve Bank has provided Australian banks with $86 billion of low-cost funding for terms of 3 years via the Term Funding Facility. At the same time, the banks have seen strong growth in their deposits and slower growth of their assets. The net result is that they have been well funded, with minimal need to issue bonds over the past year. Accordingly, their offshore issuance has dropped noticeably and this has led to a sizeable reduction in their transactions in the swap market; as shown in Graph 1, the major banks in Australia have not issued senior unsecured US dollar bonds since February 2020 (though there has been some issuance of Tier 2 bonds). This reduction in demand to borrow Australian dollars in the swap market has seen the basis on both short-term and long-term swaps fall to low, or even negative, levels. Indeed, for a brief period, the premium on very short-term swaps dropped very sharply, to as low as −175 basis points for 1-week swaps (Graph 2). In other words, the cost of swapping Australian dollars into US dollars became quite expensive. In recent years, this significant increase in the cost of obtaining US dollars in short-term swaps had been commonplace for some other currencies (e.g. euro and yen) at year-end, but not for the Australian dollar (Graph 3). However, this year the effect of elevated year-end demand for US dollars in swap markets on the Australian dollar basis has been much larger than normal. This is consistent with the smaller supply of US dollars from the Australian banks than in the past. Graph 2 Graph 3 The spot market for Australian dollars The Reserve Bank's various policy measures – including the bond purchase program – have also had an influence on the value of the Australian dollar. Over the 2 months leading up to the introduction of the Reserve Bank's package of policy measures in November, Australian interest rates declined relative to those abroad and the Australian dollar depreciated by 5 per cent in trade-weighted terms (Graph 4). The policy measures have placed, and continue to place, downward pressure on the Australian dollar, including the extension of the bond purchase program announced in February. Graph 4 Since early November, however, other factors have contributed to an appreciation of the Australian dollar, which is currently around the upper end of its range of recent years. In particular, there has been a general improvement in the outlook for global growth, which has been associated with an appreciation of a range of currencies against the US dollar and a marked increase in many commodity prices. Indeed, the price of iron ore has increased by around 40 per cent since early November. Even so, historical relationships with commodity prices would have implied a much larger appreciation of the Australian dollar than what's actually occurred. While history only provides a rough guide, this difference suggests that the Bank's policy measures have contributed to the Australian dollar being as much as 5 per cent lower than otherwise (in trade-weighted terms). The Reserve Bank's use of foreign exchange swaps I'll conclude with some news on the ways in which the Bank will be making use of foreign exchange swap markets to manage our operations. For over 30 years, the Reserve Bank has made use of foreign exchange swaps to manage domestic liquidity. [3] These are short-term transactions (of 3 months or less) that alter the extent of Australian dollar liquidity in the banking system. Because the Australian dollar flows in the near and far legs of the swaps are offsetting, they have no impact on the exchange rate. When foreign currency is acquired in this way it adds to the Bank's stock of foreign exchange assets. However, because the swaps are due to be unwound within a few months at most, they are not considered to be part of the Bank's foreign exchange reserves available for policy purposes. Up till now, the Bank has held foreign currency reserves on an outright basis to satisfy its policy needs. This includes the capacity for intervention in the spot foreign exchange market. We also need foreign exchange to assist the Australian Government in meeting its foreign currency commitments to the IMF (which in turn supports the Fund's lending activities). To meet this specific need we have decided to start acquiring foreign currency via swaps over longer terms. By using sufficiently long-term swaps – with initial durations of 2 years or more – the Bank will be able to minimise any rollover risks and hence can treat the foreign exchange acquired in this way as part of its foreign currency liquidity. [5] And in contrast to outright holdings, foreign exchange swaps do not entail any foreign exchange risk and therefore do not require capital to be held against these positions. [6] Many other central banks and finance ministries use long-term swaps in the management of their foreign exchange reserves. For the Reserve Bank, outright holdings will continue to represent the vast majority of the Bank's foreign currency liquidity. Currently, outright holdings are worth around US$35 billion. Foreign currency will be obtained through long-term swaps over a period of some weeks until that part of the portfolio reaches between US$3–4 billion. As is the case currently with short-term swaps conducted by the Bank, these transactions will have no effect on the value of the Australian dollar. Endnotes [*] I thank Dan Fabbro and Jarkko Jaaskela for their assistance in preparing these remarks. An Australian investor can swap Australian dollars for US dollars in order to invest in US dollar-denominated assets. By using the swap, the investor is able to lock in an exchange rate at which the US dollars will be converted back into Australian dollars in the future. This means the investor is not exposed to the risk that the US dollar will depreciate against the Australian dollar. It is known that the supply of US dollars in swap markets at year-end is reduced by some large international banks in order to achieve a lower (G-SIB) capital surcharge than otherwise (FSB (2020), ‘Evaluation of the effects of toobig-to-fail reforms’, Consultation Report, June). These banks may also reduce their activities in swap markets in response to other factors such as leverage ratio regulations, taxes and deposit insurance assessment fees. For a discussion of the Bank's past use of foreign exchange swaps, see Robertson B (2017), ‘Structural Liquidity and Domestic Market Operations, RBA Bulletin, September, pp 35–44. Information on recent use of foreign exchange swaps can be found in the RBA Annual Report (2020). Spot intervention by the Bank has become less frequent as the market has developed, hedging foreign currency risk has become more efficient and as awareness of the benefits of a floating exchange rate regime has grown. Nonetheless, the Reserve Bank has always retained the discretion to intervene in the foreign exchange market to address dysfunction and/or a significant misalignment in the value of the Australian dollar. Beginning with the release of data in March (RBA Statistical Table A4), additional information will be made available on the maturity of the Bank's forward foreign currency commitments (which includes commitments under swaps). These long-term swaps will have an impact on domestic liquidity. However, if required, the Bank could adjust its use of other instruments in domestic liquidity management to achieve desired outcomes. The materials on this webpage are subject to copyright and their use is subject to the terms and conditions set out in the Copyright and Disclaimer Notice. © Reserve Bank of Australia, 2001–2021. All rights reserved. The Reserve Bank of Australia acknowledges the Aboriginal and Torres Strait Islander Peoples of Australia as the Traditional Custodians of this land, and recognises their continuing connection to Country. We pay our respects to their Elders, past, present and emerging. | reserve bank of australia | 2,021 | 2 |
Address by Mr Philip Lowe, Governor of the Reserve Bank of Australia, at the AFR Business Summit, Sydney, 10 March 2021. | Speech The Recovery, Investment and Monetary Policy Philip Lowe [ * ] Governor AFR Business Summit Sydney – 10 March 2021 Thank you for the invitation to participate in this year's AFR Business Summit and it is great to be here in person. I would like to begin by congratulating the AFR on its 70th anniversary – that is quite an achievement in an industry with so much change. I look forward to many more years of business and finance reporting and analysis. The timing of this year's summit coincides with a lift in sentiment about the global economy. The rapid development of vaccines and their rollout have improved the global outlook and lessened some of the downside risks. The plan for further fiscal stimulus in the United States has also improved growth prospects there. The result has been a reassessment by investors of the outlook for inflation and interest rates around the world. Against this backdrop, I would like to begin by reviewing recent economic and financial developments. I will then turn to the importance of business investment in sustaining a strong economic recovery. Finally, I will discuss the outlook for monetary policy in Australia. Recent economic and financial developments Last week we received further confirmation that the Australian economy is recovering well, and better than expected. GDP increased by 3.1 per cent in the December quarter, following a similar rise in the previous quarter (Graph 1). These back-to-back large increases are materially better outcomes than we expected back in August. They reflect the success that Australia has had on the health front, the very large fiscal and monetary policy support, and the flexibility of Australians in getting on with their lives and businesses. As a result, we are now within striking distance of recovering the pre-pandemic level of output. Graph 1 GDP Growth % % Year-ended Quarterly -2 -2 -4 -4 -6 -6 -8 -8 Source: ABS There has also been positive news on the employment front over recent months. The recovery in employment has been V-shaped and there has been a welcome decline in the unemployment rate to 6.4 per cent (Graph 2). Job vacancies, job ads and hiring intentions remain strong. This suggests that the unemployment rate will continue to trend lower, although this trend could be temporarily interrupted when JobKeeper comes to an end later this month. Graph 2 Labour Market % Unemployment rate m Employment 13.0 12.5 12.0 11.5 Sources: ABS; RBA These better-than-expected outcomes are very welcome news. However, they do not negate the fact that there is still a long way to go and that the Australian economy is operating well short of full capacity. There are still many people who want a job and can't find one and many others want to work more hours. And on the nominal side of the economy, we have not yet experienced the same type of bounce-back that we have seen in the indicators of economic activity. For both wages and prices, there is still a long way to go to get back to the outcomes we are seeking. In underlying terms, inflation is running at 1¼ per cent, and we expect it to remain below 2 per cent over at least the next 2 years (Graph 3). Graph 3 Trimmed Mean Inflation Year-ended % % Sources: ABS; RBA Turning to other countries now, the recent experience has been mixed. A number are benefiting from a pick-up in international trade in goods, following the shift during the pandemic to spending on goods, rather than services. This shift has underpinned stronger conditions in the manufacturing sector, especially in east Asia, and broad-based increases in commodity prices (Graph 4). In contrast, in some other countries, virus outbreaks around the turn of the year have interrupted their recoveries. Graph 4 Commodity Prices USD, January 2013 = 100 index Iron ore index Oil index index Aluminium Copper Sources: Bloomberg; RBA Looking forward, the rollout of vaccines has improved the prospect of a sustained recovery in the global economy. In the United States another important factor is the further large fiscal stimulus, amounting to 9 per cent of GDP, with this stimulus coming on top of the significant measures announced last year. The brighter global outlook has been associated with an increase in bond yields (Graph 5). This follows a period in which 10-year bond yields were at historic lows in many countries, including Australia. These historic lows reflected a combination of structural and cyclical factors. On the structural side, there has been, for some time, an elevated desire to save, relative to invest, which has kept real interest rates low. On the cyclical side, the steep declines in GDP, the uncertainty about the future and an expectation of a long period of very low inflation have each played a role. Graph 5 10-year Government Bond Yields % % 2.0 US 2.0 1.5 1.5 Canada Australia 1.0 1.0 0.5 0.5 UK 0.0 S D M J S D M 0.0 Sources: Bloomberg; Yieldbroker Recently, as the outlook improved it is understandable that yields moved off their historic lows, although explaining the exact timing and trigger for any change is always difficult. Initially, the repricing in the bond market was associated with additional volatility in financial markets. Subsequently, conditions settled down more quickly than they did in March/April last year, although further bouts of volatility are possible. The move higher in bond yields since November mainly reflects a lift in investors' expectations of future inflation, although there has also been some bring forward in the expected timing of future policy rate increases. The lift in inflation expectations is evident in the graph below (Graph 6). For most of the past year, expected inflation was well below the rates being targeted by central banks. This has now changed and expected inflation has moved to be closer to those targets. This suggests that investors have more confidence that the policy measures are working to stimulate the global economy and that the recovery will be strong enough to generate inflation close to target. If so, this would be good news. It is also worth noting that expected inflation rates are not especially high and are still not above central bank targets. Graph 6 Inflation Expectations* % % UK** Australia US Canada S D * ** M J S D M Measured as the difference in yields between nominal and inflation-linked 10-year government bonds. UK breakeven inflation is structurally higher as it is linked to the UK Retail Prices Index rather than the Consumer Price Index. Source: Bloomberg The other element of the lift in yields is the bringing forward of the timing of the expected increases in policy interest rates. Current market pricing suggests an expectation that some central banks will increase policy rates next year and in 2023 (Graph 7). This is a change from the situation a few months ago, when longer periods of unchanged policy rates were expected. This change has occurred despite expected inflation remaining below the thresholds set by central banks for higher policy rates. Graph 7 % Policy Rate Expectations United States % United Kingdom % Canada % Australia -1 -1 Sources: Bloomberg; RBA Reflecting these global developments, we have seen a similar move in market expectations about future policy rates in Australia. I will return to this issue shortly when I discuss the outlook for monetary policy here. Investment Before doing that, I would like to focus on one piece of the economic recovery in Australia that has been slow to click into gear: that is, private business investment. The left-hand side of the next chart shows the RBA's forecast for non-mining business investment prepared in February last year together with the actual outcomes (Graph 8). The right-hand side shows the same for consumption. Graph 8 Investment and Consumption Chain volume, December quarter 2019 = 100 index Non-mining business investment Consumption index Feb 2020 forecast M J S DM J S DM J S D M J S DM J S DM J S D Sources: ABS; RBA The rebound in consumption has been strong, with growth of 12 per cent over the second half of last year. Investment is a different story. While there was a welcome pick-up in the December quarter, particularly in machinery and equipment investment, investment is still 7 per cent below the level a year earlier and over 10 per cent below where we thought it would be at the start of last year. Nonresidential construction is especially weak, with the forward-looking indicators suggesting that this is likely to remain so for a while yet. This weakness in business investment follows a run of years in which non-mining business investment as a share of nominal GDP was already low by historical standards (Graph 9). Since 2010, this investment ratio averaged 9 per cent, compared with 12 per cent over the previous 3 decades. This is a material difference and cumulates to slower growth in Australia's capital stock, with implications for our longer-term productive capacity. Graph 9 Private Non-mining Business Investment* Share of nominal GDP % % * Net of second-hand asset transfers; RBA estimates Sources: ABS; RBA A durable recovery from the pandemic requires a strong and sustained pick-up in business investment. Not only would this provide a needed boost to aggregate demand over the next couple of years, but it would also help build the capital stock that is needed to support future production. Stronger investment would also support a more productive workforce and a lift in both nominal and real wages. Unfortunately, there is no magic ingredient for boosting business investment. A good starting point, though, is businesses having confidence that the economy will grow and that there will be demand for their products and services. Another important ingredient is having stable and predictable regulatory regimes. Access to finance on reasonable terms is also important. To this list, you could add businesses that are able to generate great new ideas and that have the risk appetite and the capability to back these ideas. Having a highly skilled workforce and management are obviously important elements here. Looking across the economy, there are investment needs and opportunities in areas as diverse as infrastructure, power generation and distribution, health and social services, food production, advanced manufacturing and digitalisation and data science. So there is no shortage of areas where additional investment would help our economy grow. I would like to highlight the important role that small business has in driving investment. My colleagues have recently been examining this using the ABS's BLADE database. [1] One of the exercises that we have undertaken is to examine the investment and output of firms grouped by size – small, medium and large. The results of this work are shown in this next graph (Graph 10). Graph 10 Output and Investment Shares by Firm Size* Private, non-mining sector, financial years 2002–2017 % % Output Investment Small Medium Large * Output is measured by total revenue; small firms are classified here as those with annual output less than $2 million, medium as annual output between $2 million and $50 million, and large as annual output greater than $50 million; firms with annual output less than $10,000 are excluded Sources: ABS; RBA Not surprisingly, large firms account for the biggest shares of output (blue bars) and investment (red bars). But small firms, on average, invest much more relative to their output than do other firms. There is, of course, a lot of variation among small firms, but many of them invest very intensively. In aggregate, small firms accounted for 32 per cent of investment in Australia from 2002–17, while accounting for only 17 per cent of output. This investment drives innovation, generates new ideas, stimulates competition and supports employment. So one of the important ingredients to the recovery in business investment in Australia is ensuring a supportive environment for innovative small and mediumsized businesses. Monetary policy I would now like to return to the outlook for monetary policy in Australia. Over the past year, monetary policy has complemented fiscal policy in cushioning the economic effects of the pandemic and in building the bridge to the recovery in economic activity and jobs. The RBA's policy measures have been keeping financing costs very low, contributing to a lower exchange rate than otherwise, supporting the supply of credit to businesses, and strengthening household and business balance sheets. In doing so, we have been helping in the national recovery effort. The Reserve Bank is committed to continuing to provide the necessary assistance and will maintain stimulatory monetary conditions for as long as is necessary. We want to see a return to full employment in Australia and inflation sustainably within the 2 to 3 per cent target range. These are our goals and we are committed to achieving them. An important element of our policy package is the cash rate target being set at what is the effective lower bound of 0.1 per cent (Graph 11). The Board will maintain this setting of the cash rate target until inflation is sustainably within the 2–3 per cent range. It is not enough for inflation to be forecast to be in this range. Before we adjust the cash rate, we want to see actual inflation outcomes in the target range and be confident that they will stay there. This is an evolution from the approach earlier in the inflation-targeting regime, in which forecasts of inflation played a more central role in decision-making about interest rates. We continue to pay close attention to the forecasts, but we want to see actual inflation outcomes consistent with the target before moving the cash rate. Graph 11 Cash Rate % % Source: RBA A question that investors have been grappling with recently is when will this condition for a higher cash rate be met? As I discussed earlier, over the past couple of weeks market pricing has implied an expectation of possible increases in the cash rate as early as late next year and then again in 2023. This is not an expectation that we share. For inflation to be sustainably within the 2 to 3 per cent range, it is likely that wages growth will need to be sustainably above 3 per cent. This is assuming that Australia generates ongoing growth in labour productivity and that the profit share of national income does not continue to trend higher. Currently, wages growth is running at just 1.4 per cent, the lowest rate on record (Graph 12). Even before the pandemic, wages were increasing at a rate that was not consistent with the inflation target being achieved. Then the pandemic resulted in a further step-down. This step-down means that we are a long way from a world in which wages growth is running at 3 per cent plus. Graph 12 Wage Price Index Growth* Year-ended % % * Excluding bonuses and commissions Source: ABS The evidence from both Australia and overseas strongly suggests that the journey back to sustainably higher rates of wages growth will take time and will require a tight labour market for an extended period. Prior to the pandemic, multi-decade lows in unemployment rates were recorded in many countries, yet even then there was only a modest lift in wages growth and inflation. And here in Australia, even though unemployment rates in some states fell to levels last recorded in the early 1970s, wage growth remained subdued. The commonality of experience across advanced countries suggests that there are some powerful structural factors at work. These include: increased competition in goods markets, which makes firms very conscious of cost increases the trend towards more services being provided internationally advances in technology, which have reduced the demand for some types of skills and increased the demand for others changes to the global supply of labour and regulation of labour markets. Together, these factors have altered wage and pricing dynamics in almost all advanced economies and these changes are likely to persist. This means that, in the absence of another major shock, it is a long way back to seeing wage increases consistent with the inflation target. Wages, of course, are only one factor influencing inflation outcomes. We will be reminded of this when headline CPI inflation increases temporarily to around 3 per cent in the June quarter because of the reversal of some pandemic-related price reductions. Also, there are always relative price shifts occurring due to changes in the balance of supply and demand: recent examples include higher prices for homewares following strong demand during the pandemic and higher prices for meat as farmers rebuild herds after the drought. We will see more such examples as other sectors adjust to the altered balance of supply and demand due to the pandemic. In setting monetary policy, the Reserve Bank Board will look through these transitory fluctuations in inflation. The point I want to emphasise is that for inflation to be sustainably within the 2–3 per cent target range, wages growth needs to be materially higher than it is currently. The evidence strongly suggests that this will not occur quickly and that it will require a tight labour market to be sustained for some time. Predicting how long it will take is inherently difficult, so there is room for different views. But our judgement is that we are unlikely to see wages growth consistent with the inflation target before 2024. This is the basis for our assessment that the cash rate is very likely to remain at its current level until at least 2024. I also want to emphasise that the monetary stimulus is not just about achieving an inflation rate of 2 point something. It is just as much about achieving the maximum possible sustainable level of employment in Australia. Unemployment is a major economic and social problem and the Board places a high priority on a return to full employment. There is, inevitably, some uncertainty about exactly what constitutes full employment in our modern economy. Over the past decade, the estimates of the unemployment rate associated with full employment have been repeatedly lowered both here and overseas. So there is uncertainty. But based on this experience, it is certainly possible that Australia can achieve and sustain an unemployment rate in the low 4s, although only time will tell. As we progress towards full employment, we will be relying on the wages and prices data to provide a signal as to how close we are. The current signal is that we are still a long way away from full employment. Consistent with the judgement that the condition for an increase in the cash rate is unlikely to be met before 2024, the Bank remains committed to the 3-year yield target. We are not considering removing the target or changing the target from 10 basis points. The Board has, though, discussed the question of whether to keep the April 2024 bond as the target bond, or to move to the next bond – that is the November 2024 bond – later this year. If we were to keep the April 2024 bond as the target bond, the maturity of the yield target would gradually decline as time passes until the bond finally matures in April 2024. The Board has not yet made a decision on this 15/17 question and will consider it again later in the year when it has more information about the economic recovery and the labour market. Later in the year, the Board will also consider the case for further extending the bond purchase program. We are prepared to undertake further bond purchases if that is required to reach our goals. Until then, we remain prepared to alter the timing of purchases under the current programs in response to market conditions. We did this last week when liquidity conditions deteriorated and bid-ask spreads widened noticeably, and will do so again if necessary. At its recent meetings, the Board has also discussed developments in the housing market, including the rising housing prices across most of the country. There are many moving parts at present: record low interest rates; a shift in preferences towards houses and away from apartments; strong demand for housing outside our largest cities; large government incentives for first-home buyers and home builders; and the slowest population growth in a century. Time will tell as to how these various factors ultimately balance out, but history suggests that shifts in population growth can have large effects on the housing market. I would like to reiterate that the RBA does not target housing prices, nor would it make sense to do so. I recognise that low interest rates are one of the factors contributing to higher housing prices and that high and rising housing prices raise concerns for many people. There are various tools, other than higher interest rates, to address these concerns, leaving monetary policy to maintain its strong focus on the recovery in the economy, jobs and wages. As part of this focus, we are continuing to pay close attention to lending standards, especially given the combination of low interest rates and rising housing prices. Looser standards would increase mediumterm risks and add to the upward pressure on prices, so would be of concern. Reflecting this, the Council of Financial Regulators has indicated that it would consider possible responses should lending standards deteriorate and financial risks increase. We are not at this point, but we are watching carefully. Conclusion I will conclude by briefly drawing the 3 themes together – the recovery, investment and the outlook for monetary policy. The full recovery of our economy requires a further lift in business investment. Stronger investment will also boost our productivity and provide a firm basis for stronger growth in nominal and real wages. Globally, higher levels of investment relative to savings are also one of the keys to a return to more normal levels of interest rates over the medium term. The Australian economy is recovering from the pandemic and we expect this recovery to continue. We are also expecting further progress towards the RBA's goals, although the journey back to full employment and inflation consistent with the target is likely to be a long one. The RBA will maintain supportive monetary settings for as long as is required to achieve these goals. Thank you for listening and I am happy to answer your questions. Endnotes [*] I would like to thank Ellis Connolly for assistance in preparing this talk. This analysis uses data sourced from the Australian Bureau of Statistics' BLADE (Business Longitudinal Analysis Data Environment) database (see BLADE). The materials on this webpage are subject to copyright and their use is subject to the terms and conditions set out in the Copyright and Disclaimer Notice. © Reserve Bank of Australia, 2001–2021. All rights reserved. The Reserve Bank of Australia acknowledges the Aboriginal and Torres Strait Islander Peoples of Australia as the Traditional Custodians of this land, and recognises their continuing connection to Country. We pay our respects to their Elders, past, present and emerging. | reserve bank of australia | 2,021 | 3 |
Keynote address (online) by Mr Christopher Kent, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to ISDA Benchmark Strategies Forum Asia Pacific, 18 March 2021. | Speech The End of Libor and the Australian Market Christopher Kent [ * ] Assistant Governor (Financial Markets) Keynote Address to ISDA Benchmark Strategies Forum Asia Pacific Online – 18 March 2021 Introduction Thank you for the opportunity to speak at this ISDA Forum on the very important issue of the end of LIBOR. After many years of planning for the end of LIBOR, the deadline is now just 9½ months away. In that short time left, market participants need to take concrete steps to ensure they are ready for the end of LIBOR. An orderly transition away from LIBOR is important not only for your own firm, but for the smooth functioning of financial markets and the stability of the financial system. Today, I want to focus on the steps firms need to take to be ready for the end of LIBOR. Ensuring that these steps are taken is a global regulatory priority. I will also give an update on progress in the Australian market and what's required in the period ahead. As part of that I will make a few remarks about the multiple-rate approach we are taking for Australia's local reference rates. The deadline for LIBOR is fast approaching – what do you need to do To prepare for the end of LIBOR, financial market participants need to take 2 key steps. 1. Move to alternative robust reference rates The first step is for firms to move to robust reference rates for all new contracts. Earlier this month, Ice Benchmark Administration (which administers and publishes LIBOR), confirmed that it will publish most LIBOR rates for the last time on 31 December 2021. [1] On 1 January 2022, these rates will not be published – they will not exist. For the most widely used USD LIBOR tenors, Ice Benchmark Administration will continue publishing these rates until 30 June 2023, but not beyond that. This 18-month extension is being made to allow most legacy USD LIBOR contracts to mature before LIBOR ends. But it is critical to stress that this extension applies to legacy contracts only. Similarly, the UK's Financial Conduct Authority is considering whether there is a need to further extend the publication of a limited number of LIBOR settings in an amended form. But again, this would be to support legacy contracts only. Importantly, this does not change the approach to new contracts referencing LIBOR, which is the same across all currencies and tenors. The clear and universal expectation among regulators is that firms should not reference LIBOR in new contracts beyond 31 December 2021. [3] To do so would be a material risk for an institution's operations, which is why it is such a critical focus of regulators globally. So moving to robust alternative reference rates is imperative for new contracts. In each of the LIBOR jurisdictions, (near) risk-free rates have been identified for this purpose, and liquidity continues to build in products referencing these rates. A lot of important work is also going on within different industry bodies to develop new conventions for referencing risk-free rates (RFRs) in the various products. Good progress has been made in the UK market in particular, where it's also notable that the regulators' target for stopping new LIBOR lending in sterling is the end of this month. In other cases, products referencing RFRs remain a small share of trade, so there is still a lot of work to do. 2. Include robust fallbacks in contracts Ideally, existing contracts will also be amended to reference a new robust reference rate. But the reality is that is not possible in all cases. So the inclusion of robust fallback provisions in contracts is the second key step to take to move away from LIBOR. Robust fallback provisions will make it clear how to proceed when LIBOR ends. In the absence of robust fallbacks, there is no doubt that there will be disputes, litigation and frustration for firms on both sides of the contract when LIBOR ends. A major step towards achieving robust fallbacks was reached when ISDA's new fallback provisions and associated protocol came into effect on 25 January this year. If a particular LIBOR was to become unavailable, these fallback provisions provide for that LIBOR to be replaced with the relevant risk-free rate plus a spread based on its past differences from LIBOR. With the LIBOR end-date announcements earlier this month, this spread has now been set for all LIBOR tenors. All new ISDA interest rate derivatives contracts referencing LIBOR now automatically include these fallbacks. So do all outstanding ISDA contracts where both parties have signed the associated ISDA protocol. More than 13,000 firms have now signed the protocol, including 70 in Australia. Overall, it is estimated that more than 90 per cent of the US$260 trillion in derivative contracts that reference LIBOR are covered by the ISDA fallbacks. This is a massive achievement, but there is more work to do. Regulators globally – including ASIC, APRA and the Reserve Bank – are strongly encouraging financial institutions and corporations that use derivatives contracts referencing LIBOR to review and, wherever practical, adhere to the ISDA protocol. [5] So if you haven't already signed the protocol, we'd urge you to do so as soon as possible. There is also a lot of good work going on across industry to develop robust fallbacks for non-derivatives products. This must proceed in a timely way so that these other contracts are also protected when LIBOR ends after 2021. Some more details Last year the FSB published a Global Transition Roadmap. This describes all of the steps involved and the relevant timelines for financial market participants. [6] For example: By now you should have identified and assessed all existing LIBOR exposures and be following a detailed plan to manage your transition before the end of 2021. Financial institutions should already be offering non-LIBOR linked loans to their customers. If your bank is not doing so, ask why. If you are not satisfied, find a bank which does offer such products. Firms should also adhere, if they haven't already, to the ISDA IBOR fallbacks protocol. By the middle of this year, firms should have established formal plans to amend legacy contracts where this can be done. They also need to have implemented the necessary changes to their systems and processes to enable transition to robust alternative rates. ASIC, APRA and the Reserve Bank have published a more detailed checklist of the range of things you need to include in your transition plans. [7] If you follow these steps in a timely manner, your institution will be ready for the end of LIBOR. Banks' LIBOR transition plans are proceeding. Progress in stakeholder education and the required changes to contracts, systems and processes is in train. It was very pleasing to see overall notional exposures to LIBOR declining over the course of 2020 for the key Australian institutions. It was disappointing though to see that exposures had increased at some individual institutions. That needs to reverse course over the next 9½ months. Regulators everywhere – including in Australia – will be taking action as required to ensure that risks are appropriately managed. Key LIBOR messages In short, by the end of 2021, institutions must have already transitioned to alternative reference rates, and for existing contracts where that's not possible, robust fallback provisions must be in place to make clear what the replacement rate will be when LIBOR ends. Any firms that have not done this will, on the 1 January 2022, be facing the prospect of significant disruption to their contracts and operations. This could lead to more widespread disruption through the financial system. [8] Regulators will therefore be keeping a close eye on progress between now and then to ensure that the necessary work is completed on time. For any that may still hold doubts about the need to act, I'd like to stress that there is no alternative path to follow to move away from LIBOR. Waiting and seeing – for what others do or what other more convenient benchmarks might emerge in the future – is not a viable transition plan. It may be that a term RFR or a credit-spread adjustment on top of a RFR would more conveniently slot into the existing infrastructure and processes you have around your deals and products. We know progress has been slower in non-derivatives markets in part for these reasons. But in most cases, transition to an overnight RFR is feasible and a range of products that previously referenced LIBOR have successfully transitioned to RFRs. Use of the available overnight RFRs compounded in arrears is preferable to the alternative of using a forward-looking term or credit-spread adjusted RFR that is not robust. You need to move forward now with the robust overnight RFRs that are currently to hand. Hopefully, you have found these to be familiar messages. It is incredibly important that all users of LIBOR – financial institutions and businesses alike – manage these risks by preparing for the imminent demise of LIBOR. BBSW and Australia's multiple-rate approach I will now talk briefly about the multiple-rate approach we are taking for Australia's local reference rates. Unlike LIBOR, Australia's local credit-based benchmark BBSW, remains robust. A lot of work has gone into strengthening the methodology underlying its calculation and the supporting infrastructure and market practices. This means that, unlike for LIBOR, regulators in Australia aren't advocating a wholesale transition to referencing the risk-free rate, which in Australia's case is the cash rate, also known as AONIA. Instead, we expect market participants to choose robust reference rates that best suit each of their products and situations, taking into account their own and their clients' needs or hedging strategies: In some cases, referencing the cash rate will make sense. Floating rate notes issued by governments, non-financial corporations and securitisation trusts are possible examples. But in other cases, a credit-based benchmark, like BBSW will continue to make sense. Floating rate notes and corporate loans issued by banks are examples of this. But as I've said before, not all BBSW tenors are as robust as others. [9] In particular, the 1-month BBSW is largely a buy-back market. Accordingly, it is less liquid than other tenors. So users of 1-month BBSW should give careful consideration to using alternative benchmarks given the lack of liquidity in this market. It's also worth noting that for some products, approaches adopted widely by market participants offshore will have an important bearing on the reference rates we are likely to end up using. So regardless of the robustness of BBSW, we can expect to see a shift towards referencing risk-free rates in Australia for some products if that is the trend adopted offshore. Fallbacks are important for all contracts Fallbacks are also a key element in Australia's multiple-rate approach. Fallbacks provide valuable insurance. And if there's one thing that LIBOR has shown us, it's that we shouldn't take existing benchmarks for granted. Regardless of the reference rate used in a contract, the inclusion of robust fallbacks is required for prudent risk management. Accordingly, it is something that the global central banking and financial supervisory community expects. This is why the Reserve Bank worked closely with ISDA as fallback provisions for credit benchmark rates were being developed. Our local credit-based benchmark, BBSW, is included in the ISDA fallbacks and protocol. So adherence to the protocol is not only important for managing LIBOR transition, but as a matter of good practice for your contracts that reference BBSW rates as well. In due course, the Reserve Bank will also require securities that reference BBSW to include robust fallback provisions in order to be eligible as collateral in our market operations. There is a lot of good work already underway in industry towards developing market conventions in this area – including by the ASF. The Reserve Bank is currently working through feedback from industry on the proposed implementation of a principles-based requirement to take effect in mid 2022. We expect to confirm the implementation details in coming months. Thank you for your time today. I look forward to answering questions you may have. Endnotes [*] I thank Andrea Brischetto for invaluable assistance in preparing this material. See ICE Benchmark Administration Limited (2021), ‘ICE LIBOR Feedback Statement on Consultation on Potential Cessation’, Statement, 5 March. Available at <https://www.theice.com/publicdocs/Feedback_Statement_on_Consultation_on_Potential_Cessation.pdf>. See FCA (Financial Conduct Authority) (2021), ‘Announcements on the end of LIBOR’, Press Release, 5 March. Available at <https://www.fca.org.uk/news/press-releases/announcements-end-libor>. There are very limited exceptions to this, including contracts necessary to support or manage risks relating to legacy LIBOR contracts entered into before the end of 2021. For example, see Federal Reserve Board (2020), ‘Agencies issue statement on LIBOR transition’, Joint Press Release, 30 November. Available at <https://www.federalreserve.gov/newsevents/pressreleases/bcreg20201130a.htm>. In ICE Benchmark Administration's statement on 5 March, it stated that it will not be possible to publish the LIBOR settings on a representative basis beyond the nominated cessation dates. The UK Financial Conduct Authority publicly confirmed this finding (see footnote 2), thereby constituting an index cessation event under the ISDA 2020 IBOR Fallbacks Protocol, triggering the setting of the spreads to be used in the fallback rate calculations. See ISDA (International Swaps and Derivatives Association) (2021), ‘ISDA Statement on UK FCA LIBOR Announcement’, Press Release, 5 March. Available at <https://www.isda.org/2021/03/05/isda-statement-on-uk-fca-libor-announcement/>. See RBA (2020), ‘Regulators urge Australian institutions to adhere to the ISDA IBOR Fallbacks Protocol and Supplement', Media Release No 2020-25, 13 October. Available at https://www.rba.gov.au/media-releases/2020/mr-2025.html. See FSB (Financial Stability Board) (2020), ‘Global Transition Roadmap for LIBOR’, 16 October. Available at <https://www.fsb.org/2020/10/global-transition-roadmap-for-libor/>. See RBA (Reserve Bank of Australia) (2020), ‘Regulators Release Feedback on Financial Institutions' Preparation for LIBOR Transition’, Media Release No 2020-12, 8 April. Available at https://www.rba.gov.au/media-releases/2020/mr-2012.html. While there are limited exceptions where authorities are providing for legacy LIBOR contracts to be supported beyond this date, this cannot be relied on in general. Any firm relying on this would be pursuing a very risky strategy. See Kent C (2020), ‘Benchmark Reforms’, Remarks to the Australian Securitisation Forum Virtual Symposium, Sydney, 17 November. Available at https://www.rba.gov.au/speeches/2020/sp-ag-2020-11-17.html and Kent C (2019), ‘Bonds and Benchmarks’, Speech at the KangaNews DCM Summit, Sydney, 19 March. Available at https://www.rba.gov.au/speeches/2019/sp-ag-2019-03-19.html The materials on this webpage are subject to copyright and their use is subject to the terms and conditions set out in the Copyright and Disclaimer Notice. © Reserve Bank of Australia, 2001–2021. All rights reserved. The Reserve Bank of Australia acknowledges the Aboriginal and Torres Strait Islander Peoples of Australia as the Traditional Custodians of this land, and recognises their continuing connection to Country. We pay our respects to their Elders, past, present and emerging. | reserve bank of australia | 2,021 | 3 |
Address by Mr Christopher Kent, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to the Australian Finance Industry Association, 17 March 2021. | Speech Small Businesses Finance in the Pandemic Christopher Kent [ * ] Assistant Governor (Financial Markets) Address to the Australian Finance Industry Association Sydney – 17 March 2021 Thank you for the opportunity to discuss small business finance with you today. Small businesses play a critical role in the Australian economy. They employ nearly 5 million Australians. They account for about one-third of private (non-financial) output, and they are a key source of innovation and competition. Many small businesses use external finance from banks and other sources to manage their cash flows, invest in new equipment and expand their operations. The Reserve Bank has been paying close attention to small businesses' access to finance for many years. Every year for almost 3 decades we have convened a panel of small businesses to better understand the issues they face. [1] We also speak with businesses, banks and other financiers through our various liaison programs. [2] A consistent and ongoing theme is that smaller businesses find it a challenge to access finance. Today I'll discuss how smaller businesses have been affected by the economic downturn over the past year, with a focus on their access to finance. [3] I'll also outline the measures that were introduced to help mitigate the additional financing difficulties that small businesses faced as a result of the pandemic. Smaller Businesses have been Heavily Affected by the Pandemic While economic conditions are improving, it has been a particularly tough year for small businesses. The pandemic caused the largest economic downturn in Australia since the 1930s. Businesses in all industries and of all sizes have been significantly affected, although the experience has been quite uneven. In particular, small businesses have generally been hit harder than larger businesses. Many businesses surveyed by the ABS reported that revenue in June of last year was much lower than the year prior. But, small businesses were around twice as likely as large businesses to have reported declines of 50 per cent or more. This difference was also apparent in retail sales data (Graph 1). Much of the difference between small and large businesses reflects the fact that many small businesses operate in industries such as cafes, restaurants, arts and recreation that were most affected by COVID-19 restrictions. Graph 1 Retail Sales Growth by Firm Size Year-to-latest three months, current prices % % Large firms Small firms -10 -10 -20 -20 Sources: ABS; RBA When it comes to finance, the past year has actually been less volatile for small businesses in general. Aggregate lending to SMEs has been little changed since the onset of the pandemic (Graph 2). Indeed, SME lending has been around its current level for the past few years. Aside from lending to the agricultural sector, which increased throughout much of 2020, lending has been flat for SMEs across the board (Graph 3). But lending to SMEs in those industries most adversely affected by the pandemic has been low for some time. In contrast to SMEs, lending to large businesses increased sharply in March and April last year, as those businesses drew upon sizeable lines of credit. Large businesses have since repaid these funds, though outstanding lending remains a bit above pre-pandemic levels. Graph 2 Lending to Business* $b $b Large business Medium business Small business J A S O N D J F M A M J J A S O N D J F * Data cover financial institutions with $2 billion or more in business credit Sources: APRA; RBA Graph 3 Lending to Selected Industries Small and medium-sized businesses, credit outstanding $b Highly affected by COVID-19* Less affected by COVID-19* $b Rental Agriculture Other highly affected** Other services*** Accom & food Construction Admin Healthcare S D M J S D M S D M J S D M * Highly affected industries had the highest share of businesses report a fall in revenue of greater than 50 per cent in a June 2020 ABS survey; less affected industries are the top four by value of SME lending ** Education & training; arts & recreation; information media & telecoms *** Other services includes a broad range of personal services, selected repair and maintenance activities and private households employing staff Sources: APRA; RBA There has been little change in total SME lending over the past 12 months for several reasons. In part, it reflects the reluctance of some businesses to take on more debt in a weaker and more uncertain economic environment. At the same time, many businesses, including smaller ones, have been able to make use of government and private-sector measures designed to support business cash flows. This reduced the need for many businesses to access external finance, which is more expensive than a business's own internal funds. Another factor weighing on lending is a more cautious approach by banks in deciding whether to finance small businesses. Much of this has reflected the application of pre-existing lending standards in a weaker economic environment. But lending standards have also been tightened. For example, banks have required a greater degree of verification of borrowers' information, and banks have been more cautious about lending to new business customers and to the sectors hit hardest by the pandemic. Small Businesses have Reported Difficulties Accessing Finance for Years Many of the challenges small businesses face when accessing finance have been around for many years. Although I am focusing on the experience in Australia, it is worth noting that these challenges are not unique to SMEs in Australia. Small businesses, particularly less established ones, tend to be riskier than large, established firms with a track record of profitability. As a result, lenders reject a greater proportion of loan applications from smaller businesses. They also charge more to take on the additional risk associated with the loans that they provide. The terms for the loans may also be more restrictive. For instance, loans to small businesses may often be small relative to the size of the business, or require collateral or personal guarantees. Indeed, around 95 per cent of loans to SMEs are secured – compared with around 70 per cent for large business loans (Graph 4). And about half of small business loans are secured by residential property. Many small business owners may not be well placed to provide sufficient home equity to secure a suitable loan. Graph 4 Lending to Businesses Not seasonally adjusted, break-adjusted $b Small business Medium business Large business $b S D M J S D M S D M J S D M S D M J S D M 2020 2021 2019 2020 2021 2019 2020 2021 Secured (other) Secured (residential property) Unsecured Secured Sources: APRA; RBA Small businesses generally have few viable alternatives for external finance outside of traditional intermediated finance. Unlike large businesses, it is too costly for them to raise funds directly from capital markets. Australian small businesses have made increasing use of non-traditional sources of finance in recent years, such as balance sheet lending and marketplace lending (Graph 5). [5] However, the available data suggest that non-traditional sources of finance accounted for less than 2 per cent of overall SME lending in 2018. Graph 5 Non-Traditional Finance Transaction volume A$m A$m Total 1,500 1,500 Other* 1,250 1,250 Marketplace consumer lending 1,000 1,000 Balance sheet business lending * Includes balance sheet consumer lending, marketplace business lending, property lending, invoice trading, crowdfunding, and other models Sources: Cambridge Centre for Alternative Finance; RBA Programs to Mitigate Financing Problems for SMEs during the Pandemic It was expected that the difficulties smaller businesses face in accessing finance would worsen during the pandemic. So a range of policies were put in place to support the provision of low cost finance to small businesses. The Reserve Bank introduced a package of monetary policy measures at the onset of the pandemic. These have helped to reduce the costs of finance to historically low levels, and have been supporting the supply of credit to businesses and strengthening household and business balance sheets. The Term Funding Facility (TFF) provides low cost term funding to banks. It includes incentives for banks to increase their lending to non-financial businesses, especially SMEs; for every dollar of extra lending to SMEs, a bank is allocated a further 5 dollars of low cost funds from the TFF. A range of banks have expanded their lending to SMEs and benefited from these additional allowances under the TFF (Graph 6). Graph 6 TFF Allowances $b $b A M J J A S O Initial* Additional (large business) N D J F M Additional (SMEs) Supplementary * Represents final usage from October 2020 onwards, as the drawdown period for the initial allowance closed on 30 September 2020 Sources: APRA; RBA The Government also introduced a range of significant measures to support business cash flows and balance sheets. Policies such as JobKeeper, Boosting Cash Flow for Employers and enhanced tax incentives for investment have reduced costs for businesses, increased household disposable income and supported aggregate demand more broadly. They have preserved employment relationships between firms and employees, and have helped otherwise viable businesses stay afloat when their revenues were markedly reduced by COVID-19 restrictions. These measures reduced the need for many businesses to borrow. This accords with ABS surveys conducted in both October last year and February this year, in which most businesses indicated that they had sufficient funds and did not need additional finance. Similarly, late last year, non-financial companies had built up cash buffers that could cover nearly 6 months' worth of expenses, an increase of around 30 per cent compared with before the pandemic. Unincorporated businesses had increased their cash buffers by 20 per cent to a little over 2 months' worth. Other measures associated with the pandemic have been introduced to support the supply of credit. This includes the Australian Government's $15 billion Structured Support Fund to help smaller lenders access funding and a $40 billion SME loan guarantee scheme to enable participating lenders to issue cheaper loans to small businesses. The loan guarantee scheme has just been enhanced for SMEs that have been receiving JobKeeper. Those SMEs can borrow up to $5 million for up to 10 years (up from $1 million and 5 years previously). The funds can now also be used for refinancing of some existing loans. In addition, the Government is guaranteeing 80 per cent of each loan under the expanded scheme (up from 50 per cent). Support has also been provided by the private sector. Landlords allowed for more flexible rent arrangements and banks offered to defer loan payments. Along with the country's successes on the health front, these policies have lessened the economic impact of the pandemic and underpinned the economic recovery that is now well underway. The effects of this have started to flow through to small businesses. Measures of small business confidence have increased over the past 6 months. In February, a smaller share of businesses indicated that economic uncertainty was weighing on their investment plans than was the case in August last year. Labour market outcomes have also improved. The increases in job openings and employment growth observed since late last year have been particularly pronounced in industries that were most affected by COVID-19 restrictions. Again, these are the industries that are heavily populated with smaller businesses. Finally, a number of ongoing government initiatives will continue to support small businesses after the temporary measures associated with the pandemic are phased out. These were developed prior to the pandemic in response to long-running concerns about access to finance by SMEs. One such initiative is the $2 billion Australian Business Securitisation Fund. This invests in securitisations that are backed by loans to SMEs issued by small banks and non-bank lenders. Another initiative is the Australian Business Growth Fund. This will provide longer-term equity funding to established SMEs looking to expand, and is jointly backed by the Australian Government and a number of banks. It was launched with $540 million to invest in SMEs. The Australian Government has also recently reformed insolvency laws for small businesses and introduced a new scheme for monitoring how quickly large businesses pay their invoices. Both aim to improve the environment for small businesses. How Effective have Policy Measures been at Supporting Credit? Roughly a year on from the onset of the pandemic, it's useful to reflect on the effectiveness of the various policies for small businesses. The supply of finance remains tighter than before the pandemic, particularly for those businesses that were hit the hardest. While there are signs that conditions have started to improve a little recently, surveys of small businesses indicate that access to finance remains difficult (Graph 7). Graph 7 Small Business Perception of Access to Finance* Per cent of all respondents % ppt Net balance** Relatively difficult Easier access Harder access -10 Relatively easy * ** -20 -30 Survey has asked about perceptions of changes in access to finance relative to a previous period since July 2019; before that the survey asked for point-in-time assessments Net balance is the difference between the percentage of firms indicating access is relatively easy and the percentage of firms indicating access is relatively difficult Sources: RBA; Sensis Even so, the policy responses have helped to cushion the impact of tighter access to credit. The cash rate cuts through 2020, and other initiatives to reduce banks' funding costs, have flowed through to lower interest rates on SME loans. Outstanding rates on variable-rate loans to SMEs, on average, have declined by about 85 basis points since February last year. This is a little more than the corresponding decline in banks' funding costs, and interest rates on loans are still drifting lower. The Reserve Bank's TFF has provided a strong incentive to banks to increase their overall lending to SMEs, and a range of banks have been able to take advantage of this benefit. The Australian Government's loan guarantee scheme has also put some downward pressure on SME interest rates. Some SMEs that have borrowed unsecured through the scheme have done so at rates that are comparable to those for secured loans issued outside of the scheme. Although the spread between rates on SME loans and large business loans has increased over the past year, the increase has only been slight (Graph 8). In particular, the widening is considerably smaller than that which occurred at the time of the global financial crisis; although the spread had never returned to pre-GFC levels. I should emphasise, however, that pricing alone does not provide a complete picture on the availability of finance. Indeed, small businesses have reported that the price has not been the biggest impediment to accessing finance over the past few years. For instance, entrepreneurs in our small business panels have noted that access to finance for start-ups is a challenge, banks often have substantial collateral requirements, and the process for getting finance is lengthy and onerous. Graph 8 Australian Business Lending Rates % Outstanding rates* % Small loans Large loans SME Large business bps bps Spread * Small loans data up to June 2019 reflect loans valued less than $2 million; large loans data up to June 2019 reflect loans valued $2 million or more; from July 2019 new data are used from the Economics and Financial Statistics (EFS) collection (See Statistical Table F7) Sources: APRA; RBA Over 200,000 SME borrowers arranged to defer their loan payments last year. The vast majority have now resumed payments. The share of SME loans with a deferral peaked at 13 per cent in June (Graph 9). It is now around 1 per cent. Consistent with these outcomes, modelling by large banks suggests that the risk of default for small businesses relative to large businesses did not change much in 2020 (Graph 10). Nevertheless, business failures are expected to rise as some of the pandemic support measures are phased out. Graph 9 SME Loan Repayment Deferrals Share of total SME loans by number % % J J A Sources: APRA; RBA S O N D J F M Graph 10 Business Lending Default Probabilities Average estimate from internal ratings-based models* % % Default probabilities** Small business Large business bps bps Difference * ** On-balance sheet exposures of major banks Small business is the SME retail and SME corporate categories in APRA's capital framework; Large business is the corporate category Sources: APRA; RBA SME lending overall has been little changed over the past year, in part reflecting the effectiveness of various measures in supporting businesses' cash flow. However, there have been pockets of increased financing activity. In the second half of 2020, commitments for new SME loans increased a little to around the level seen in the lead up to the pandemic. Much of the increase owes to businesses borrowing funds for the purchase of property, and plant and equipment. The latter is consistent with the expansion of the Australian Government's instant asset tax write-off scheme. Also, refinancing by SMEs has been higher over the financial year to date compared with the same period a year earlier (Graph 11). This is consistent with businesses seeking to obtain a better deal with the lower interest rates on offer. Graph 11 Conclusion Overall, smaller businesses have suffered significantly from the economic hardship caused by the pandemic. A wide range of monetary, fiscal and private-sector measures have provided support. Indeed, many of those measures obviated the need for small businesses to take out additional debt over the past year. While businesses' confidence has improved markedly of late, a number of businesses, particularly smaller businesses, remain reluctant to take out new loans. Some of this reflects an economic outlook that, while improved, is still very uncertain. Also, access to finance for smaller businesses has been a long-standing challenge. There are a range of policies in place to help support the supply of business credit as the economic recovery proceeds. Given the importance of small businesses to the economy, we will continue to pay close attention to their access to finance and their prospects more broadly. Endnotes [*] I thank Joel Bank and Michelle Lewis for tremendous assistance in preparing this material. Information about the Small Business Finance Advisory Panel can be found on the RBA website: https://www.rba.gov.au/about-rba/panels/small-business-finance-advisory-panel.html. This month we expanded our coverage of finance for small and medium-sized enterprises (SMEs) in our monthly chart pack, which is available on the RBA website: https://www.rba.gov.au/chart-pack/. Some of my colleagues at the Reserve Bank have written articles on the subject, which my remarks today draw upon. See Bank J and M Lewis (forthcoming), ‘Australia's Economic Recovery and Access to Small Business Finance’, RBA Bulletin, March and Lewis M and Q Liu (2020), ‘The COVID-19 Outbreak and Access to Small Business Finance’, RBA Bulletin, September. See, for example, the OECD's latest scoreboard on ‘Financing SMEs and Entrepreneurs’ <https://www.oecd.org/cfe/smes/financing-smes-and-entrepreneurs-23065265.htm> and G20/OECD high-level principles on SME financing <http://www.oecd.org/finance/G20-OECD-High-Level-Principles-on-SME-Financing.pdf> Indeed, Australia was the largest non-traditional finance market in the Asia Pacific region after China and the seventh largest globally in 2018 (the latest year with comprehensive data). The largest sources of non-traditional business finance in Australia are balance sheet lending (where the lending entity provides a loan directly to the borrower, mechanically similar to traditional bank finance) and invoice trading (where the lending entity purchases unpaid invoices or receivables from a business at a discount). Marketplace lending (which uses new technology to connect fundraisers directly with funding sources, for example peer-to-peer lending) is not as common. The materials on this webpage are subject to copyright and their use is subject to the terms and conditions set out in the Copyright and Disclaimer Notice. © Reserve Bank of Australia, 2001–2021. All rights reserved. The Reserve Bank of Australia acknowledges the Aboriginal and Torres Strait Islander Peoples of Australia as the Traditional Custodians of this land, and recognises their continuing connection to Country. We pay our respects to their Elders, past, present and emerging. | reserve bank of australia | 2,021 | 3 |
Text of the Shann Memorial Lecture by Mr Guy Debelle, Deputy Governor of the Reserve Bank of Australia, online, 6 May 2021. | 5/6/2021 Monetary Policy During COVID | Speeches | RBA Speech Monetary Policy During COVID Guy Debelle [ * ] Deputy Governor Shann Memorial Lecture Online – 6 May 2021 Thank you for the opportunity to speak to you tonight. I am honoured to be giving the Shann lecture. Edward Shann's work had a lasting impact on Australian economic thought. As an economic historian, Shann looked to the past to inform solutions to the most important problems of his time, including how to lift Australia out of the Great Depression. Many of Shann's key contributions seem orthodox today but were well ahead of his time. Shann advocated for the removal of tariffs, a shift away from centralised wage fixing and a move to a more flexible exchange rate. Shann also saw an important role for an independent central bank to prevent and respond to crises. [1] He was widely regarded as an excellent teacher, who left a significant impact on his students. One such student was HC ‘Nugget’ Coombs, the Reserve Bank's first Governor. Coombs described Shann as ‘supremely capable of communicating the excitement of intellectual exploration … and establishing the sense of social responsibility, which should guide those who work in academic fields’. Taking inspiration from Shann, tonight I will talk to you about the role the Reserve Bank has played in responding to the current crisis. I will describe what the Reserve Bank has done over the past year to support the economy through the COVID pandemic. I will talk about why we have taken these actions and some of the thinking behind the policy decisions. Then I will look at the outcomes of these policy actions to date. Finally, I will highlight some of the issues the Bank will be thinking about in the period ahead. Policy actions during COVID The Reserve Bank of Australia (RBA) has taken a number of complementary policy actions to support the Australian economy since the onset of COVID. The RBA has lowered its policy interest rate to near zero, set a target for the 3-year government bond yield, enhanced its forward guidance, https://www.rba.gov.au/speeches/2021/sp-dg-2021-05-06.html 1/26 5/6/2021 Monetary Policy During COVID | Speeches | RBA commenced a program of purchasing government bonds and provided long-term low-cost funding to the banking system. I will explain each of these actions in more detail shortly. The overall aim of all these monetary policy actions has been to support economic activity in Australia through a number of channels. The policy actions have underpinned record low funding costs across the financial system and for governments. Lower borrowing costs free up cash flow for both households and businesses, some of which is spent. The lower interest rates and the funding for the banking system support the flow of credit to households and businesses. Lower interest rates also support asset prices, which boost balance sheets, and thereby consumption and investment. Finally, a lower structure of interest rates leads to a lower value of the Australian dollar than would otherwise be the case. The end result is a stronger Australian economy. The policy response has evolved over the pandemic period as information about the extent of the pandemic and its economic impact has unfolded. The initial policy decisions were taken in March 2020, including at an unscheduled policy meeting on 18 March. Further measures were announced in September and November 2020 and in February 2021. In mid March 2020, as the impact of the virus and the health policy actions on the Australian economy became evident, the Reserve Bank Board put in place a comprehensive package at an unscheduled meeting to support jobs, incomes and businesses, so that when the health crisis receded, the country was well placed to recover strongly. The package comprised: a reduction in the cash rate target (the policy interest rate) to 25 basis points, having already reduced the cash rate to 50 basis points at the earlier March Board meeting forward guidance that the Board will not increase the cash rate target until progress is being made towards full employment and it is confident that inflation will be sustainably within the 2–3 per cent target band reducing the interest rate paid on Exchange Settlement (ES) balances (the balances the banking system holds with the RBA) to 10 basis points the introduction of a target on the 3-year Australian Government bond yield of around 25 basis points the purchase of bonds to address the dysfunction in the Australian government bond market a Term Funding Facility (TFF) for the banking system under which funds equivalent to 3 per cent of lending could be borrowed from the RBA for 3 years at 25 basis points (against eligible collateral) up until end September 2020. The TFF provided additional incentives to support lending to businesses, particularly small and medium-sized businesses the continued use of the RBA's open market operations to make sure that the financial system had a high level of liquidity. The RBA had already been expanding its liquidity provision prior to the mid-March Board meeting to address the growing dislocation in financial markets. https://www.rba.gov.au/speeches/2021/sp-dg-2021-05-06.html 2/26 5/6/2021 Monetary Policy During COVID | Speeches | RBA In September 2020, as the end-September deadline for the drawdown of funding under the TFF approached, the Board decided to expand the TFF to provide additional low-cost funding equivalent to 2 per cent of lending in the banking system. It also decided to extend the drawdown period for this, as well as the additional funding linked to business lending, to June 2021. In October, the Board changed its forward guidance to focus on actual outcomes for inflation, rather than expected outcomes in guiding its future policy decisions. At the November 2020 Board meeting, the Board decided on a further package of measures to support the economy: a reduction in the cash rate target, the 3-year yield target and the interest rate on new drawings under the TFF to 10 basis points, from the previous rate of 25 basis points a reduction in the interest rate on ES balances from 10 basis points to zero the introduction of a program of government bond purchases, focusing on the 5 to 10 year segment of the yield curve. The RBA would buy $100 billion of government bonds over the following six months in the secondary market, purchasing bonds issued by the Australian Government (AGS) as well as by the Australian states and territories (semis). The Board took this decision given the assessment that Australia was facing a prolonged period of high unemployment and inflation was unlikely to return sustainably to the target range of 2–3 per cent for at least 3 years. In February 2021, to provide further support to the Australian economy as it recovered, the Board announced that it would purchase an additional $100 billion of government bonds, after the first program was completed. Those purchases are underway now. The policy actions taken to deliver low funding costs have had a number of complementary elements, and have been mutually reinforcing in underpinning low interest rates across the economy. Next, I will explain each of these actions in detail. Policy rate reduction The first policy action I will talk about is the reduction in the cash rate target. This has been the primary lever of monetary policy for more than 3 decades now. The effect of this reduction in the cash rate on financial markets and the economy have been similar to the experience over those 3 decades. The reduction in the cash rate provides stimulus to the economy through a number of channels. When the cash rate is lowered it reduces funding costs for the banking system which in turn flows through to lower borrowing rates for households and businesses. These lower borrowing rates stimulate borrowing and economic activity. The lower cash rate also boosts the cash flow of existing borrowers. It supports asset prices, including housing prices, which boosts household wealth and hence spending. In addition, it puts downward pressure on the Australian dollar which is stimulatory for the economy. https://www.rba.gov.au/speeches/2021/sp-dg-2021-05-06.html 3/26 5/6/2021 Monetary Policy During COVID | Speeches | RBA The Board has reduced the cash rate target to what it assesses to be the effective lower bound of 10 basis points. The Board has stated that it does not see negative rates as being appropriate in Australia in the current circumstances. I see there are at least two reasons for this. First, there is uncertainty about the efficacy of negative interest rates, including because of the negative effect on savers. [4] Second, and at least as important, there were other actions that the Bank could take to provide monetary stimulus, which we have taken. In this episode, there has been an additional aspect of the cash rate reduction that is important to highlight. At the same time as the cash rate target was reduced in March and November 2020, the remuneration rate on ES balances was also reduced (Graph 1). The remuneration rate on ES balances is the interest rate the RBA pays on deposits that banks hold with the RBA (I will refer to it as the ES rate in the remainder of this speech). When the cash rate target is reduced, the ES rate is also reduced. Graph 1 Cash Market Rates % Cash rate Cash rate target* % ES rate 0.75 0.75 0.50 0.50 0.25 0.25 0.00 0.00 M J S D * M J Assumes unchanged future policy settings Source: RBA Normally, this is not that important to anyone outside of those who manage the banking system's accounts at the RBA. But this time around, the ES rate has much more significance. In the past, the cash rate target set by the Board was the primary anchor for money market rates and hence the whole structure of interest rates in the Australian financial system. The actual cash rate, that is, the overnight interest rate at which banks borrow and lend their balances at the RBA, https://www.rba.gov.au/speeches/2021/sp-dg-2021-05-06.html 4/26 5/6/2021 Monetary Policy During COVID | Speeches | RBA was almost always equal to the cash rate target. The RBA conducted its daily market operations to keep the size of ES balances small, with minimal ‘excess liquidity’ in the market, so that demand and supply pressures in the market invariably ensured the cash rate traded at the cash rate target each day. Because of the policy actions I will talk about shortly, particularly the bond purchases and the TFF, ES balances are now very large, around $200 billion. Put simply, the banking system has a very large amount of deposits at the RBA. [6] There is now a large amount of liquidity in the system. Some banks still need to borrow overnight in the market to ensure their balance with the RBA remains positive, but these amounts are very small. And there are a lot of banks with large ES balances who are willing to lend to them. Given this balance of demand and supply, the actual cash rate is trading just above the ES rate of zero, which is what the banks receive if they don't lend their excess balances. In technical terms, given the large amount of liquidity in the system as a result of the RBA's policy actions the RBA is now effectively operating a floor system, rather than the corridor system that had been the case for the past few decades. The actual cash rate has declined to around 3 basis points and has been around that level since November, when the ES rate was reduced to zero. There is a small spread above the floor of the corridor reflecting a small credit premium and transaction costs. The actual cash rate is still the anchor of the structure of interest rates in the Australian financial system. But it is the ES rate, rather than the cash rate target that is now the primary determinant of the cash rate. The Board had fully expected this outcome of the actual cash rate declining below the cash rate target, given the large increase in liquidity in the system. ES balances are going to remain at a high level for quite a number of years, until the funds provided to the banking system under the TFF are repaid, and until the government bonds the RBA has bought mature. While ES balances are at a high level, the ES balance rate is going to continue to be the main anchor of the cash rate. The reduction in the cash rate target, the remuneration on ES balances and the actual cash rate has seen all short-term interest rates in the Australian financial system decline to historically low levels, including the important interest rate benchmark the Bank Bill Swap Rate (BBSW) (Graph 2). As the graph shows, the BBSW rate has fallen even further because of the availability of low-cost funding to the banking system. The lower BBSW rate translates directly to lower borrowing costs for the interest rates that reference it, particularly business borrowing rates. https://www.rba.gov.au/speeches/2021/sp-dg-2021-05-06.html 5/26 5/6/2021 Monetary Policy During COVID | Speeches | RBA Graph 2 Money Market Rates % % 3-month BBSW 0.75 0.75 0.50 0.50 0.25 0.25 Cash rate Expected cash rate 0.00 M J S D M J S D 0.00 Sources: Bloomberg; RBA In turn, these short-term interest rates, along with the low-cost funding available through the TFF, have reduced the funding costs to the banking system and thereby resulted in large declines in household and business borrowing rates (Graph 3). https://www.rba.gov.au/speeches/2021/sp-dg-2021-05-06.html 6/26 5/6/2021 Monetary Policy During COVID | Speeches | RBA Graph 3 Variable Lending Rates* % % Housing % % Business * Major banks; data from the EFS collection from July 2019 Sources: APRA; major banks' websites; RBA; Securitisation System Forward guidance The RBA's policy announcements have enhanced forward guidance about the Board's expectations for the future path of monetary policy. The forward guidance takes the form of describing the economic conditions the Board would be looking to see before it would consider raising the cash rate. That is, the guidance is based on the state of the economy (in technical terms, the guidance is state-based). The Board's guidance has evolved over the past year to emphasise outcomes rather than forecasts. That is, the Board has stated that it will not increase the cash rate until actual inflation, not forecast inflation, is sustainably within the target range. In addition, it has stated this will require a lower rate of unemployment and a return to a tight labour market. That sort of guidance is meaningful for financial market participants and for economists. But many people are interested about the Bank's views about how long it will be before the economy will reach these conditions. They want to know how long it will be before interest rates start to rise. Hence, the Bank has provided a possible timeframe alongside its description of the state of the economy required before considering a rise in the cash rate. At the May Board meeting earlier this week, the Board reiterated that in its central scenario, these conditions are unlikely to be met until 2024 at the earliest. This complements the 3-year government bond yield target and has helped underpin the low level of interest rates across the economy. But I https://www.rba.gov.au/speeches/2021/sp-dg-2021-05-06.html 7/26 5/6/2021 Monetary Policy During COVID | Speeches | RBA would highlight that it is the state of the economy that is the key determinant of policy settings, not the calendar. Bond purchases Turning to government bond purchases, they have been comprised of three elements (Graph 4): purchases to maintain the 3-year yield target since November 2020, the bond purchase program purchases to address market dysfunction. Graph 4 RBA Bond Purchases Face value; cumulative from 20 March 2020 $b $b Total AGS M A M J J A Semis S O N D J F M A M Source: RBA I will explain each of these in more detail. Three-year yield target From March 2020, the RBA commenced purchasing government bonds focussed on the 3 year point of the yield curve. This is because in Australia, most borrowing is at variable rates that key off the front part of the yield curve. This is in contrast to other markets such as the US where longer-term yields are more important benchmarks for borrowing rates. https://www.rba.gov.au/speeches/2021/sp-dg-2021-05-06.html 8/26 5/6/2021 Monetary Policy During COVID | Speeches | RBA The 3-year yield target has helped anchor the Australian yield curve and has had significant traction in lowering borrowing rates for households and businesses, together with the other policy measures adopted. It has also helped reinforce the RBA's forward guidance regarding the cash rate. It is appropriate to characterise the policy as a yield target not yield curve control. The RBA is targeting one particular yield on the curve, not trying to control the curve as a whole. I will come back to this when talking about the bond purchase program. To maintain this target, the RBA has conducted auctions to buy the 3-year target bond when the yield has moved above the target in a material and sustained way. Such purchases have been necessary on relatively few occasions. Much of the time, the market has had sufficient confidence in the sustainability of the target that the yield has been anchored close to the target, which was 25 basis points from March to November 2020, and then 10 basis points (Graph 5). Graph 5 Three-year Australian Government Bond Yield* % % 0.75 0.75 Target introduced 0.50 0.50 Target lowered 0.25 0.25 0.00 0.00 N D J F M A M J J A S O N D J F M A M * Three-year yield target bond is the April 2023 Treasury bond until 20 October 2020, and the April 2024 Treasury bond thereafter Sources: RBA; Yieldbroker Initially the target was for the April 2023 bond maturity. Subsequently the target was changed to the April 2024 maturity when it became the closest bond maturity to the 3-year horizon. [7] In March 2021, the Board agreed that it would not consider removing the yield target completely or changing the target yield of 10 basis points when reviewing the yield target bond later in the year. If the Board were to maintain the April 2024 bond as the target bond, rather than move to the next bond https://www.rba.gov.au/speeches/2021/sp-dg-2021-05-06.html 9/26 5/6/2021 Monetary Policy During COVID | Speeches | RBA maturity that becomes closest to the 3-year horizon, the maturity of the target would gradually decline until the bond finally matured in April 2024. The Board will consider whether to extend the target to the next maturity at the July meeting. In the past couple of months, while the 3-year government bond rate has remained very close to the Board's target, the 3-year swap rate has risen relative to the 3-year government bond rate. [8] The swap rate often trades above the government bond rate because it involves more credit risk. But the spread between the two has widened by around 20 basis points in recent months. In part this reflects the market's expectations about the future direction of monetary policy. The market is assigning some probability to the scenario that the cash rate could be higher in 2024 than the Board's current forward guidance. [9] This expectation is being reflected in the swap rate, but not in the April 2024 bond rate, because the Bank is ensuring the bond rate remains at the target. This move upward in the swap rate will put some upward pressure on longer-term household and business borrowing rates. But the effect is unlikely to be that large. Overall funding costs for banks remain at historic lows. Moreover, the 3-year yield target is still playing a significant role in anchoring that part of the curve. If the yield target wasn't there, the government bond curve and swap rates would be higher still. Bond purchase program In November 2020, the Board announced a quantity-based bond purchase program that is complementary to the 3-year yield target. The Board decided to implement this policy for a number of reasons. Longer-term Australian Government bond yields were higher than those in other advanced countries. This provided evidence that the size of other central banks' bond purchase programs was affecting longer-term Australian bond yields beyond the anchoring effect of the Bank's 3-year yield target. This in turn was contributing to a higher exchange rate, which was restraining the recovery in the Australian economy. The bond purchase program announced in November 2020 was for the purchase of $100 billion in bonds of maturities of around 5 to 10 years over the following 6 months. It includes bonds of both the Australian and state and territory governments, with $80 billion allocated to the Australian Government and $20 billion to the state and territory governments. In February 2021 the Board announced an additional $100 billion with the same composition and rate of purchase of $5 billion per week. The bonds are purchased in the secondary market through transparent auctions. The Board opted not to extend the yield target to a longer horizon for a number of reasons. First, the yield target reinforces the Board's forward guidance on the cash rate. Three years is a reasonable horizon over which the Board has some confidence about the economic outlook. Beyond that horizon, the economic outlook is considerably less certain and with it, confidence about the settings of monetary policy. Second, further out along the yield curve, other factors also start to have a greater influence on yields, particularly global developments. The RBA does not, and will not, directly finance governments. While the bond purchases are lowering the cost of finance for governments – as is the case for all borrowers – the Bank is not providing direct finance. There remains a strong separation between monetary and fiscal policy. https://www.rba.gov.au/speeches/2021/sp-dg-2021-05-06.html 10/26 5/6/2021 Monetary Policy During COVID | Speeches | RBA How do bond purchases work? Bond purchases returned to the central bank toolkit in a number of advanced countries in the aftermath of the global financial crisis. You might recall that economics textbooks used to talk about monetary policy in terms of buying and selling government bonds to control the money supply. But since the late 1980s, short-term policy interest rates rather than bond purchases to affect the money supply have generally been the primary tool of monetary policy. When interest rates fell to their lower bound after the GFC in some economies, including the US and Europe, central banks in a number of economies again turned to bond purchases, often known as quantitative easing (QE), to provide additional stimulus. (Japan had been in such a position a decade earlier). How do bond purchases work to provide stimulus? When the central bank buys a bond, it is putting downward pressure on government bond yields. You can think of the central bank being an additional buyer of government bonds in the market. More demand for government bonds increases the price of bonds and lowers bond yields. In turn the lower bond yields flow through to lower borrowing rates for households and businesses (Figure 1). From there the transmission is similar to that of a cash rate reduction that I talked about earlier. Figure 1 : Stylised transmission mechanism https://www.rba.gov.au/speeches/2021/sp-dg-2021-05-06.html 11/26 5/6/2021 Monetary Policy During COVID | Speeches | RBA When the RBA buys a bond, it credits the account of the bank that it buys the bond from. The RBA's balance sheet gets bigger: on the asset side there is the government bond, on the liability side there is the deposit of the bank, in the form of a higher exchange settlement balance. The money supply has increased, though in electronic form rather than physically. When the bond matures, the government repays the RBA, just as it does any other bondholder. The RBA's balance sheet shrinks: its bond-holdings decline and this is matched by a decline in exchange settlement balances. The banks are generally intermediaries in this transaction. The bonds that the banks sell to the RBA in turn have probably been bought from an investor in government bonds such as a super fund. That investor now has more money in their bank account, which does not pay them much of a return. This incentivises these investors to switch into other assets to earn a higher rate of return. This increases the price of other assets, such as equity prices and lowers interest rates on other fixed income assets. The bond investor might be a foreign investor. They may choose to invest the money in assets in other countries which would lead to a lower exchange rate. So bond purchases work through a number of channels to put downward pressure on interest rates for the government, households and businesses, as well as downward pressure on the exchange rate. There is also another important channel by which bond purchases operate. This is often referred to as the signalling effect. As I said earlier, bond purchase programs have been introduced by central banks when policy interest rates have been reduced to around their lower limit. The bond purchases reinforce the view that the central bank will be keeping the policy rate low for a long period of time (the bond purchases reinforce the forward guidance). The presumption is that the central bank will stop its bond purchases before it begins to raise its policy rate. That does not mean that the day the bond purchases stop is the day that the policy rate increases. There may well be quite a period of time between those two actions. Rather, it is a statement about the sequencing of policy actions. Since the financial crisis, there has been a program of research into the effects of bond purchases or QE. Recently, I was involved as an external adviser in a review by the Bank of England of its QE Program. [13] That review summarised the state of the research into the effects of quantitative easing. The review highlighted that much of the research has focussed on the impact of QE on financial conditions, particularly bond yields and interest rates. It noted that there is much less research of the impact of QE on output and inflation. How should we think about the size of the bond purchase program? How stimulatory is it? The general assessment of the research literature is that it is the stock of central bank bond purchases that matters rather than the flow. That is, it is the total size of the purchases that affects bond yields and financial conditions including the exchange rate, rather than how many bonds the https://www.rba.gov.au/speeches/2021/sp-dg-2021-05-06.html 12/26 5/6/2021 Monetary Policy During COVID | Speeches | RBA central bank is buying each week. Clearly the two are closely related. But one important implication of this is that the stimulus remains in place even when the bond purchase program finishes. The stimulus only begins to unwind as the bonds that the central bank has bought mature. The RBA's estimate of the impact of the $100 billion bond purchase program that was announced in November was that it would reduce the 10-year bond yield by around 30 basis points. The lower yields would in turn put some downward pressure on the exchange rate. This estimate of the impact of bond purchases on yields was based on a review of the experience in other economies, including the literature referred to in the Bank of England report. Our assessment is that this estimate has turned out to be close to the mark. We have reached this assessment in a number of different ways, but all arrive at a similar conclusion. [15] Bond yields started to decline ahead of the actual announcement of the bond purchase program at the November RBA Board meeting as the market formed the expectation that such a program was increasingly likely. So the estimate of the impact has to take this into account. Graph 6 shows the decline in the spread between Australian and US 10-year bond yields between September and November last year as market expectations of a bond purchase program increased and were then realised with the announcement at the November Board meeting. The US yield provides a reference point for global developments affecting bond yields. Again this decline in the spread amounts to around 30 basis points. Graph 6 Government Bond Yields 10-year % % 1.5 1.5 Australia 1.0 1.0 United States ppt ppt 0.0 0.0 Differential -0.5 -0.5 -1.0 -1.0 D M J S D M J Sources: Bloomberg; RBA; Yieldbroker https://www.rba.gov.au/speeches/2021/sp-dg-2021-05-06.html 13/26 5/6/2021 Monetary Policy During COVID | Speeches | RBA To repeat, our assessment is that the bond purchase program announced in November reduced longer-term government bond yields by around 30 basis points. In turn, this led to a lower exchange rate and easier financial conditions than otherwise would have been the case. The impact of these easier financial conditions on output and inflation is harder to calibrate. We do not have any direct Australian experience to draw on, although we are accumulating relevant experience now. Again, we can draw on the experience in other economies, while noting that the outcomes in those other cases are significantly influenced by their particular circumstances and the different structures of financial systems across economies. For example, longer-term government bond yields have a much more direct relationship with mortgage rates in the United States than they do in Australia. An important thought to bear in mind at this point is that when a central bank announces a bond purchase program, the market will form some expectation of the total size of the program. For example, when the RBA announced its $100 billion purchase program in November that would run for 6 months, it is highly likely that the market assumed that there would be further bond purchases beyond that. That is, it was unlikely that there was only going to be one program. And that has turned out to be the case here in Australia, with the Board announcing a further $100 billion of purchases at its February meeting. Hence the announcement effect of the program on bond yields and the exchange rate will include some impact from the market's assessment of the whole size of the bond purchase program, not just the size of the first one that is announced. Moreover, as the economy evolves over the life of the bond program, the market will adjust its assessment of the total expected size of the program, which will in turn affect bond yields and broader financial conditions. (This is similar to the way that the market adjusts its expectations for the future path of cash rate as the state of the economy changes). This makes estimating the impact of bond purchase programs quite challenging. It is one explanation why empirical work tends to find that subsequent QE programs have a smaller impact than the first program. It is hard to separate out what the market had already been anticipating in terms of future bond purchases. We don't have good measures of the expectations of market participants about the size of the whole program of bond purchases, particularly at the time of initial announcement. There is no obvious bond market equivalent to the OIS curve, which provides a read on the market's expectations about the future path of the policy rate. There are surveys of market economists' expectations of future bond purchases by the RBA, but they are not necessarily the same as the expectations of participants in the financial markets who actually determine bond yields and the exchange rate. As I mentioned, the aim of the bond purchase program is to put downward pressure on bond yields and the exchange rate to provide stimulus to the Australian economy. The RBA is not targeting any particular level of bond yields, other than the 3-year target, nor the exchange rate. Nor is it targeting any particular spread between Australian Government bond yields and US Government bond yields. Our assessment is that the bond purchase program has continued to keep longer-term yields in Australia about 30 basis points lower than they otherwise would have been, and the exchange rate https://www.rba.gov.au/speeches/2021/sp-dg-2021-05-06.html 14/26 5/6/2021 Monetary Policy During COVID | Speeches | RBA lower than otherwise. But I recognise that does depend on your assessment of the counterfactual: that is, where would yields (and the exchange rate) have been if the bond purchases hadn't occurred. Yields will move as the Australian and global economies evolve. Earlier this year, there was a rise in bond yields both globally and in Australia. This rise in yields reflected the better outcomes in the Australian and global economies. The rise also reflected a rise in the market's expectations for future inflation. Yields rising because economic conditions are improving is a desirable outcome. It is not one that the RBA and other central banks would seek to resist. The bond purchases are still working to ensure that yields were lower than they otherwise would be, and continue to provide stimulus to the economy. But the bond purchases are not intended to hold the whole structure of yields down at any particular level. Inflation expectations reflected in bond yields have risen to a point that is at best barely reaching central banks' inflation targets, certainly not anything more than that. Bond markets have moved from expecting a reasonable chance of deflation to expecting low inflation. And that outcome is only achieved with the large stimulus in place currently. In Australia, estimates of inflation in the bond market have inflation just reaching 2 per cent in a few years' time. That is only just reaching the bottom of the RBA's inflation target range. The bond market is not pricing any material risk of an inflation breakout. I mentioned that the general consensus is that it is the size of the bond purchase program that is relevant for assessing the degree of stimulus. Graph 7 shows the size of the bond purchase program in Australia relative to those in other countries. I have shown the size along two dimensions. The first is the size of the program relative to GDP. The second is the size relative to bonds on issue. Both metrics are relevant in assessing the degree of stimulus. https://www.rba.gov.au/speeches/2021/sp-dg-2021-05-06.html 15/26 5/6/2021 Monetary Policy During COVID | Speeches | RBA Graph 7 Central Bank Government Bond Holdings* % Per cent of GDP** % Per cent of eligible stock outstanding NZ Euro area*** UK US Australia Canada * Central government debt only for all countries except the Euro area. Dashed lines represent forecasts based on announced purchase programs or recent pace of purchases ** Four-quarter rolling sum; forecasts are based on the IMF's World Economic Outlook *** Holdings data for Euro area only include bonds held as part of asset purchase programs; holdings for other central banks also include bonds held for operational or liquidity purposes Sources: Central banks; debt management offices; IMF; RBA; Refinitiv The RBA's purchase program started later but is currently on a faster upward trajectory to that of other central banks. The graph shows that by the end of the current bond program, the RBA will have purchased bonds equal to around 10 per cent of GDP. The size of the government bond market is smaller in Australia than in nearly every other economy. In recent months, the RBA has often been buying bonds at a faster weekly pace than the Australian Office of Financial Management (AOFM) has been issuing. This is not true in some other countries, including most notably the US. Hence the RBA's share of the bond market is rising faster than in other economies. In considering the impact of the bond purchase program, we need to be mindful that the Bank's bond purchases do not cause dysfunction in the market, by the Bank holding too large a share. As I said earlier, government bond yields are a very important benchmark and anchor of the financial system. For example, we would not want our bond purchases to push bond yields higher (rather than lower) because of market dysfunction, which resulted in an illiquidity premium. We do not think we are close to that point, but it is certainly something we are alert to. https://www.rba.gov.au/speeches/2021/sp-dg-2021-05-06.html 16/26 5/6/2021 Monetary Policy During COVID | Speeches | RBA Purchases to address market dysfunction In March and April 2020, as was the case for many other central banks, the RBA bought government bonds in the secondary market to alleviate the dysfunction in the Australian government bond market at the time. These purchases helped to restore the functionality to this important pricing benchmark in the Australian financial system, which serves as the risk-free pricing curve for most financial assets. That is, the government bond curve is an important reference point for other interest rates which are priced as a spread to it. The risk-free rate is also often the relevant discount rate to determine equity prices. Hence it is important that the government bond market is functioning properly. The dysfunction was evident in the heightened interest rate volatility in the bond market, reflecting the reduced liquidity even in the US Treasury market (Graph 8). There were wide bid/offer spreads, and bond dealer inventories were large and constrained by capital and risk considerations. As a result, the RBA bought bonds across the maturity spectrum out to 10 years. Since early May 2020, as market conditions improved, the RBA ceased purchases for this reason. Graph 8 AGS Bid-offer Spreads bps bps 10-year 3-year M J S D M J S D M J S D M J Sources: RBA; Yieldbroker These purchases also are boosting liquidity in the system and putting downward pressure on government bond yields. Even though their original motivation was different, they still achieve the same effect now as bond purchases under the bond purchase program. https://www.rba.gov.au/speeches/2021/sp-dg-2021-05-06.html 17/26 5/6/2021 Monetary Policy During COVID | Speeches | RBA There was some increased volatility in the bond market in late February/early March this year as bond yields moved higher. Bid/offer spreads in the market widened, though much less than they did in March/April 2020. The Bank responded to this by bringing forward some purchases under the bond purchase program, by increasing the amount purchased at one of its regular auctions, buying $4 billion rather than the regular $2 billion. This action along with the media release following the March Board meeting and a speech by the Governor helped restore more orderly functioning to the market. We were not concerned about the fact that bond yields were rising nor the volatility per se, but rather market functioning. Term Funding Facility The Term Funding Facility provides the banking system with the capacity to borrow from the RBA for 3 years at cheaper than market rates. It has two main goals. The first is to lower funding costs for the entire banking system so that the cost of credit to households and businesses is low. In this regard, it complements the target for the 3-year government bond yield and the forward guidance. The second objective is to provide an incentive for lenders to extend credit to businesses, especially small and medium-sized businesses. Lenders are able to borrow additional funds from the RBA if they have increased credit to business since the start of the scheme. For every extra dollar lent to large businesses, lenders will have access to an additional dollar of funding under the TFF. For every extra dollar of loans to small and medium-sized businesses they will have access to an additional five dollars. The TFF was announced in March 2020. Banks were able to borrow up to 3 per cent of their total lending (around $90 billion) until end September 2020 (against high-quality collateral). Banks had until March 2021 to draw down any additional allowances they might have accumulated owing to lending to businesses. [17] The size and duration of the TFF was extended in September 2020, when an additional 2 per cent could be accessed until end June 2021 (the deadline for drawing down additional allowances related to business lending was also extended to this date). The initial borrowings were at 25 basis points, while from November 2020 the borrowing rate was lowered to 10 basis points for new drawdowns. This is materially below the cost of banks obtaining 3-year funding in the market. In the first phase of the program, the bulk of the funds were drawn down in the weeks leading up to the end of September 2020 deadline (Graph 9). We expect borrowing under the TFF to ramp up in the coming weeks as the end June deadline approaches. https://www.rba.gov.au/speeches/2021/sp-dg-2021-05-06.html 18/26 5/6/2021 Monetary Policy During COVID | Speeches | RBA Graph 9 Term Funding Facility $b $b Total available Drawdowns* A M J J A S O N D J F M A M J J * Includes all settled, contracted and pre-processed repos to date Sources: APRA; RBA The date for final drawings under the TFF is 30 June 2021. Given that financial markets in Australia are operating well, the Board announced earlier this week that is not considering a further extension of the TFF. But it is important to remember that the Term Funding Facility will be providing stimulus while the funds borrowed by the banking system are outstanding. It will continue to provide low-cost funding to the banking system and keep downward pressure on borrowing rates for businesses and households throughout the next 3 years until the funds are repaid. What has been the effect on the economy? All of these policy measures have worked collectively to deliver lower borrowing costs for households, business and governments. They are supporting the flow of credit and boosting cash flow for household and business borrowers. It is difficult to determine the individual contribution that each particular policy action is making because they are all working collectively in the same direction, alongside the substantial support to the economy provided by the Commonwealth and State governments. Tomorrow, the Bank publishes the quarterly Statement on Monetary Policy. The Statement will provide a detailed account of the evolution of the economy over the past year and an update to the https://www.rba.gov.au/speeches/2021/sp-dg-2021-05-06.html 19/26 5/6/2021 Monetary Policy During COVID | Speeches | RBA outlook for the economy. The main message is that the economy has turned out to be much better than expected. The economy has exceeded all of the upside scenarios that we had described. Economic growth has been higher than expected. The Australian economy is now back to its prepandemic level of GDP (Graph 10). Employment is above its pre-pandemic level (Graph 11). The unemployment rate has declined rapidly to be currently 5.6 per cent, half a percentage point higher than before the pandemic. Measures of underemployment have declined by similar magnitudes. Participation in the labour market has remarkably increased to a record high. These are much better labour market outcomes than have occurred in other countries. Graph 10 GDP Growth* From December 2019 to March 2021 % -5 -5 -10 -10 -15 -15 Taiwan China Vietnam Hong Kong India South Korea New Zealand Australia Singapore United States Indonesia Brazil Canada Poland Russia Japan Malaysia Thailand Euro area Philippines United Kingdom % * Forecasts used where March quarter GDP has not yet been reported Sources: ABS; Bloomberg; CEIC Data; Consensus Economics; RBA; Refinitiv https://www.rba.gov.au/speeches/2021/sp-dg-2021-05-06.html 20/26 5/6/2021 Monetary Policy During COVID | Speeches | RBA Graph 11 Change in Employment Since December quarter 2019 United States Hong Kong Italy Israel United Kingdom Philippines Portugal -6 Spain -6 Finland -4 France -4 Canada -2 South Korea -2 Switzerland Norway Taiwan New Zealand ppt Australia ppt Sources: RBA; Refinitiv Household spending has been particularly strong. There has been a marked switch from spending on services to spending on goods, though that has started to unwind in recent months. Household incomes have been very high. This has been a remarkable episode where households' incomes have risen at the same time as the economy has been through a historically large recession. That reflects the large support provided to the household sector by fiscal policy through JobKeeper and JobSeeker, and more recently by the very strong employment growth. Because consumption opportunities have been significantly constrained at various times over the past year, the strength in household income has shown up in high saving. An important influence on the outlook for the economy in the period ahead is what households do with their higher savings. Tomorrow's Statement will present some scenarios that consider this issue. Outcomes in the Australian economy have significantly exceeded even the optimistic expectations in terms of economic activity. But that is not the case on the nominal side of the economy in terms of wages and inflation. While the Australian economy has experienced better employment outcomes than most other countries, wages growth in Australia has been noticeably weaker than in many comparable economies, most notably the United States (Graph 12). https://www.rba.gov.au/speeches/2021/sp-dg-2021-05-06.html 21/26 5/6/2021 Monetary Policy During COVID | Speeches | RBA Graph 12 Wages Growth* Year-ended % % United States Australia Euro area * Wages Price Index for Australia; Employment Cost Index for the United States; indicator of negotiated wages for the euro area Sources: RBA; Refinitiv Inflation has come in very close to where the Bank has expected it to be, despite the significantly better state of economic activity and employment. There haven't been any material upside surprises. Inflation in the year to the March quarter was just over 1 per cent. The June quarter inflation reading will spike higher, to above 3 per cent, because of higher oil prices and the unwinding of policy measures in areas such as child care compared to the depths of the pandemic in the June quarter last year. But after these base effects wash through, we expect inflation to fall back to below 2 per cent. One price that has received a lot of attention has been housing prices. Housing price rises are part of the transmission of expansionary monetary policy to the economy. They help encourage home building, along with government grants such as the HomeBuilder policy, which boosts activity and employment. There is plenty of evidence of that here in Perth. The Bank recognises that rising housing prices heighten concerns in parts of the community. Housing price rises can have distributional consequences. That is certainly an issue that needs to be considered, and there are a number of tools that can be used to address the issue. But I do not think that monetary policy is one of the tools. Monetary policy is focussed on supporting the economic recovery and achieving its goals in terms of employment and inflation. It is important to remember that while housing prices may not rise as fast without the monetary stimulus, unemployment would https://www.rba.gov.au/speeches/2021/sp-dg-2021-05-06.html 22/26 5/6/2021 Monetary Policy During COVID | Speeches | RBA definitely be materially higher without the monetary stimulus. Unemployment clearly has large and persistent distributional consequences. Where to from here? I have described the package of stimulus measures that the Reserve Bank Board has implemented over the past year. There are a number of decision points about various elements of the package coming up in the months ahead. As I mentioned earlier, the Board announced on Tuesday that drawings under the TFF will close at the end of June, although the stimulatory impact of that program will continue for another 3 years. The current program of bond purchases runs through to early September. A decision needs to occur on the yield curve target as to whether to stay with the April 2024 bond or extend it to the November 2024 bond. At its meeting earlier this week, the Board announced that it will announce the outcome of both these decisions at its July meeting. These decisions will take account of state of the economy and the state of financial conditions, including whether financial conditions are appropriate for the state of the economy. The assessment will also take into account the state of the world economy and the policy settings of other central banks, as is always the case. The Board is prepared to undertake further bond purchases to assist with progress towards the goals of full employment and inflation. The Board places a high priority on a return to full employment. Beyond that, at some point in the future the Board will consider an increase in the cash rate target and the interest rate on ES balances. The Board earlier this week continued to reiterate its forward guidance. The Board will not increase the cash rate until actual inflation is sustainably within the target band of 2 to 3 per cent. For that to occur, we will need to see further significant gains in employment and a lower unemployment rate. We will need a tighter labour market to lead to higher wage rises. In the Board's central scenario for the Australian economy, it does not expect these conditions to be met until 2024 at the earliest. Conclusion In Australia, the monetary policy response to the pandemic is aimed at ensuring borrowing costs in the economy remain low for households, business and governments, and providing an environment that is supportive of credit growth. The monetary response comprised a number of different but complementary actions. The monetary policy package has worked broadly as expected in supporting the economy. The recovery in the Australian economy has significantly exceeded earlier expectations, reflecting the sizeable fiscal and monetary policy support, as well as the favourable health outcomes. But significant monetary support will be required for quite some time to come. Appendix https://www.rba.gov.au/speeches/2021/sp-dg-2021-05-06.html 23/26 5/6/2021 Monetary Policy During COVID | Speeches | RBA Table 1: Chronology of RBA's support for the economy and financial system in response to COVID-19 3 March 2020 Statement by RBA Governor: Monetary Policy Decision Cash rate target reduced from 0.75 per cent to 0.5 per cent. RBA will ensure that the Australian financial system has sufficient liquidity. 16 March 2020 Statement by RBA Governor The RBA stands ready to purchase Australian government bonds in the secondary market to support the smooth functioning of that market. The RBA will be conducting one-month and 3-month repo operations in its daily open market operations to provide liquidity to Australia's financial markets; the RBA will also be conducting longer-term repo operations of 6 months or longer at least weekly as long as market conditions warrant. The RBA will be announcing further policy measures to support the Australian economy on 19 March 2020. 19 March 2020 Statement by RBA Governor: Monetary Policy Decision Cash rate target reduced from 0.5 per cent to 0.25 per cent. Forward guidance that the cash rate target will not be increased until progress is being made towards full employment and the RBA is confident that inflation will be sustainably within the 2–3 per cent target band. Given this, it was considered likely that the cash rate would remain at a very low level for an extended period. Interest rate on Exchange Settlement (ES) balances at the RBA reduced from 0.25 per cent to 0.1 per cent (narrowing the corridor between RBA's repo lending and deposit rates from 50 basis points to 40 basis points. Introduced target for the 3-year Australian Government bond yield of 0.25 per cent. Such a target would also be consistent with the expectation that the cash rate would remain at a very low level for several years. Introduced Term Funding Facility for the banking system, providing at least $90 billion in 3-year funding to authorised deposit-taking institutions (ADIs) at a fixed rate of 0.25 per cent; initial funding of up to 3 per cent of ADIs' existing outstanding credit until the end of September 2020, with access to additional funding until March 2021 if they increase lending to businesses, especially small and medium-sized businesses. Announcement of RBA's policy package timed to coordinate with policy announcements by the Australian Prudential Regulation Authority (that banks can use their large capital buffers to facilitate ongoing lending to the economy) and the Australian Government (the Australian Office of Financial Management will invest $15 billion in wholesale funding markets used by small ADIs and non-ADI lenders). 20 March 2020 RBA commences purchasing Australian government bonds, purchasing $5 billion in Australian Government Securities. 20 March 2020 RBA and US Federal Reserve Announce Swap Arrangement RBA and US Federal Reserve establish a temporary swap line for the provision of US dollar liquidity, allowing the RBA to access up to US$60 billion in exchange for Australian dollars. The US dollars are made available to financial institutions operating in Australia via repos with the RBA. 7 April 2020 Statement by RBA Governor: Monetary Policy Decision Open market operations likely to be on a smaller scale in the near term, given the substantial liquidity that was already in the financial system. Operations at longer terms will continue, but the frequency will be adjusted as necessary according to market conditions. 5 May 2020 Statement by RBA Governor: Monetary Policy Decision Broadened the range of eligible collateral in the RBA's domestic market operations to include Australian dollar securities issued by non-bank corporations with an investment grade credit rating. 1 September 2020 Statement by RBA Governor: Monetary Policy Decision The Term Funding Facility increased to around $200 billion, with ADIs provided access to additional funding equivalent to 2 per cent of their outstanding credit at a fixed rate of 0.25 per cent for 3 years until the end of June 2021, and access to additional funding associated with increased lending to businesses extended to June 2021. https://www.rba.gov.au/speeches/2021/sp-dg-2021-05-06.html 24/26 5/6/2021 Monetary Policy During COVID | Speeches | RBA 15 October 2020 Speech by RBA Governor Forward guidance that the Board will not be increasing the cash rate until actual inflation is sustainably within the target range. The Board does not expect to be increasing the cash rate for at least 3 years. 3 November 2020 Statement by RBA Governor: Monetary Policy Decision Cash rate target reduced from 0.25 per cent to 0.1 per cent. Forward guidance that the RBA will not increase the cash rate until actual inflation is sustainably within the 2–3 per cent target range. For this to occur, wages growth will have to be materially higher than it is currently. This will require significant gains in employment and a return to a tight labour market. Given the outlook, the RBA is not expecting to increase the cash rate for at least 3 years. Interest rate on ES balances at the RBA reduced from 0.1 per cent to 0 per cent (narrowing corridor between RBA's repo lending and deposit rates from 40 basis points to 35 basis points). Target for the 3-year Australian Government bond yield reduced from 0.25 per cent to 0.1 per cent. Interest rate on new drawings under Term Funding Facility reduced to 0.1 per cent. Announced bond purchase program, for the purchase in the secondary market of $100 billion of bonds issued by the Australian Government and the states and territories, focusing on bonds with maturities of 5 to 10 years, with purchases at a rate of $5 billion per week over the following six months. 2 February 2021 Statement by RBA Governor: Monetary Policy Decision Bond purchase program extended, with an additional $100 billion of government bonds to be purchased when the existing program completed in April 2021, at the same rate of $5 billion per week. Forward guidance that the RBA will not increase the cash rate until actual inflation is sustainably within the 2–3 per cent target range. For this to occur, wages growth will have to be materially higher than it is currently. This will require significant gains in employment and a return to a tight labour market. The RBA does not expect these conditions to be met until 2024 at the earliest. 10 March 2021 Speech by RBA Governor The Reserve Bank Board agreed that it would not consider removing the target for the 3-year Australian Government bond yield or changing the target from 10 basis points. If the Board were to maintain the April 2024 bond as the target bond, rather than move to the next bond, the maturity of the target would gradually decline over time until the bond finally matures in April 2024. 4 May 2021 Statement by RBA Governor: Monetary Policy Decision The Board confirmed that the final date for drawings under the Term Funding Facility is 30 June 2021. Endnotes [*] Thanks to Ellis Connolly and Penny Smith for their assistance. Shann, EOG (1933), Quotas or Stable Money? Three Essays on the Ottawa and London Conferences, 1932–1933, Angus and Robertson, Sydney. HC Coombs (1963), ‘Some Ingredients for Growth’, The Shann Memorial Lecture, Perth, 31 May. The table in the appendix provides a chronology of the monetary policy actions taken since March 2020. Arguments for negative rates are discussed in Tenreyro S (2021), ‘Let's Talk About Negative Interest Rates’, Speech to the UWE Bristol webinar, 11 January, and L Brandao-Marques, M Casiraghi, RG Gelos, G Kamber and R Meeks (2021), ‘Negative Interest Rates: Taking Stock of the Experience So Far’, IMF Departmental Paper No 2021/003. See ‘The Framework for Monetary Policy Implementation in Australia’, RBA Bulletin, June 2019. Available at <https://www.rba.gov.au/publications/bulletin/2019/jun/the-framework-for-monetary-policy-implementation-in- https://www.rba.gov.au/speeches/2021/sp-dg-2021-05-06.html 25/26 5/6/2021 Monetary Policy During COVID | Speeches | RBA australia.html> The large amount of deposits is a direct consequence of the RBA's policy actions. There is little the banking system can do to reduce these deposits. Note that there are relatively few bond lines in Australia given the low level of government debt historically. There are no more than one or two lines per annum. Interest rate swaps are hedging instruments used by banks and corporations to convert fixed-rate interest rate exposures to floating-rate exposures, and vice versa. The ‘swap rate’ is the fixed-rate that one party to a swap will pay, versus receiving a floating 3- or 6-month BBSW rate. As such, the swap rate can be interpreted as an expectation for the average short-term BBSW rate over the life of the swap contract. The market has almost no expectation that the cash rate will decline any further. This asymmetry in the distribution of expectations is also reflected in both the OIS curve and the swap curve. These curves reflect average expected short-term interest rate outcomes as well as the risk-preferences of investors, which are not necessarily the same as the most likely outcome (the modal outcome). See: <https://www.rba.gov.au/mkt-operations/government-bond-purchases.html> The government, through the Australian Office of Financial Management, will have already prefunded the bond maturity by issuing more bonds to the public. So while on the actual day the bond matures, government deposits at the RBA will decline, in net terms, it is ES balances that move up and down with the RBA's bond holdings. We have seen some evidence of this at times, with some Japanese fixed income investors adjusting the benchmarks they base their Australian bond holdings around to take account of RBA-owned bonds. In effect, the RBA is replacing those Japanese investors in the bond market, leading to a lower exchange rate than otherwise. See Bank of England (2021), ‘IEO evaluation of the Bank of England's approach to quantitative easing’, January. Available at <https://www.bankofengland.co.uk/independent-evaluation-office/ieo-report-january-2021/ieoevaluation-of-the-bank-of-englands-approach-to-quantitative-easing>. The stimulus is sometimes calibrated to the duration of the central bank's bond holdings. If this is the case, then once purchases cease, the duration of the holdings starts to decline, gradually reducing the stimulus in the system. See the February 2021 Statement on Monetary Policy: < https://www.rba.gov.au/publications/smp/2021/feb/> and R Finlay, D Titkov and M Xiang (forthcoming), ‘An Initial Assessment of the Reserve Bank's Bond Purchase Program’, RBA Bulletin. It also reflected an increase in inflation compensation, that is, the premium the market wants to be compensated for the risk of higher inflation. The borrowing is against appropriate collateral, generally mortgage-backed securities that banks hold on their balance sheets (self-securitisations), and with haircuts to provide adequate protection to the RBA. The materials on this webpage are subject to copyright and their use is subject to the terms and conditions set out in the Copyright and Disclaimer Notice. © Reserve Bank of Australia, 2001–2021. All rights reserved. The Reserve Bank of Australia acknowledges the Aboriginal and Torres Strait Islander Peoples of Australia as the Traditional Custodians of this land, and recognises their continuing connection to Country. We pay our respects to their Elders, past, present and emerging. https://www.rba.gov.au/speeches/2021/sp-dg-2021-05-06.html 26/26 | reserve bank of australia | 2,021 | 5 |
Address (online) by Mr Christopher Kent, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to KangaNews, 9 June 2021. | Speech The Term Funding Facility, Other Policy Measures, and Financial Conditions Christopher Kent [ * ] Assistant Governor (Financial Markets) Address to KangaNews Online – 9 June 2021 Introduction The Reserve Bank's package of monetary policy measures is supporting the Australian economy through the pandemic. It reduced funding costs across the economy and is aiding the provision of credit to households and businesses. The Term Funding Facility – the TFF – is a key part of that package. The Board confirmed in May that the TFF will proceed as planned, with final drawings of 3-year funding due by the end of this month. So it is timely to discuss the operation of that facility and the ways in which it is contributing, and will continue to contribute, to stimulatory monetary conditions. I'll then discuss some of the Bank's other monetary policy measures and the evolution of financial conditions of late. Average interest rates being paid by business and household borrowers are at or close to historic lows and financial conditions more broadly remain very accommodative. Term Funding Facility The TFF was announced at the onset of the pandemic to provide banks access to low-cost funding for 3 years. [1], [2] The facility has 3 overall aims: First, it was put in place at a time when wholesale funding markets had been significantly disrupted and the economic outlook was extremely uncertain. The facility has enabled banks – which provide the bulk of financing to the Australian economy – to confidently extend credit to businesses and households. Second, the TFF is contributing to lower funding costs for banks, which has in turn led to lower borrowing rates for their business and household customers. In addition, as I have discussed in an earlier speech, the TFF is indirectly helping to lower funding costs more broadly, including by encouraging investors in bank bonds to look to close substitutes, thereby pushing down yields on bonds issued by businesses and on asset-backed securities issued by non-banks. Third, the TFF has provided an incentive for banks to increase their lending to businesses, particularly SMEs. Banks have received an additional dollar of low-cost funding from the TFF for every dollar of extra loans to large businesses, and an additional five dollars for every dollar of extra loans to SMEs. The bulk of additional TFF allowances are attributable to increases in SME lending by a range of banks since March 2020. To date, drawdowns from the TFF amount to $145 billion. Banks have until the end of this month to draw on remaining allowances of $64 billion. Drawdowns have accelerated in recent weeks (Graph 1). This growth is similar to the experience prior to the deadline for the initial allowance in September 2020. We expect that the bulk of available funding will be taken up because the cost of the facility remains well below the cost of similar funding available in the market. Most banks are expected to take up most or all of their remaining allowances. Graph 1 Term Funding Facility $b $b Total available Drawdowns* A M J J A S O N D J F M A M J J * Includes all settled, contracted and pre-processed repos to date Sources: APRA; RBA What has the TFF achieved? The TFF, in combination with the Bank's other policy measures, is contributing to a significant reduction in the structure of interest rates in Australia. The substantial fall in banks' funding costs has been passed through to borrowers, who are benefiting from historically low rates. The most direct effect of the TFF has been to provide banks with a low-cost source of funding. In particular, the TFF provides access to funds for 3 years at a cost that has been well below the cost of wholesale debt for the same term (Graph 2). As banks have drawn on the TFF, they have largely refrained from issuing new senior debt, so the total stock of bank bonds has declined as existing bonds have matured. Graph 2 Cost of Major Banks' Funding Sources RBA estimates; 3-year funding; marginal % % Senior unsecured (offshore) TFF rate M J S D M J S D M J Sources: Bloomberg; RBA At the same time, banks have been able to take advantage of the strong growth in deposits, the cost of which has declined to be much lower than the cost of issuing a new bond. The run-up in deposits has been driven, in part, by RBA purchases of government bonds from non-banks, as well as the indirect effects of the TFF (Graph 3). [4] In short, the availability of the TFF, along with the large increase in low-cost deposits, have combined to reduce banks' cost of funds to historic lows. Graph 3 Banks' Funding Sources Amounts outstanding $b $b Deposits 2,400 Offshore bonds 2,300 Domestic bonds 2,200 TFF M J S D M J S D M J 2020 2021 2,100 M J S D M J S D M J 2020 2021 2,000 Sources: APRA; Bloomberg; RBA; Refinitiv In addition to reducing banks' funding costs, the decline in bond issuance has benefited other institutions issuing debt. With fewer bank bonds on offer, investors have switched into other securities, including asset-backed securities and non-bank corporate bonds. This has contributed to a noticeable decline in spreads on these securities. For example, spreads on newly issued residential mortgagebacked securities (RMBS) have declined to their lowest level since 2007 (Graph 4). Non-bank lenders have responded by issuing large volumes of RMBS, and their market share in housing lending has rebounded from the modest decline around the middle of last year (Graph 5). Issuance of bonds by non-financial corporations has also been above average since mid 2020, particularly in the domestic market. Graph 4 Non-Bank RMBS Issuance and Pricing $b Cumulative gross issuance Spread to 1-month BBSW* bps Primary Secondary Range (2017-19) M * J S D 2017 AAA notes of prime RMBS Sources: Bloomberg; ICE; KangaNews; RBA Graph 5 Market Share of Housing Credit* Seasonally adjusted and break-adjusted % % Foreign banks Non-major Australian banks Non-banks 2021 2017 * Remaining share consists of major banks Sources: APRA; RBA The effect of the TFF on funding costs has been complemented by the Bank's other monetary policy measures. The Bank has lowered its policy interest rate to near zero, enhanced its forward guidance, set a target for the 3-year government bond yield, and put in place a program of purchasing government bonds. In combination, these measures have caused interest rates across the economy to be lower than they would have been otherwise. The sizeable decline in short-term risk-free rates has caused interest rates on variable loans to decline to historic lows (Graph 6). In Australia, the bulk of loans are in this form. Around 70 per cent of housing loans are variable rate. For business loans the share is even higher at 85 per cent. Funding costs for banks, and so ultimately these lending rates, are largely determined by the bank bill swap rate, which is closely linked to the cash rate. Bank bill swap rates have been at record lows, and banks have passed on lower rates to their existing customers by reducing their standard variable rates. The average rates paid by borrowers have fallen in addition to the decline in standard variable rates because new borrowers have been offered even lower rates than most existing borrowers, and many existing borrowers have been able to refinance their loans at lower rates. Graph 6 Lending Rates % Outstanding Housing % New Housing Variable Fixed % Outstanding % New Business Business Sources: APRA; RBA Fixed loan rates have also declined as a result of the RBA's package of policy measures. In particular, 2 other policy measures are influencing expectations of the future path of the cash rate and hence other benchmark rates out along the yield curve. First and foremost there is the Bank's forward guidance. This is a commitment not to raise the cash rate target until inflation is sustainably within the 2–3 per cent target range. Achieving that goal will require the labour market to become tight enough to generate a sizeable increase in wages growth. The Board's assessment is that these conditions are unlikely to be met until 2024 at the earliest. The Bank's target of around 10 basis points for the 3-year Australian Government bond yield has worked to reinforce the Bank's forward guidance and thereby guide market expectations around the cash rate target. Together, these policies have helped to reduce interest rates on fixed-rate loans. Indeed, fixed housing rates have declined by more than variable rates since the start of the pandemic in response to the Bank's policy measures – so much so that there's been a noticeable increase in the share of new household loans at fixed rates (Graph 7). Since late last year, the volume of loans fixed for 3-4 years has grown rapidly, albeit from a low base. As a result, a number of Australian households have locked in low rates on their mortgages for some years. Graph 7 Fixed-rate Housing Credit Proportion of total outstanding housing credit; by residual term % % More than 3 years 2-3 years Less than 2 years S D M J S D M J Sources: APRA; RBA The bond purchase program has also led to an easing in financial conditions by contributing to lower yields beyond the 3-year mark. Our estimates suggest that this program caused the yield on 10-year Australian Government Securities (AGS) to be 30 basis points lower than otherwise, and has also reduced the spread relative to AGS on securities issued by the states and territories. This lower level of yields puts downward pressure on interest rates for governments, households and businesses, as well as downward pressure on the exchange rate. Overall, the Bank's package of policy measures has brought about very accommodative financial conditions in Australia. The TFF has been an important part of this package, and will continue to provide support in the years ahead. Financial Conditions While bond yields and interest rates remain very low, they have increased over recent months out beyond the shorter end of the yield curve. This is in response to the improved outlook for economic activity and inflation, both here and offshore. Sovereign bond yields at the longer end of yield curves rose to around pre-pandemic levels earlier this year, underpinned by a rise in inflation expectations from very low levels to be more in line with central banks' inflation targets (Graph 8). Graph 8 10-year Government Bond Yields % % 3.0 3.0 2.5 2.5 US 2.0 2.0 Australia 1.5 1.5 1.0 1.0 0.5 0.5 0.0 0.0 Sources: Bloomberg; Yieldbroker The adjustments in financial markets to date are not a cause for concern, however. Measures of inflation expectations have returned to levels of a few years ago, when inflation was consistent with, or even below, inflation targets (Graph 9). In other words, they don't point to inflation over the coming years sitting above central bank targets in a sustainable way. The increase in nominal yields has been smaller than the increase in expected inflation, which implies that real yields have declined (Graph 10). This is beneficial because it means that monetary policy is more stimulatory than otherwise. Graph 9 Expected and Observed Inflation % 2.5 % 2.5 10-year inflation compensation* Australia 2.0 US 2.0 1.5 1.5 1.0 1.0 Germany 0.5 % 0.5 % Headline consumer price inflation, year-ended -1 -1 * Spread between the yield on nominal and inflation-protected government bonds Sources: Bloomberg; RBA; Yieldbroker Graph 10 10-year Government Bond Real Yields % % Australia US Germany -1 -2 -1 -2 Sources: Bloomberg; RBA; Yieldbroker The Bank's yield target has ensured that the 3-year AGS yield remains around 10 basis points. But 3year yields in other domestic markets rose over the first few months of this year alongside the global correction in bond markets and the rise in inflation expectations. In particular, the 3-year swap rate rose a bit and has remained at those slightly higher levels (Graph 11). Graph 11 Australian Yields % 1.5 3-year % 5-year A-rated non-financials Major banks Swap AGS 1.5 1.0 1.0 0.5 0.5 0.0 0.0 N D J F M A M N D J F M A M Sources: Bloomberg; RBA; Yieldbroker Higher government bond yields (beyond the 3-year point) and swap rates have passed through to other interest rates that affect private sector borrowers. Corporate bond yields have increased a little, although these yields are still low, including because spreads remain at low levels (Graph 12). Moreover, the domestic corporate bond market has served firms well. The market recovered relatively quickly after the beginning of the pandemic, and in addition to above-average issuance by non-financial businesses in 2020, the domestic market has absorbed a large volume of issuance at long tenors of around 10 years. Graph 12 Non-financial Corporate Bond Pricing 10-year bonds, BBB rated % % Bond yield Swap rate bps bps Spread to swap Sources: Bloomberg; RBA The rise in the swap rate around the 3-year mark has flowed through to higher yields on bank bonds in the secondary market. Bank bond issuance is low, however, so the rise in bank bond yields is having minimal effect on banks' outstanding funding costs. Some banks have increased rates on fixed-rate loans with terms of between 3 to 4 years in response to the rise in swap rates at those terms (Graph 13). The increase has been modest to date and so these rates remain very low in historical terms. In any case, fixed-rate loans at these longer terms account for a small share of overall lending. Meanwhile, the rates on shorter-term fixed-rate mortgages are little changed. Also, many older fixed-rate loans that are rolling off in the period ahead will be moving to lower rates than they had been paying. Graph 13 Advertised Fixed Housing Interest Rates Owner-occupier; major banks % % Advertised 4-year fixed rates Advertised 2-year fixed rates Sources: Banks’ websites; RBA In short, there's been a bit of an increase in some new fixed rates, but the effect of this on broader financial conditions is minimal, and shorter-term rates, including for variable-rate loans which constitute the bulk of credit, will remain low for as long as it takes to achieve the Bank's inflation goals. Conclusion Drawings under the TFF have picked up noticeably ahead of the 30 June deadline. We anticipate that the bulk of funding available under the facility will be taken up, and so the scheme will be providing a substantive source of low-cost funds for the next 3 years. This and the Bank's other policy measures have delivered, and will continue to deliver, very stimulatory monetary conditions until the economy returns to full employment and inflation is consistent with the target. Recently, the improvement in the economic outlook globally and in Australia has contributed to a rise in sovereign bond yields to around pre-pandemic levels. Underpinning this, there has been an increase in inflation expectations to be more in line with central banks' targets. At the same time, expectations of shorter-term interest rates over the coming years have increased a bit. Even so, household and business borrowers continue to benefit from record low interest rates on most loans, their balance sheets are in good shape, and the economy is benefiting from supportive fiscal policy. So there are good prospects for growth and an eventual increase in wages and inflation. We anticipate that will be a gradual process, with inflation unlikely to be sustainably within the target range of 2−3 per cent until 2024 at the earliest. Endnotes [*] I thank Ben Jackman and Kevin Lane for their great assistance in preparing this material. These borrowings are collateralised and lent under repurchase (repo) agreements. For details, see the TFF Operational Notes <https://www.rba.gov.au/mkt-operations/term-funding-facility/operational-notes.html>, or ‘The Term Funding Facility’, RBA Bulletin, December 2020. Available at <https://www.rba.gov.au/publications/bulletin/2020/dec/the-termfunding-facility.html>. The Australian Government created a complementary program of support for the non-bank financial sector, small lenders, and the securitisation market. For an earlier discussion of this sort of mechanism see Kent C (2020) ‘The Stance of Monetary Policy in a World of Numerous Tools’, Address to the IFR Australia DCM Roundtable Webinar, Online, 20 October 2020. Available at <https://www.rba.gov.au/speeches/2020/sp-ag-2020-10-20.html>. For an explanation of how the Reserve Bank's purchase of bonds and the Term Funding Facility contribute to deposits, see ‘Box D: Recent Growth in the Money Supply and Deposits’, RBA Statement on Monetary Policy, August 2020. Available at <https://www.rba.gov.au/publications/smp/2020/aug/box-d-recent-growth-in-the-money-supply-anddeposits.html>. The TFF has also put downward pressure on interest rates at around the 3-year tenor. Because the TFF represents a 3year fixed-rate liability for banks, those that draw on the facility have an incentive to either write a fixed-rate loan for the same term, invest in a security, or enter into a swap. All of these measures place downward pressure on important 3-year interest rates throughout the economy, complementing forward guidance and the yield target. The materials on this webpage are subject to copyright and their use is subject to the terms and conditions set out in the Copyright and Disclaimer Notice. © Reserve Bank of Australia, 2001–2021. All rights reserved. The Reserve Bank of Australia acknowledges the Aboriginal and Torres Strait Islander Peoples of Australia as the Traditional Custodians of this land, and recognises their continuing connection to Country. We pay our respects to their Elders, past, present and emerging. | reserve bank of australia | 2,021 | 6 |
Keynote address by Mr Philip Lowe, Governor of the Reserve Bank of Australia, at the the Australian Farm Institute Conference, Toowoomba, 17 June 2021. | Speech From Recovery to Expansion Philip Lowe [ * ] Governor Keynote Address at the Australian Farm Institute Conference Toowoomba – 17 June 2021 Thank you for the invitation to join the Australian Farm Institute's conference. It is a great pleasure for me to visit Toowoomba and to learn more about the issues facing the farm sector and regional Australia. As we all know, the past year has been an extremely challenging one in the life of our nation. But as a country we pulled together, and we have been up to the task. The results are evident in our health and economic outcomes, which are better than elsewhere in the world. It is important that we don't lose sight of this. This morning, I would like to talk about how the economy is now transitioning from recovery mode to expansion mode, and highlight some of the issues that this raises, including for regional Australia. I will then conclude with some comments about the outlook for monetary policy. Back in March last year, the national economic strategy quickly turned to building a bridge to the day when the virus was contained. The idea was to use this bridge to help people and businesses get across to the other side. The hope was that by doing this, we could avoid much of the costly damage that would be caused by mass unemployment and widespread business failures. This was the right strategy, and it was supported by governments across Australia, the RBA and Australia's financial institutions. The results speak for themselves. Today, the level of employment in Australia is above its pre-pandemic level. Australia and New Zealand are the only advanced economies where this is the case (Graph 1). In the United States, employment is still nearly 5 per cent below the pre-pandemic level and in Spain it is 3 per cent below. Graph 1 Change in Employment Since December 2019 % -2 -2 -4 -4 -6 -6 N ew Ze a Au lan N str d et he alia Sw rla it nd So zer s ut lan h Ko d U re ni F te r a d anc Ki ng e do Ja m G pa er n m a Sw ny ed C en an ad Sp a ai n U ni te Ital y d St at es % Sources: RBA; Refinitiv The GDP data also paint a positive picture of the recovery, which has been V-shaped (Graph 2). The level of output in Australia is now above its pre-pandemic level; not many other countries are in this same position. The bounce-back has been quicker and stronger than was widely expected; back in August we did not expect the previous level of output to be regained before the first half of 2022, yet here we are already. Graph 2 GDP Growth % % Year-ended Quarterly -2 -2 -4 -4 -6 -6 -8 -8 Source: ABS There has also been a sharp V-shaped recovery in farm output (Graph 3). After the devastating drought, farm output is up 40 per cent since the middle of last year, and now stands at a record high. Rural exports are also at a record high. This recovery in the farm sector is positive news not only for those in the industry and the communities that support it, but it is also making a welcome contribution to the recovery in the national economy. Graph 3 Farm GDP Chain volume, quarterly, 2018/19 prices $b $b Source: ABS As positive as these outcomes are, it is important not to lose sight of the fact that we are still in the recovery phase. Our international borders are still largely closed, outbreaks of the virus are still leading to periodic lockdowns, and many firms are still adjusting to changes in how people spend their money and where they work. It is also worth recalling that the economic recovery is being underpinned by unprecedented fiscal and monetary policy measures that will not last forever. So we still have a way to go before the recovery is complete. It is time, though, to be thinking about how we transition from recovery mode to expansion mode and consider the issues that will affect that transition. I would like to touch on 3 of these issues this morning, including: how household spending evolves in light of the substantial changes in household balance sheets the tightening of the labour market and its implications for wages and prices the need for further productivity growth. Household balance sheets One of the stand-out features of the past year has been the large increase in household saving. Last June, the saving rate spiked to 22 per cent, the highest level on record (Graph 4). This increase in saving reflected the combination of: the boost to incomes from government support; the limited opportunities to spend; and households feeling uncertain about the future. While the saving rate has since declined as restrictions have been eased, it remains high by historical standards. The fact that households have saved more means that, in aggregate, household balance sheets are in better shape than they were previously. Graph 4 Household Net Saving Rate Quarterly % % -5 -5 Sources: ABS; RBA Household balance sheets have also been affected by the recent rise in housing prices. This rise has been a nationwide development, but was first seen in parts of regional Australia, with price gains in many areas outstripping those in the capital cities. (Graph 5). Global factors, including low interest rates, have played a role here. But there has also been strong demand for properties in regional Australia due to people moving out of the capital cities and fewer people leaving regional areas during the pandemic. The effects of this are evident not just in prices but in rental markets too, with rents rising quickly in many regional centres (Graph 6). Graph 5 Housing Prices March 2020 = 100, seasonally adjusted index index Regional* Capital cities* * Capital cities index captures the 8 capital cities; the regional index captures the rest of Australia Sources: CoreLogic; RBA Graph 6 Advertised Rents March 2020 = 100, seasonally adjusted index New South Wales Queensland index Capital city Regional Sources: CoreLogic; RBA How households respond to these changes in their balance sheets will help shape the next stage of the recovery. If households were to run down their additional savings quickly or if higher housing prices spurred more spending than usual, a stronger economic path than the one we have envisaged could eventuate. On the other hand, it is possible that households sit on these extra savings for a long time and restrain their spending because of uncertainty about the future. If so, this would slow the recovery. So this is an issue we are watching carefully. It is also worth noting that the rise in housing prices is encouraging more housing construction. The challenge here is to make sure that planning processes are sufficiently flexible to allow the supply side of the market to respond to the extra demand; regional centres should be better placed on this front than capital cities, although this is not always the case. A related challenge is to find the workers to build the new housing in regional Australia – an issue to which I will return shortly. The other aspect of the housing market that we are paying close attention to is the increase in household borrowing. The RBA does not, and should not, target housing prices. We do though have a strong interest in trends in household borrowing, especially given the already high level of household debt in Australia. It is important that lending standards remain sound in an environment of low interest rates and rising housing prices. At its meeting last week, the Council of Financial Regulators also discussed the risks that could arise if growth in household borrowing substantially outpaced growth in household income. This is not the case at the moment, but the Council did discuss possible policy responses to a scenario in which rapid growth in household debt posed heightened risks to the future stability of the economy. The labour market I would now like to turn to the second issue and that is the labour market. The recovery here has been much stronger than was anticipated. The result is that the national unemployment rate fell to 5.5 per cent in April, which is just a little higher than before the pandemic. Job vacancies and job ads are at high levels and hiring intentions are very strong. Given this, we are expecting the unemployment rate to trend lower over the months ahead, with our central scenario being that unemployment declines to around 4½ per cent by the end of 2022. The improvement in the labour market is especially evident in many regional communities (Graph 7). For the first time in many decades unemployment in regional Australia is noticeably lower than it is in the capital cities. There is still a lot of variation across regions, but the average unemployment rate for regional Australia as a whole is at its lowest level in more than a decade. Graph 7 Unemployment Rate* % % Regional areas Capital cities * Seasonally adjusted by the RBA Sources: ABS; RBA The labour market is uneven, though. Many people are still struggling to find work, while, at the same time, some firms are reporting that they are finding it difficult to find workers. Many of these reports come from businesses in regional Australia, including those in the agricultural, hospitality, mining and construction sectors. And in nationwide business surveys, many firms are now saying that finding suitable labour is a major constraint on output (Graph 8). Graph 8 Constraints on Output Share of firms reporting significant or minor constraint % % Sales & orders Suitable labour Availability of materials Sources: NAB; RBA Notwithstanding these signs of a tightening labour market, wages growth and inflation remain subdued and there have not been upside surprises. The Wage Price Index increased by just 1½ per cent over the past year, with wages growth slow in the private and public sectors (Graph 9). And it is noteworthy that even in those pockets where firms are finding it hardest to hire workers, wage increases are mostly modest. There are some exceptions to this, but they are fairly isolated. Graph 9 Wage Price Index Growth* % % Year-ended Quarterly * Total hourly rates of pay excluding bonuses and commissions Source: ABS This experience speaks to a broader dynamic in the economy that has been evident for some time and is contributing to the subdued wage and price outcomes. Most businesses feel they are operating in a very competitive marketplace and that they have little ability to raise prices. As a result, there is understandably a laser-like focus on costs: if profits can't be increased by expanding or by raising prices, then it has to be achieved by lowering costs. This has become the predominant mindset of many businesses. This mindset can be helpful in making businesses more efficient, but it also has the effect of making wages and prices less responsive to economic conditions. This mindset became entrenched during the resources boom when the exchange rate appreciated very significantly. When one Australian dollar was worth more than one US dollar, many Australian businesses felt that their Australian dollar cost structure was simply too high. You might recall that through this period many businesses were saying that Australian costs, including labour costs, were leaving them uncompetitive. This experience has left a lasting imprint on many businesses and it has reinforced the narrative about the importance of cost control. Against this background, the economy is now recovering from the pandemic and some firms are finding themselves facing labour shortages. At least some of these business face a choice: do they increase wages in an effort to attract new employees and put up their prices or do they pursue another strategy? Many firms are choosing this second option, relying on non-wage strategies to retain and attract staff. Some are also adopting a ‘wait and ration’ approach: wait until labour market conditions ease, perhaps when the borders reopen, and until then, ration output. For some, this is a better option than paying higher wages and driving up their own cost base. This is especially so if: increases in the cost base are difficult to reverse later on; there is a reluctance to increase prices; and the business expects labour market conditions to ease before too long. By waiting and rationing, firms can avoid entrenching a higher cost structure in response to a problem that might be only temporary. The underlying point here is that there are a range of factors that are contributing to limited upward pressure on wages, even in tight labour markets. I have previously talked about the effects of globalisation, technology and industrial relations arrangements. While there is always a degree of uncertainty about the future, we are not expecting the influence of these various factors to wane quickly. Some are structural in nature and others will not be overcome until a tight national labour market is sustained for some time. As I will discuss shortly, our monetary policy strategy is designed to achieve this. It is also noteworthy that fiscal policy is also seeking to achieve lower unemployment in Australia. Productivity growth I would now like to turn to a third issue that will shape the expansion: that is productivity growth. Earlier, I spoke about how the economic strategy during the early days of the pandemic was to build a bridge to the other side. On the fiscal front, that bridge was built by governments borrowing against future national income to support households and businesses in the here and now. This was the right thing to do. It was affordable and the higher level of public debt that has resulted from this is manageable. The stronger our future national income is, the more this strategy makes sense. It is for this reason that I have raised the issue of productivity growth. The best response to higher debt levels is stronger growth in future national income, underpinned by a more productive economy. Over the past year, Australia's national income has once again been boosted by the higher prices for our exports. Australia's terms of trade are now approaching the once-in-a-century peak reached during the resources boom a decade ago (Graph 10). There has been a lot of focus on the price of iron ore, but the prices of many agricultural commodities have also increased substantially (Graph 11). Since the start of 2019, wheat prices have increased by 15 per cent, beef prices are up by 20 per cent and lamb prices are up by 25 per cent. The prices of canola, sugar and cotton have also increased sharply over the past year. Graph 10 Australia’s Terms of Trade* 2018/19 = 100 index index * Annual data from 1870 to 1959; quarterly data from September 1959 Sources: ABS; Gillitzer and Kearns (2005); RBA Graph 11 Rural Commodity Prices January 2016 = 100, SDR index Total index Beef index Lamb index Wheat Sources: Bloomberg; Landmark; MLA; RBA These higher commodity prices are welcome news and they are helping the national recovery. But, ultimately, it is a more productive economy that will form the basis of sustainable increases in future national income. As has been well documented, labour productivity growth in Australia had slowed prior to the pandemic (Graph 12). The reasons for this are complex and they are not fully understood, but it is likely that this slowing is related to the subdued levels of investment over recent times. Graph 12 Labour Productivity* March 1993 = 100, log scale, quarterly index 1993–2002 2003–2014 2015–2021 index 0.6% 1.2% 2.4% * GDP per hour worked; black lines denote linear trend; labels show average annual growth Sources: ABS; RBA From this perspective, it was pleasing to see a pick-up in business investment in the recent national accounts. Machinery & equipment investment increased by 10 per cent in the March quarter and was particularly strong in the manufacturing, construction, retail and farm sectors, as firms responded to the government incentives. The farm sector had been at the forefront of this pick-up in investment, with tractor sales surging over the past year (Graph 13). Graph 13 Tractor Sales Seasonally adjusted, quarterly ’000 ’000 4.0 4.0 3.5 3.5 3.0 3.0 2.5 2.5 2.0 2.0 Sources: Agriview; RBA This pick-up in business investment is welcome, but we have a fair way to go to reverse the decline in investment over the past decade. If we are to build the capital stock that is needed for a more productive economy and a durable expansion, a further lift in business investment is required. This should be possible, as there are investment needs and opportunities in many areas of our country. The government has rightly identified the digital economy as one of these areas. The farm sector knows this, with some exciting opportunities in the area of agtech. Ongoing investment in infrastructure and human capital is also needed. Further investment is also required in the energy sector, where technology is evolving quickly, as are the attitudes of investors. The changes in the global energy system are opening up new sources of comparative advantage for Australia. We will need more investment to capitalise on this advantage, with much of this investment being in regional Australia. How well we do this will have a bearing on our future national income and the shape of the ongoing expansion. Monetary policy I would now like to turn to monetary policy, which has played an important role in building the bridge that I spoke about earlier. The RBA's actions have led to the lowest funding costs on record, a banking system that is flush with liquidity and very low bond yields. The actions have also meant that the exchange rate is lower than would otherwise have been the case and household and business balance sheets are stronger. This has been our contribution to the recovery in jobs and economic activity. At the Reserve Bank Board's next meeting we have 2 important decisions to make. The first is whether or not to extend the yield target from the April 2024 bond to the next bond, which matures in November 2024. And the second is whether, and in what form, to extend the bond purchase program once the current program is completed in September. The 3-year yield target was introduced in March 2020 during an exceptional period. Our judgement is that it has been a successful monetary policy response, which has helped keep funding costs low and reinforced our forward guidance about the cash rate. At the time the target was introduced, the 3-year government bond had a maturity date in early 2023. At that time, the Board recognised that the pandemic would require an extended period of very accommodative monetary policy. Reflecting this, the Board's view was that the probability was extremely low that the conditions for an increase in the cash rate would be met within 3 years. Adopting a 3-year yield target reinforced that message. Now, with the passage of time, the 3-year government bond has a maturity date of April 2024 and, in a few months' time, the maturity date will move to November 2024. In considering whether or not to extend the target to the November 2024 bond, the central issue is again the probability of the cash rate increasing over a 3-year window. In this context, the Board has reviewed a range of possible scenarios. In some of these, the conditions for an increase in the cash rate could be met during 2024, while in others these conditions are not met. The Board will review these scenarios again at its next meeting. The bond purchase program has also been an important part of the RBA's monetary policy response. It has lowered bond yields and funding costs across the economy and contributed to a lower exchange rate. With the current 6-month bond purchase program to be completed in September, the Board has been working through a range of options for what comes next. These options include: i. ceasing purchasing bonds in September; ii. repeating the current $100 billion purchase program over a similar time frame; iii. scaling back the amount purchased or spreading the purchases out over a longer period; or iv. moving to an approach where the pace of the bond purchases is reviewed more frequently, based on the flow of data and the economic outlook. We have made no decisions yet, other than to rule out the first option – the cessation of bond purchases in September. The RBA's bond purchase program is one of the factors underpinning the accommodative conditions necessary for our economic recovery. It is premature to be considering ceasing bond purchases. The key consideration in our decision here is how the RBA can best support the ongoing recovery of the economy. The Board wants to see the recent recovery transition into strong and durable economic growth, with low unemployment and faster growth in wages than we have seen recently. Over time, this will help achieve the inflation target. As part of the Board's overall strategy, it will not increase the cash rate until inflation is sustainably within the 2–3 per cent target range. Year-ended CPI inflation will temporarily spike in the June quarter to around 3½ per cent due to the unwinding of some pandemic-related price reductions. There have also been price increases for some items due to pandemic-related interruptions to supply. But beyond this, inflation pressures remain subdued and are likely to remain so. For inflation to be sustainably in the 2–3 per cent range, wage increases will need to be materially higher than they have been recently. Partly for the reasons I talked about earlier, this still seems some way off. Thank you for listening. I look forward to your questions. Endnote [*] I would like to thank Penny Smith for assistance in preparing this talk. | reserve bank of australia | 2,021 | 6 |
Speech by Ms Luci Ellis, Assistant Governor (Economic) of the Reserve Bank of Australia, to the Ai Group, Adelaide, 23 June 2021. | Lessons and Lasting Effects of the Pandemic Luci Ellis [ * ] Assistant Governor (Economic) Speech to the Ai Group Adelaide – 23 June 2021 Plans are worthless, but planning is everything. – Dwight D Eisenhower It's wonderful to be here in Adelaide, and to able to speak to the Ai Group in person. It truly has been an extraordinary time since we last came together in Geelong, back in 2019. The title of my speech that time was ‘Lumps, Bumps and Waves’. Well, since then, we really have taken our lumps, seen an enormous bump, and come to dread additional waves (of the pandemic)! The human, social and economic costs of this pandemic have been huge. The outcomes have diverged wildly from expectations. There really was no rulebook for understanding how the pandemic would play out. The possibility of a pandemic was certainly contemplated by governments, and the relevant policymakers did formulate scenarios and plans in case one emerged. But things didn't turn out like those scenarios and plans. The epidemiology of the virus that causes COVID-19 is quite different from the avian flu viruses that were usually assumed to be the relevant pathogen. The public health response was also different. Perhaps the starkest example of things not turning out as pre-pandemic scenarios envisaged was the rapid development of effective vaccines – and not only one, but several. There have been plenty of movies about pandemics, but the rollout of multiple vaccines within a year generally hasn't featured in the final act. I doubt any studio would have bought such a script. Forecasting in this environment is inevitably an exercise in humility. Even before the rollout of vaccines, Australia's recovery exceeded all expectations. Employment and output are already above their pre-pandemic levels. Unemployment has returned to its pre-pandemic levels. As the Governor outlined last week, New Zealand is the only other advanced economy with employment above its end-2019 level. Only a handful of economies, most of them in the Asian region, have seen GDP recover to pre-pandemic levels. Both on the health and economic fronts, Australia has faced up to the enormous challenge posed by the pandemic. And as a nation, we have been up to that task. Much of the unexpected strength of the recovery stems from Australia's relatively good health outcomes. Good control of the virus allowed a rapid and near-complete opening of the domestic economy. The recent short lockdowns have not been as disruptive for the economy as the earlier, longer ones. And while the border closure has posed challenges in some parts of the economy, so far it has not materially impeded the recovery. Policy support has also been key to this positive surprise. Additional monetary and fiscal policy support over the course of the past year, beyond the initial responses, boosted the outlook beyond what was originally envisaged. Three lessons Different economies have had very different experiences as the pandemic has evolved. But 3 common themes have emerged, from which we can draw lessons: In a big shift, people adapt When the crisis is over, people bounce back And when policy supports, people respond. In a big shift, people adapt Throughout the history of our species, humans have adapted to many different environments and a range of challenges. When circumstances change, we adapt. We can see this adaptability in the economic response to subsequent waves of the pandemic. Even though lockdowns were in many cases at least as stringent as the first time around, the drag on activity was usually smaller. This was the pattern in Victoria's second lockdown, and even more starkly in the winter lockdowns in the northern hemisphere late last year and early this year. Conditioned to the extreme effects of the lockdowns in March and April last year, many forecasters – including us – overestimated how damaging subsequent ones would be. Output did decline in many advanced economies in the December quarter of last year or the March quarter of this year. But in almost all cases, the outcome was not as bad as forecasters expected (Graph 1). Graph 1 Distribution of GDP Growth Surprises* Q4 2020 and Q1 2021 no no -0.5 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 5.0 5.5 Percentage point surprise * Actual compared with consensus forecasts around a fortnight prior; based on 2 quarterly observations for a sample of 20 economies including Australia and its major trading partners Sources: CEIC Data; Consensus Economics; RBA; Refinitiv One way people adapted was finding ways to operate effectively while in lockdown. I'm sure you all remember the rush in March last year to get everyone who could working from home. Not all firms and not all workers could do this because of the nature of their work. Of those that could, some firms were already well prepared for flexible working, but for many it was a huge shift. Over time, though, people adapted. For some, working from home has been a struggle. But most businesses we speak to as part of our liaison program report that when they made the switch their operations continued reasonably effectively. A small number of firms even report that productivity rose. Other firms adapted in how they dealt with their suppliers and customers. Existing trends towards greater use of e-commerce and home delivery were greatly accelerated. Another way people adapted was shifting the pattern of demand. Around the world, restrictions on activity constrained services industries in particular. So consumer spending shifted away from services to goods, as the Australian data clearly show (Graph 2). This went beyond the obvious substitutions, such as from restaurant meals to groceries to cook at home. Sports equipment substituted for closed gyms, toys and games for organised children's activities. And with more time at home, people renovated, redecorated and kitted out home offices. Graph 2 Household Consumption December 2019 = 100 index Discretionary goods index (20%) Essential services Essential goods (44%) (16%) Discretionary services (20%) M J S D M J S D M J S D M Sources: ABS; RBA As this switch in spending was a global phenomenon, it supported a swift recovery in global trade; goods trade is now above pre-pandemic levels. Strong demand for manufactured goods has been a positive for economies with large export sectors, including China and some economies in east Asia. It has also increased demand for many commodities as well as for other components, such as semiconductors. This has boosted prices in many cases. Overall, these price rises have tended to add to incomes in Australia. The ratio of the prices of things we export to those of things we import – known as the terms of trade – is approaching the peak reached a decade ago, itself a 150-year high. Our inherent adaptability doesn't mean that all adjustments are smooth, though. This shift in demand has contributed to bottlenecks and delays throughout global supply chains (Graph 3). Our liaison contacts and others in the business community have certainly seen the effects of this. Shipping costs are up sharply, and so are some other costs (Graph 4). It is hard to know how long these disruptions will last. Many countries are still contending with outbreaks that are constraining output. In others, exporters are trying to catch up on backlogs of past orders as well as deal with high levels of new orders. But it is reasonable to expect that these disruptions will ease over time, as bottlenecks are dealt with and health-related constraints on production ease. Some key producers also plan to expand capacity, for example in semiconductors and ships. So the effects on prices should also dissipate. Graph 3 Global Manufacturing Delivery Times index index Sources: IHS Markit; RBA; Refinitiv Graph 4 Global Shipping Prices 2019 average = 100 index index Containers Baltic Dry Index* M J S D M J S D M J S D M J * A composite measure of the cost of shipping bulk commodities Sources: RBA; Refinitiv When the crisis is over, people bounce back A second lesson relates to the recovery phase. Australia has been one of the early examples, given our relatively good outcomes on controlling the virus. Our experience may point to possible outcomes for others, as they emerge from their larger waves of the pandemic. Our experience is that once the virus comes under better control and the restrictions on activity are lifted, activity bounces back very quickly. Activity declined during lockdowns and other periods of restrictions because that was mandated. It was not primarily because demand was very weak. So as long as incomes were maintained in this period, people reverted to spending levels that were very close to pre-pandemic levels as soon as it was permitted to do so. Perhaps that should have been less of a surprise. People like doing the things that were necessarily restricted by public health measures – whether that's visiting family and friends, going to a restaurant or even (for some people at least) going to the gym. The result is a sharp recovery in output and employment, far sharper than most of us would have dared imagine a year ago (Graph 5). This is very different from the pattern of past downturns. They were triggered by other events, including issues in the financial system. Those events weakened privatesector balance sheets and so weighed on confidence and demand for extended periods. As a result, the recoveries were drawn out. There was a time last year when we worried that the uncertainty around the course of the pandemic would dampen demand in a similar way, again slowing the recovery phase. But, fortunately, it hasn't turned out that way. So the large, swift contraction of mid 2020 has been reversed by a similarly swift recovery. Graph 5 GDP Through Recessions Indexed to GDP peak index index 1970s 1990s 1980s 2020s -2 -1 Quarters from peak Sources: ABS; RBA We see the same pattern after subsequent lockdowns as well. Spending declines when they are in force, but the recovery is rapid. Timely data on spending suggest that the snap-back after the shorter lockdowns imposed in parts of Australia this year has been almost immediate. The big question for the outlook is whether the recovery is simply a snap-back to prior patterns of activity, or whether there is some make-up from the lost growth. This is, in fact, the same question I addressed in that 2019 speech: when you hit an economic bump – whether it is a flood, a cyclone or a lockdown to control a pandemic – do you just return to normal, and the production that didn't occur during the bump is lost forever? Or is there a period of catch-up, where spending is higher than normal for a while? The answer is shaping up to be that it depends on which category of spending we are talking about. There are some categories of spending where catch-up is feasible. Mostly these are for durable goods, where timing of purchases can shift around. Certainly we have seen this in vehicle sales (Graph 6). But most of the categories of spending that were most affected by restrictions on activity were services, especially in-person services. It is much harder if not impossible to catch up here. If you weren't able to get a haircut for a few months, you don't get two haircuts to make up for it – one will suffice. And while some hospitality and travel spending might see some catch-up as we finally catch up with all the friends and family we've only been able to see on a screen, there are limits to that. Graph 6 New Car Sales Monthly ’000 ’000 Business Household Sources: RBA; VFACTS When policy supports, people respond A third lesson relates to one of the key reasons why this time we did get a V-shaped recovery. Support from various arms of policy helped to sustain economies through the periods of lockdown, smooth the shock and speed up the recoveries. The use of wage subsidies to preserve employment had been a feature of labour markets in some advanced economies for many years. But these programs were used much more widely in response to the pandemic than they had been in past downturns. Several advanced economies, including Australia, adopted them for the first time. And the share of the workforce covered by these schemes has generally been higher than seen in previous downturns (Graph 7). Graph 7 Share of Labour Force on Wage Subsidy Schemes* % % New Zealand France Canada United Kingdom Spain Germany M A M J J A S O N D J F M A M J * Share of average labour force size over 2019; data may not yet be complete as in some economies claims can be retroactively submitted; data in some economies refer to number of jobs rather than heads Sources: ifo Institute; national sources; RBA; Refinitiv The benefit of these schemes in preserving the employee–employer relationship is clear. In countries that did not use these schemes, such as the United States, most of the adjustment to lockdown took the form of people losing their jobs (Graph 8). Unemployment spiked up dramatically. And though it came down quickly, employment is still well below pre-pandemic levels there. By contrast in Europe and Japan, almost all of the adjustment has been in average hours worked. Far fewer people actually lost their jobs, and unemployment rates increased by much less. So policy support really matters. Australia's initial experience was somewhere in the middle of these 2 extremes. Not all workers were eligible for JobKeeper, and for some organisations, especially those affected by border closures, keeping staff on might have been seen as postponing the inevitable. But the JobKeeper program clearly supported the recovery in the labour market. Graph 8 Cumulative Change in Hours Worked Contributions since December 2019 % United States Canada Australia % -10 -10 -20 -20 % Japan Italy United Kingdom % -10 -10 -20 -20 -30 M J S D M J Total hours worked M J S D M J M J S D M J Employment Average hours worked -30 Sources: CEIC Data; Office for National Statistics; RBA; Refinitiv The income provided by JobKeeper was an important part of the Australian fiscal policy response more generally. Around the world, governments responded to the economies' need for support. Their scope to provide that support has varied according to individual country circumstances. But in the main, advanced economies have provided more support than was the case in other downturns over recent decades. There is perhaps no better indication of the scale of this support than the paths of household and business incomes during this period. At a time when economic activity contracted more and faster than at any time since the Great Depression in the 1930s, household disposable income actually increased (Graph 9). This is not the usual pattern in a downturn, to say the least. Profits also increased, partly because JobKeeper covered more of many firms' costs than their revenues declined, and partly because other tax and business support measures improved their post-tax incomes. Rent and loan repayment deferrals helped as well. Some individual households and businesses are facing tough times. Taking each sector as a whole, though, both the household sector and the business sector are entering the expansion phase with stronger balance sheets than they had before the pandemic. This is an exceptional, and welcome, outcome. Graph 9 Household Income and Business Profits Nominal, quarterly $b $b Household gross disposable income (LHS) Gross operating surplus (RHS) Source: ABS And again, policy support clearly affects people's responses. Whether it's the consumer spending response to higher incomes, the response of residential construction activity to the HomeBuilder program and state-based measures, or the response of machinery & equipment investment to various tax incentives, policy support has worked. Monetary policy support has played a role in supporting the economy, too. Others have discussed the detail of the Bank's policy measures recently, so I won't repeat much of that information today. The response has come in 2 main waves. In March of last year, the Board cut the cash rate to 0.5 per cent, and later that month made a further reduction to 0.25 per cent as part of a larger package of policy measures. Financial markets were quite dislocated at that time, so the Bank used its existing market operations to provide liquidity to the market and address the dislocation. As part of that March package, the Board introduced several new policy measures. It set a target for the 3-year government bond yield and provided low-cost funding to the banking system, also with a 3-year term, known as the Term Funding Facility (TFF). The TFF was structured to encourage lending to business, and especially to small and medium-sized firms. The initial tranche of funding under the TFF was available to be drawn down until the end of October. In September, the Board decided to add another tranche of funding as part of the Term Funding Facility; this tranche is available to be drawn down up until the end of this month. Altogether, the TFF has made available more than $200 billion of low-cost funding, to support the provision of credit to the economy and thus the broader recovery. Then in November of last year, the Board decided on a further package of measures. It reduced the cash rate, the yield target and the cost of the TFF to 0.1 per cent. And it introduced a program to purchase, in the secondary market, bonds issued by the Australian and state and territory governments. The initial announcement was for the purchase of $100 billion of bonds over the following 6 months. A further $100 billion tranche of bond purchases was announced in February this year. These measures have all contributed to maintaining highly expansionary monetary conditions. In this way, they have helped lower funding and borrowing costs, supported the provision of credit, and kept the exchange rate lower than it would otherwise have been. And again, people have responded to that support, especially in the housing market but also in some aspects of business activity. The lasting effects A once-in-a-century pandemic might lead you to think that things will never be the same again. And yet so many of us yearn to return to what we used to think of as normal. So in the rest of my talk, I would like to discuss some of the things we have learned, mostly from our discussions with liaison contacts, about which of the effects of the pandemic may be lasting. … in where we work If this pandemic had happened a decade or more ago, the response would have been very different. It was to be expected that many businesses had to shut entirely, while others continued to work on-site. But the advent of faster home internet and videoconferencing enabled many white-collar workers to continue working, just from home. The question of whether this shift is here to stay is clearly one of intense community interest. On this question, one size definitely does not fit all. Some people have loved working from home, others itched to get back to the office, and others have appreciated a mix of both. Different firms have taken different approaches, too. Some work can only be done in person: industries such as hospitality or construction had little scope to introduce remote working. Some other kinds of work run smoother with at least some in-person contact. There is nothing like face-to-face interaction for building trust, strengthening relationships and reinforcing culture. Australian Bureau of Statistics (ABS) surveys suggest that larger firms are more likely to have staff working remotely than smaller firms. The share of businesses with remote working arrangements increased notably following the onset of the pandemic (Graph 10). While some firms have already ceased these arrangements, most have retained them and plan to stick with the current pattern in future. So this is a lasting effect on the way we plan to work. A sizeable minority plan to reduce the amount of remote working at their firms over the longer term, but few will eliminate remote work completely. Graph 10 Businesses with Remote Working Share of total businesses % % Small Medium Prior to COVID-19 After the onset of COVID-19 Large All At April 2021 Long-term intentions Source: ABS With more people working remotely, the need for as much office space comes into question – just as the need for retail space does as more shopping goes online. Certainly vacancy rates for both office and retail property have jumped up since the pandemic began. Occupancy of the space that is still leased is also below pre-pandemic norms. What this means for the longer term has been a constant discussion, both in our liaison program and globally. The general theme that comes out of these discussions is one of uncertainty; while the direction is towards reduced demand for office space, it's too soon to decide how far to cut down on space. A desire for greater space per worker might partly offset the reduction in space required when more people are working from home. The supply response, if there is one, will take a while to come through. Much of the new supply in coming years was already underway before the pandemic. That said, many planned projects have been put on hold and some might end up being cancelled (Graph 11). And if some office or retail property turns out to be surplus to requirements, it will take a while – and some creativity – before it is repurposed. Graph 11 ’000m² Estimated Office and Retail Construction Office Retail ’000m² Completed or under construction Planned, yet to commence Sources: JLL Research; RBA … in how we work As I mentioned earlier, adjusting to lockdowns and other restrictions on activity accelerated the existing trends to online commerce and home delivery. Prior to the pandemic, the online share of retail sales was trending up and had reached around 7 per cent. It is currently just under 10 per cent. We don't expect this shift will be reversed. Online delivery stretches beyond retail; many other contacts in our liaison program have indicated to us that they have increased online services and plan to continue with these services. This pattern is apparent in a range of industries, from telehealth and online learning, to construction and property development firms using virtual walk-throughs in place of in-person inspections. And although business travel is unlikely to disappear completely, many contacts expect to be more selective about whether in-person meetings are needed. Our own liaison program has also adapted to these new realities in a lasting way. Before the pandemic, almost all our meetings with liaison contacts were in person. Our move to working from home also entailed switching to liaison by phone and videoconference. The rapidly changing environment during the peak of the pandemic necessitated more and more frequent discussions with our liaison contacts. As it turned out, the efficiencies of this change in approach also made that increased tempo possible. More recently, we have scaled back the tempo to something more ‘normal’, and resumed in-person visits in some cases. But we plan to continue with a mix of in-person and online meetings. Where we have not yet seen large-scale changes in how firms work is in supply networks. The global pandemic has disrupted production and shipping, including for Australian firms. [ 1] But this does not seem to have prompted a wholesale rethinking of supply relationships or reshoring. More common has been minor changes to procurement practice, such as ordering supplies earlier to allow for delays. … in where we live There is nothing like being forced to spend more time at home to make you appreciate – or become frustrated with – where you live. The lasting effects of this pandemic on where and how we live will touch all of us, directly and indirectly. And they will have implications for housing construction, urban planning, transport and the provision of social services and infrastructure. At the same time, we need to be mindful that some of the shifts going on could in part be temporary. For example, the border closures have paused immigration, which especially affects Australia's 2 largest cities. And internal migration to Melbourne declined during the extended Victorian lockdown last year. Those flows are likely to resume as borders open and restrictions ease, though perhaps at different rates to previous years. Similarly, while many of the people moved out of larger population centres to escape the virus, or the lockdowns, some of them might return to their previous locations over time. It is difficult to disentangle these transitory effects from the more lasting ones. There will be at least some cases of people moving further out from the city centre, because long commutes will not seem so unpleasant if you only need to do it a couple of days a week. And where full-time working from home is possible, ‘work from home’ really starts to mean ‘work from anywhere’. So for some it has been possible to move to an entirely different population centre. These bigger changes are almost certainly going to affect only a minority of the population. Many of us would not leave our existing social networks and support systems lightly. And as I have already mentioned, ‘work from anywhere’ isn't really feasible for everyone. But there will be some shifts, at least at the margin, which could alter patterns of relative growth. These could matter for plans for urban expansion and the provision of new infrastructure, even if the distribution of population doesn't shift wholesale. The task for public policy The pandemic is not over. Australia has seen a swift bounce back, but many other economies are still recovering or contending with outbreaks. During the height of the pandemic, when restrictions on activity are tight, the task for policy is to build a bridge to the recovery. As economies move through recovery to the expansion phase, the focus naturally turns to sustaining that expansion. That means ensuring that demand continues to be supported for as long as spare capacity remains. Absorbing spare capacity and achieving full employment is an important national priority. Full employment is a worthy goal for its own sake, given how important jobs and income are for people's welfare. It is also a precondition for achieving the rates of wages growth that would be consistent with inflation being sustainably within the 2–3 per cent target range that the Bank is mandated to achieve. In the context of the post-pandemic recovery, there is another reason to support demand: to help enable any structural adjustments that might be needed. It is far easier for a firm to change business models when demand is robust, and far easier for a worker to switch industries or careers when there are plenty of jobs available. To the extent that the post-pandemic world is indeed different from the pre-pandemic one, a robust recovery and expansion can smooth the transition. For all these reasons, the Board remains committed to maintaining highly supportive monetary conditions. The aim of these policy settings is to support a return to full employment and inflation consistent with the target. Thank you for listening. I look forward to any questions you might have. Endnotes [*] This speech has greatly benefited from the input of the Bank's liaison teams in our Adelaide, Brisbane, Melbourne, Sydney and Perth offices. See RBA (2021), ‘Box B: Supply Chains During the COVID-19 Pandemic’, Statement on Monetary Policy, May, pp 24–27. Available at <https://www.rba.gov.au/publications/smp/2021/may/box-b-supply-chains-during-the-covid-19pandemic.html> | reserve bank of australia | 2,021 | 6 |
Speech by Mr Philip Lowe, Governor of the Reserve Bank of Australia, at the Economic Society of Australia (QLD), online, 8 July 2021. | Speech The Labour Market and Monetary Policy Philip Lowe [ * ] Governor Economic Society of Australia (QLD) Online – 8 July 2021 I would like to thank the Economic Society of Queensland for the invitation to speak today. I was looking forward to my first trip to Brisbane in 18 months, but given the current lockdowns that will have to wait for another day. When I spoke at this lunch 2 years ago, I talked about the accumulation of evidence that Australia could sustain an unemployment rate below 5 per cent without inflation becoming a problem. I also raised the possibility that the Reserve Bank would soon cut the cash rate to help secure both lower unemployment and inflation consistent with the target. Since then, a lot has happened: a global pandemic and the biggest peacetime economic contraction in our lifetimes; and not only did the RBA cut the cash rate, but we cut it as far as we reasonably could and the RBA's balance sheet has nearly tripled to over $500 billion. So a lot has changed since we last met. Even so, I would like to return to the same 2 themes that I talked about 2 years ago: first, the possibility of sustaining low rates of unemployment; and second, how the RBA's monetary policy strategy is contributing to this. I will begin with a brief update on recent labour market developments. I will then discuss the supply side of the labour market and its implications for wage and inflation outcomes. And finally, I will turn to the Reserve Bank Board's decisions earlier this week. Recent developments The recovery of the Australian labour market this year has been remarkable. The number of Australians in a job has increased by over 250,000 since the turn of the year and the level of employment is now 1 per cent above its pre-pandemic level. The unemployment rate has also fallen sharply, and is now around the same rate as it was just before the pandemic (Graph 1). Graph 1 Unemployment Rate Seasonally adjusted, monthly % % Source: ABS This sharp decline in unemployment has come as a welcome surprise. Back in February, we expected the unemployment rate to now be around 6½ per cent and not reach the low 5s until the second half of 2023. Yet, here we are now. Labour force participation is near its record high, underemployment is the lowest it has been in nearly a decade and job vacancies are at a record high level. These outcomes point to the resilience of the Australian economy and the effectiveness of the health and economic policy response. One source of uncertainty for the near term is the recent outbreaks of the virus and the lockdowns. We are watching developments carefully, but it is important to remember that Australia's experience has been that, once an outbreak is contained and restrictions are lifted, the economy and jobs bounce back quickly. It is noteworthy that the positive surprises on jobs have not been matched with equivalent surprises on wages and prices. The Wage Price Index (WPI) increased by just 1½ per cent over the past year and recent outcomes have been broadly in line with our earlier expectations (Graph 2). The same is true for inflation. Graph 2 Wage Price Index Growth* % % Year-ended Quarterly * Total hourly rates of pay excluding bonuses and commissions Source: ABS This combination of surprisingly positive employment growth and subdued wages growth had become a familiar pattern before the pandemic. This is evident in the next couple of graphs. The first shows the RBA's successive forecasts for growth in the WPI from 2014 (Graph 3). The picture is very clear: wages growth was persistently lower than forecast. The next graph is similar, but shows successive forecasts for the level of employment (Graph 4). The picture here is not quite as clear, but employment growth has mostly been in line with, or exceeded, expectations, with the obvious exception of last year. Graph 3 Wage Price Index Forecasts* Year-ended % % Actual 2016 2017 * May SMP forecasts Sources: ABS; RBA Graph 4 Employment Forecasts* Year-ended ’000 ’000 13.0 13.0 12.5 12.5 12.0 12.0 11.5 11.5 Actual 11.0 11.0 * May SMP forecasts Sources: ABS; RBA As you would expect, we have been seeking to understand this experience and its implications for our policy settings. One straightforward explanation is that the low wage growth encouraged firms to substitute labour for capital, with the result being that employment grew quickly. The more important part of the story, though, is that the strong growth in labour demand was closely matched by a strong increase in labour supply. With both demand and supply rising, there was little need for the price – that is wages – to move. The supply side There are 3 elements of the supply story that I would like to touch on: the rise in labour force participation the ability of firms to tap into overseas labour markets when workers are in short supply in Australia the trend rise in underemployment. Labour force participation Labour force participation has been trending up since the middle of the previous decade and is currently around its record high (Graph 5). This upward trend was unexpected, coming after a decade of broadly sideways movement and the ageing of the population. The increase has been particularly large for women. There has also been a rise in participation by Australians older than 55 (Graph 6). Graph 5 Participation Rate Seasonally adjusted, monthly % % Source: ABS Graph 6 Participation Rates* Monthly % Females Males and females, aged 55+ % 2021 2003 * Female participation rate is seasonally adjusted; males and females, aged 55+ series is non-seasonally adjusted Source: ABS This recent trend reflects a mix of factors, including: the wider availability of flexible and part-time work; changes to child care arrangements; improved health outcomes for older Australians; and changes in the pension age. It is possible that higher debt levels and the decline in asset values during the financial crisis have also played a role. The most important of these factors is the increased availability of flexible and part-time work, with one in 3 workers now working part time. As hours of work have become more flexible, it has become easier for people with caring responsibilities and older Australians to participate in the paid workforce. This change has coincided with another shift in the economy – that is, an increase in demand for health services and social assistance, which has led to very strong growth in jobs in these areas. Many of these jobs are able to be performed by people who are seeking part-time and flexible work. So there has been a broadly parallel increase in labour demand and labour supply, and this has lessened the upward pressure on wages. Drawing on overseas labour markets The second supply side factor is the ability that firms have had to draw on overseas workers when skills or workers were in short supply in Australia. In some cases, firms hired workers from overseas https://www.rba.gov.au/speeches/2021/sp-gov-2021-07-08.html 7/17 7/8/2021 The Labour Market and Monetary Policy | Speeches | RBA directly to fill specific gaps, but in other cases they hired people who were already in Australia for other reasons, including to study and on working holidays. It is useful to distinguish the effects of this ability to draw on overseas labour markets from the impact of immigration more broadly. Immigration adds to both the supply of, and demand for, labour: when immigrants work they supply labour and their consumption of goods and services adds to the demand for labour. The precise balance between this extra labour supply and extra labour demand is difficult to determine and depends upon the specific circumstances. The picture, though, is clearer when firms are hiring workers to overcome bottlenecks and fill specific gaps where workers are in short supply. This hiring dilutes the upward pressure on wages in these hotspots and it is possible that there are spillovers to the rest of the labour market. This hiring can also dilute the incentive for businesses to train workers to do the required job. On the positive side of the ledger, hiring overseas workers to overcome bottlenecks allows firms to hire the people they need to operate effectively, and to expand and invest. This benefit was clearly evident during the resources boom, and there are a wide range of businesses and industries that have benefited from hiring foreign workers. Without this ability, output in Australia would have been lower. At the time of the previous census (in 2016), there were around 430,000 people working in Australia on temporary visas. In the food trades, these workers filled around 18 per cent of all jobs; and in the hospitality sector, they filled 13 per cent of jobs (Graph 7). Most of these workers were on either temporary visas for skilled workers or student visas. In contrast, in the farm sector it was more common for workers to be on working holiday visas. Graph 7 Temporary Migrant Employment Share of employment by occupation and visa type, 2016 Food trades Hospitality Cleaning & laundry Food preparation Factory processes Farm, forestry & garden ICT professionals Carers & aides Sales workers Temporary Work (Skilled) Student % Other* * Includes Working Holiday Maker visas, other Temporary visas and Bridging visas Sources: ABS; RBA In conceptual terms, one can think of this ability to tap into the global labour market for workers that are in short supply as flattening the supply curve for these workers. A flat supply curve means that a shift in demand has only a small effect on prices, or in this case wages. In my view, this is one of the factors that has contributed to wages being less sensitive to shifts in demand than was once the case. Underemployment The third element of the labour supply story is underemployment. When somebody is underemployed they are, by definition, willing to supply more labour, generally at the prevailing wage. This means that when demand is strong, businesses are able to call on underemployed workers to supply more hours without much upward pressure on wages. And then, when demand is soft, hours can be scaled back. Underemployment has become a much more prominent feature of the Australian labour market over the past couple of decades. Today, over 7 per cent of the labour force report that they are underemployed – more than double the rate in the 1980s (Graph 8). Most of these people work part time and, on average, are looking for an extra 14 hours per week. In aggregate, these extra hours amount to around 3 per cent of total hours available to be worked in the economy. Graph 8 Underemployment Measures* % % Heads-based** Hours-based*** * Full-time workers on part-time hours for economic reasons and part-time workers who would like, and are available, to work more hours ** Share of the labour force *** Share of potential hours Sources: ABS; RBA The rate of underemployment varies significantly across industries and is highly correlated with the share of workers who work part time (Graph 9). For example, the underemployment rate in the accommodation and food services sector is around 20 per cent, while in mining it is less than 1 per cent. Graph 9 Underemployment by Industry 2019 average, share of industry employment % Ac c om Art &f s& oo d rec rea tio n Ad R eta mi n& il su pp ort He alt hc are Ed uc ati Tra on ns po Co rt ns tru ctio Ag n ric u ltu Ot re he W rb ho us les Ot ine ale he ss rg se oo rvi ds pro ces du ctio n Mi nin g % Sources: ABS; RBA The high rates of underemployment mean that hours of work have become an important margin of adjustment in the Australian labour market. Hours can be scaled up and down when demand changes, rather than the alternative of people being hired and fired. The benefits of this were evident during the pandemic and the financial crisis more than a decade ago. Reflecting this, the RBA has for some time been paying attention to both unemployment and underemployment when assessing the degree of spare capacity in the labour market. Cost control Together, these 3 supply side factors help explain the labour market and wage outcomes over recent times. Strong labour demand was met with a strong supply response. The result was that the price of labour did not move much. 7/8/2021 The Labour Market and Monetary Policy | Speeches | RBA A related factor I have spoken about recently is the laser-like focus on cost control in Australian business over the past decade or so. [ 1] This focus has made firms wary of increasing wages, lest it hurt their competitiveness in an environment where it is difficult to increase prices. Many have instead relied on non-wage alternatives to attract and retain staff. Higher wages have often been seen as a last resort, especially in an environment where the supply side of the labour market is so flexible. There has also been a shift by some firms towards variable, as opposed to fixed, remuneration. This has the advantage to the business of avoiding a permanent increase in the cost base, but allowing higher remuneration to be paid for a time. This change is evident in the WPI measure including bonuses, which for most of the available history increased at the same rate as the measure excluding bonuses (Graph 10). But in the second half of the previous decade, the measure including bonuses increased at a faster rate as firms competed for workers. Graph 10 Wage Price Index Growth Year-ended % % Excluding bonuses and commissions Including bonuses and commissions* * Not seasonally adjusted Source: ABS The outlook So what does this all mean for the future? The big change on the supply side has been the closure of our international borders. This has contributed to labour shortages in some areas given the strong pick-up in labour demand. In turn, https://www.rba.gov.au/speeches/2021/sp-gov-2021-07-08.html 12/17 some workers have received sizeable wage increases. However, the spillover effects to the broader labour market have been limited to date, and wage increases remain modest for most workers. Most firms retain their strong focus on cost control, with many preferring to wait things out until the borders open, and ration output in the meantime. The impact of this change on the supply side is evident in the sharp jump in the number of job vacancies, especially in the accommodation and food services sector (Graph 11). Whereas previously some of these vacancies could have been filled by people on visas, this is now more difficult to do. Since March 2020, the number of people in Australia on a visa with the right to work has fallen by over 250,000, which is a significant decline. Graph 11 Employment and Vacancies in Accommodation & Food Services Cumulative change since 2011 ’000 ’000 Employment (LHS) Vacancies* (RHS) -50 -10 -100 -20 -150 -30 * Seasonally adjusted by the RBA Sources: ABS; RBA Given this experience, an important consideration for the outlook is how long the borders remain closed. One plausible scenario is that they open gradually over the period ahead, especially for workers with skills that are in short supply. This would relieve some of the current pressure points in the labour market. Alternatively, it is also possible that the borders remain closed for an extended period and 7/8/2021 The Labour Market and Monetary Policy | Speeches | RBA that the pressure points build further. If so, aggregate wages growth would pick up more quickly than currently expected, but production and investment would be also be constrained. In terms of domestic labour force participation, we are expecting further increases, but not a repeat of the large increase since the middle of the previous decade. Increased job opportunities are expected to continue to draw more people into the labour market. In addition, the more flexible work arrangements that are a legacy of the pandemic make it easier for some people to participate in the labour market. The reforms to child care should also help, although the ageing of the population works in the other direction. With all these moving parts, and the uncertainty about the future strength of labour demand, it is challenging to determine exactly when the spare capacity in the labour market will be absorbed and, hence, when we can expect a sustained lift in wages growth. While it is hard to be sure, it is likely that the unemployment rate will need to be sustained in the low 4s for the Australian economy to be considered to be operating at full employment. Underemployment will also need to decline further. To achieve this, a further period of strong employment growth will be required. One consideration here is that the closure of the borders is making it more difficult to match workers with jobs, opening the possibility that more generalised labour shortages occur at a higher rate of unemployment than we would have expected. Another source of uncertainty is the lack of historical experience upon which to draw. In the past 4 decades, the only time that Australia has had an unemployment rate close to 4 per cent was during the peak of the resources boom. So there is some uncertainty about how aggregate wages will respond at lower rates of unemployment. Given this lack of historical experience, 2 of my colleagues at the RBA – James Bishop and Emma Greenland – have approached this issue from a different angle. [ 2] In particular, they have examined the relationship between the unemployment rate in nearly 300 individual local labour markets across Australia and the average increase in labour income in these markets using data from the Australian Taxation Office. The results are shown in Graph 12. The vertical axis shows how much growth in income in a particular labour market varies from the average and the horizontal axis shows the unemployment rate in each of the local labour markets. Graph 12 Employee Income Growth and Unemployment Employee income growth* (deviation from overall average) Based on 289 local labour markets for the period 1998/99–2017/18 ppt 1.5 Estimated relationship 1.0 0.5 0.0 -0.5 -1.0 -1.5 Unemployment rate % * Average of all labour markets with a particular unemployment rate (to the nearest 0.1 ppt) in a given year; the size of each dot is proportional to the number of region-year observations at each level of unemployment Sources: ABS; National Skills Commission; RBA These results suggest a clear relationship: the lower unemployment is, the higher is relative income growth. This relationship is stronger when the unemployment rate in a local labour market dips below 5 per cent and strongest when unemployment dips below 4 per cent. While these results are subject to a range of qualifications, they suggest a couple of conclusions. First, tighter labour markets do generate stronger wage increases – the laws of supply and demand still work. And second, the relationship seems to be stronger at unemployment rates below 5 per cent. These are important conclusions from a policy perspective, especially given the RBA's strategy is to get the unemployment rate down so that wages growth picks up and inflation returns in a sustainable way to the target range. Monetary policy This brings me to our monetary policy decisions earlier this week. At our meeting on Tuesday, the Reserve Bank Board agreed to: retain the April 2024 bond as the bond for the yield target and retain the target of 10 basis points continue purchasing government bonds after the completion of the current bond purchase program in early September. We will purchase $4 billion a week until at least mid November maintain the cash rate target at 10 basis points and the interest rate on Exchange Settlement balances of zero per cent. These measures will provide the continuing monetary support that the economy needs as it transitions from the recovery phase to the expansion phase. They will help lower unemployment and underemployment further and, in time, see inflation return to the 2 to 3 per cent target range. The Board is committed to achieving the goals of full employment and inflation consistent with target. The bond purchase program is helping us to make progress towards those goals. We decided to continue purchasing bonds because we are still some way from reaching those goals. However, at the same time we are responding to the stronger-than-expected economic recovery and the improved outlook by adjusting the amount purchased each week. This is consistent with the framework that we previously set out. Under that framework, bond purchases are reviewed in terms of: their effectiveness; the decisions of other central banks; and, most importantly, the progress towards our goals for inflation and employment. We are seeking to provide as much guidance about future bond purchases as we reasonably can in an uncertain world, while retaining the flexibility to respond in a timely way to changes in the state of the economy and the outlook. So we will be reviewing the size of our bond purchases again at our November meeting. In terms of interest rates, the condition that the Board has set for an increase in the cash rate is that inflation is sustainably within the 2 to 3 per cent range. It is not enough for inflation to be forecast in this range. We want to see results before we change interest rates. The bond purchases will end prior to any increase in the cash rate. For inflation to be sustainably in the 2 to 3 per cent range, it is likely that wage growth will need to exceed 3 per cent. That is on the basis that labour productivity continues to increase and that the labour share of national income remains broadly steady. The current rate of wage growth is materially less than 3 per cent. Partly for the reasons I have discussed, we still expect the lift in aggregate wages growth will be gradual. We also expect that it will take until 2024 for inflation to be sustainably within the 2 to 3 per cent target range. I would like to close by reiterating the 2 points I made earlier in the week. The first is that the condition for an increase in the cash rate depends upon the data, not the date; it is based on inflation outcomes, not the calendar. The second is that the step-down in the RBA's bond purchases from $5 billion to $4 billion a week does not represent a withdrawal of support by the RBA. The evidence is that central bank bond purchases have their impact through the total stock of bonds purchased, not the flow of those purchases. By mid November, our cumulative purchases under the bond purchase program will have amounted to $237 billion. We will hold a little more than 30 per cent of Australian government bonds https://www.rba.gov.au/speeches/2021/sp-gov-2021-07-08.html 16/17 on issue and 15 per cent of state and territory bonds. This represents a substantial and ongoing degree of support to the Australian economy. The adjustment in the rate of weekly purchases does not change this. Let me conclude on that note. Thank you for listening. I am happy to answer your questions. Endnotes [*] I would like to thank Mark Chambers for assistance in the preparation of this talk. Lowe P (2021), ‘From Recovery to Expansion’, Keynote Address at the Australian Farm Institute Conference, Toowoomba, 17 June. Bishop J & E Greenland (forthcoming), ‘Is the Phillips Curve Still a Curve? Evidence from the Regions’, RBA Research Discussion Paper. The materials on this webpage are subject to copyright and their use is subject to the terms and conditions set out in the Copyright and Disclaimer Notice. © Reserve Bank of Australia, 2001–2021. All rights reserved. The Reserve Bank of Australia acknowledges the Aboriginal and Torres Strait Islander Peoples of Australia as the Traditional Custodians of this land, and recognises their continuing connection to Country. We pay our respects to their Elders, past, present and emerging. | reserve bank of australia | 2,021 | 7 |
Speech by Mr Guy Debelle, Deputy Governor of the Reserve Bank of Australia, at FX Markets USA, Virtual Conference, 27 July 2021. | Guy Debelle: The FX Global Code Speech by Mr Guy Debelle, Deputy Governor of the Reserve Bank of Australia, at FX Markets USA, Virtual Conference, 27 July 2021. * * * Thanks to Matt Boge for his incredible assistance over my term as Chair, as well as Grigoria Christodoulou and the other members of the GFXC Secretariat. Tonight I will talk about the recently completed review and update of the FX Global Code. The updated Code was released on 15 July.1 Tonight I will remind you about the important role the Code plays in the foreign exchange (FX) market. I will summarise the parts of the Code that have been updated and talk about the accompanying papers on pre-hedging and last look. FX Global Code The FX Global Code was launched in May 2017. It was a direct and important response to the lack of trust the foreign exchange industry had been suffering on the back of a number of instances of misconduct in the market and the associated multi-billion dollar fines. This lack of trust was evident both between participants in the market and, at least as importantly, between the public and the market. The lack of trust was impairing market functioning. The market needed to move toward a more favourable and desirable location, and allow participants to have much greater confidence that the market is functioning appropriately. It is also important to remember what the alternative was in the aftermath of the scandals. There was a decent chance that authorities could conclude that a substantial regulatory response was necessary to generate the desired improvement in market structure and conduct. But the Code provided the opportunity for the FX market to address the lack of trust and market dysfunction. The Code was developed through a public sector–private sector partnership. It was a joint effort of central banks and market participants drawn from all parts of the markets: from the buy side, including corporates and asset managers, and the sell side, along with trading platforms, ECNs and non-bank participants. The membership was also from all around the world, drawing from the various Foreign Exchange Committees (FXCs) across the globe comprising all the top 15 FX markets by turnover, both advanced and emerging markets. The Global Foreign Exchange Committee (GFXC) that maintains the Code has since expanded to 20 members. The Code set out global principles of good practice in the FX market to provide acommon set of guidance to the market. The 55 principles in the Code cover ethics, information sharing, aspects of execution including e-trading and platforms, prime brokerage, governance, risk management and compliance, and confirmation and settlement. The Code is principles-based rather than rules-based. There are a number of reasons why this is so but, for me, an important reason is that the more prescriptive the Code, the easier it is to get around. Rules are easier to arbitrage than principles. The more prescriptive and the more precise the Code, the less people will think about what they are doing. If it’s principles-based and less prescriptive then market participants will have to think about whether their actions are consistent with the principles of the Code. The Code is not a procedures manual. Rather, the Code articulates principles that need to be taken into account. Individual firms may then take these principles and reflect them in their own procedures manuals. Our aim in setting out these principles is to provide market participants with the framework in which to think about how they, for example, handle their orders. The emphasis here is very much on the word ‘think’. 1/4 BIS central bankers' speeches These principles of good practice have helped to restore confidence and promote the effective functioning of the wholesale FX market. In my view, the FX market is in a better place than it was a few years ago. That is confirmed by surveys of market participants too, including the one conducted by the GFXC a couple of years ago. The Code has also been adopted by a number of securities regulators round the world as the primary reference for their oversight of the FX market, including in the UK, in China and in my own market Australia. When we launched the Code, it was agreed that the Code would be reviewed by the GFXC every three years to ensure it remained appropriate and to also ensure it stayed current with the ongoing evolution of the FX market. Hence, around two years ago, the GFXC surveyed market participants to assess what areas of the Code needed to be reviewed.2 The primary response of market participants was that the Code remained fit for purpose and changes should only be made as necessary. The strong guidance was that changes to the Code should be contained to a few areas. The GFXC identified a few key areas requiring review to ensure that the Code continues to provide appropriate guidance and contributes to an effectively functioning market, and remains in step with the evolution of the market.3 Over the past 18 months, various working groups of the GFXC, drawing on a diverse group of market participants and central banks, have been working on the review. The proposed updates to the Code have been through a number of rounds of feedback with market participants through the FXCs round the world, as well as a public feedback process. I would like to thank the broad range of market participants who provided us with feedback. I would particularly like to thank the working groups for their hard work, especially given the challenging environment of the pandemic. The Review of the Code Following this process of review and consultation with industry, the GFXC has published the updated version of the Code. The July 2021 version of the Code replaces the earlier, August 2018 version. In total, 11 of the Code’s 55 principles have been amended. The GFXC has also developed disclosure cover sheets and templates for algo due diligence and transaction cost analysis (TCA) to assist market participants in meeting the Code’s principles for disclosure and transparency. Additionally, the GFXC has published guidance papers on the practices of Pre-Hedging and Last Look to support market participants in applying the Code’s principles in these areas. One area that reflects the development of the market is the role played by Anonymous Trading. The Code has been amended to encourage greater disclosure by those operating anonymous platforms, including of their policies for managing the unique identifiers (‘tags’) of their users. Anonymous trading platforms are also encouraged to make available the Code signatory status of their users. Recognising the value that data related to trading activity holds for market participants, the Code now states that FX e-trading platforms (including anonymous platforms) should be transparent about their market data policies, including which user types such data is made available to and at what frequency and latency. Platforms are also encouraged to disclose the mechanisms and controls by which they are managing or monitoring the credit limits of their users. The risks associated with FX settlement are potentially very significant and have come back into view again following the publication of the previous Triennial survey of FX turnover by the BIS.4 Consequently, the GFXC identified a need to strengthen the Code’s guidance on 2/4 BIS central bankers' speeches Settlement Risk. Amendments have been made to place greater emphasis on the usage of payment versus payment (PVP) settlement mechanisms where they are available and to provide more detailed guidance on the management of settlement risk where PVP settlement is not used. New language on the potential systemic consequences of a market participant’s failure to meet their payment obligations has been included to specifically discourage ‘strategic fails’. The Code’s guidance on the information that providers of Algorithmic Trading or aggregation services should be disclosing has been expanded to include the disclosure of any conflicts of interest that could impact the handling of client orders (such as those arising from interaction with their own principal market-making desk).5 More broadly, the GFXC believes the market would benefit from greater uniformity of disclosures in this area. To enable clients to more easily compare and understand the services being offered, market participants providing algorithmic trading services are now encouraged to share their disclosure information in a standardised format. To this end, the GFXC is publishing an Algo Due Diligence Template that market participants may use, as appropriate. Similarly, the GFXC believes that Transaction Cost Analysis would be aided by greater harmonisation of data reporting within the industry. TCA is central to determining the quality of execution received by users of algorithmic trading services. As the barriers to conducting TCA can be high, a standardised information set could be particularly helpful for less-sophisticated clients or those with limited resources. The GFXC is publishing a Transaction Cost Analysis Data Template that should assist in bringing about greater standardisation. Disclosure Cover Sheet and Templates for Algo Due Diligence and Transaction Cost Analysis Clear and accessible disclosures allow market participants to make informed decisions about the other market participants with whom they interact. A key area of focus for the GFXC was the challenges market participants faced in accessing and evaluating the large amount of varied disclosure information being made available to them.6 To address this, the GFXC has created standardised Disclosure Cover Sheets for liquidity providers and for FX e-trading platforms. They have been developed to improve the accessibility and clarity of existing disclosures. You should be able to more easily compare and contrast disclosures across a set of standardised information. The Code has also been expanded to include explicit references to the provision of information about trade rejections. Market participants should be making clients aware of the basis on which trades might be rejected, and should be keeping records of the reasons behind electronic trade rejections. The Disclosure Cover Sheet, the Algo Due Diligence Template and the TCA Data Template can support market participants in meeting the range of disclosure and transparency principles within the Code. They will be made available on the GFXC website and their use is voluntary. Market participants will be able to post their Disclosure Cover Sheet alongside their Statement of Commitment on participating public registers, further supporting accessibility of disclosure. Guidance Papers on Pre-Hedging and Last Look Principles 11 and 17 of the FX Global Code describe good practice for market participants using pre-hedging and last look. They continue to be areas that generate strong and sometimes diverse views across market participants. There was demand for further clarity on the appropriate usage of these trading practices. Hence, the GFXC is publishing separate guidance papers on these topics. These papers are intended to be read alongside the Code in its entirety. (That is, there are other principles in the Code that cover practices relevant to pre-hedging and last look, not just Principles 11 and 17.) 3/4 BIS central bankers' speeches The Guidance Paper on Pre-Hedging discusses the circumstances in which pre-hedging could be used in the FX market and the controls and disclosures that could help align pre-hedging activity with the Code. As the paper states, in utilising pre hedging, liquidity providers are expected to behave with integrity both in executing their client activities and in supporting the functioning of the FX market. While the intent of any liquidity provider conducting pre hedging should be to benefit the liquidity consumer in executing an anticipated order, there is no guarantee that it will always result in a trade, or a trade at a price that is beneficial to the liquidity consumer. Pre hedging done with no intent to benefit the liquidity consumer, or market functioning, is not in line with the Code and may constitute illegal front running. The Guidance Paper on Last Look has generated a larger volume of discussion and feedback than the other parts of the review. To ensure we have appropriately taken that on board, we are undergoing a final round of feedback with the FXCs. The feedback window closes this week and we are aiming to publish the final version of the paper in the coming weeks. At the same time, we will also publish the disclosure templates as they contain disclosures on last look. Statement of Commitments Almost 1,100 entities globally have signalled their adherence to the Code’s principles by signing a Statement of Commitment. With the publication of the updated Code, the GFXC is encouraging market participants to consider renewing their Statements of Commitment, having regard to the nature and relevance of the updates to their FX market activities. The GFXC acknowledges that the changes to the Code will affect certain parts of the market more than others. For those most affected by the changes, we would anticipate a period of up to 12 months for practices to be brought into alignment with the updated principles. We would expect that the disclosure cover sheets would be posted alongside the Statement of Commitments on a similar timeframe, if not sooner. Conclusion To conclude, the GXFC has completed the three-year review of the FX Global Code. The Code has been updated to remain current with the ongoing evolution of the FX market. It will continue to serve its important role of setting the standard for good practice. But to do so, it requires that you as market participants continue to reflect the principles of the Code in your activities in the FX market. I would strongly encourage you to familiarise yourself with the changes to the Code, and particularly to make good use of the disclosure templates. In the end, we all have a strong common purpose in ensuring that the FX market continues to operate effectively and with integrity. 1 GFXC (2021), ‘GFXC Updates FX Global Code, Publishes New Templates for Disclosures and Guidance Paper on Pre-Hedging’, Press Release, 15 July. Available at . 2 GFXC (2020), ‘GFXC 2019 Survey Results’, January. Available at . 3 GFXC (2019), ‘GFXC Priorities for the 3-Year Review of the FX Global Code’, 6 November. Available at . 4 Schrimpf A and Sushko V (2019), ‘Sizing Up Global Foreign Exchange Markets’, BIS Quarterly Bulletin, December, pp 21–38. Available at . 5 For more on algo trading, see BIS (2018), ‘Monitoring of Fast-Paced Electronic Markets’, report submitted by a Study Group established by the Markets Committee, September. Available at . 6 Hauser A (2019), ‘Run Lola Run! The Good, the Bad and the Ugly of FX Market Fragmentation – And What To Do About It’, Speech at TradeTech FX 2019, Barcelona, 13 September. Available at . 4/4 BIS central bankers' speeches | reserve bank of australia | 2,021 | 7 |
Opening statement by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, online, 6 August 2021. | Philip Lowe: Opening statement to the House of Representatives Standing Committee on Economics Opening statement by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, online, 6 August 2021. * * * Good morning. Thank you for arranging this hearing via videoconference. These hearings are an important part of the accountability process for the RBA and my colleagues and I welcome this opportunity to explain our thinking and answer your questions. Later this morning, the RBA will be releasing our quarterly Statement on Monetary Policy. I would like to highlight 5 key themes from this report. The first is that the Australian economy has bounced back quicker and stronger than was earlier expected. The pre-pandemic level of GDP was regained in the March quarter, more than a year earlier than we had expected in August last year. But it is in the labour market where the recovery has been most remarkable. In June, the unemployment rate fell to 4.9 per cent, which is lower than it was before the pandemic. There has been strong growth in jobs across most parts of the economy and job vacancies have been at record highs. And in stark contrast to the experience of most other advanced economies, labour force participation and the number of hours worked had both recovered to above pre-pandemic levels. These outcomes are testament to the effectiveness of the public policy response, including the early success on the health front and the ability of Australians to adapt to changed circumstances. The economic policy response involved the public sector using its balance sheet to support the economy and keep people in jobs. Fiscal and monetary policy worked together well and the response of Australia’s financial institutions also helped. Households and businesses also showed remarkable resilience and an ability to change how they do things. So, it is a positive story here. Now to the second theme, which is that the recovery has been interrupted by outbreaks of the highly infectious Delta strain of the coronavirus, especially in New South Wales. The outbreaks mean that GDP is likely to decline in the September quarter. How large the decline will be depends on the duration of the lockdowns and whether there are further material outbreaks elsewhere in Australia in the weeks ahead. As a rough rule of thumb, household consumption in areas that are locked down is typically around 15 per cent lower than it would be otherwise. In addition, the lockdowns have directly affected construction activity in NSW and delayed some investment plans. Some increase in the unemployment rate is also expected over the months ahead, although most of the adjustment in the labour market is likely to be through declines in hours worked and participation, rather than in job losses. As we assess the impact of the lockdowns on the economy, it is important not to lose sight of the fact that not all of Australia is affected. Significant parts of the Australian economy are still on the positive trajectory that was in place before the recent outbreaks. This is quite different from the situation in the first half of last year, when the whole of Australia was in lockdown. So, it is a mixed picture. The third theme from the Statement on Monetary Policy is that the economy is expected to bounce back quickly once the restrictions ease. The experience both in Australia and elsewhere is that once restrictions are lifted, spending 1/4 BIS central bankers' speeches recovers strongly, especially if people have confidence about the future. While the exact timing of the bounce-back is difficult to predict, it is likely to start well before the end of the year. The vaccination program is ramping up and governments are providing significant targeted income support to help businesses and households get through this difficult period. This means that there is a pathway out of the current difficulties this year. At its meeting earlier in the week, the Reserve Bank Board considered a range of possible scenarios for the Australian economy over the next couple of years. Our central scenario is that the economy will return to strong growth in 2022, with GDP increasing by a little over 4 per cent, to be followed by growth of around 2½ per cent in 2023. In this scenario, the unemployment rate resumes its downward path to reach around 4¼ per cent by the end of next year and 4 per cent the following year. The Board also considered upside and downside scenarios, the details of which will be published later today, with much depending on the health outcomes. One source of uncertainty is the possibility of vaccine-resistant virus strains emerging over time. Another is that it is still unclear what type of adjustments our society will have to make to live with COVID on an ongoing basis. Once vaccination rates are high enough, we will be living with a virus that is endemic rather than living through a pandemic. What this endemic phase looks like is still to be determined. On the upside, it is possible the Australian economy will again experience a run of positive surprises, as it did earlier this year. If we are successful in containing the virus over the months ahead, it is possible there will be stronger upswings in both investment and consumption than envisaged in our central scenario. The fourth theme is that we have not seen the same upside surprises in wages and prices that we have experienced in jobs and output, and that it will take some time for inflation to be sustainably in the 2 to 3 per cent target range. Both wages growth and underlying inflation are subdued and we expect this to remain the case for some time yet. While there have been reports of labour shortages in parts of the country and a step-up in wages for some occupations, wage increases for most Australians are still modest. Underlying inflation also remains low at around 1¾ per cent over the year to the June quarter. In contrast, the headline inflation rate spiked to 3.8 per cent in the June quarter, but this largely reflected the unwinding of some earlier COVID-19-related price declines. In our central scenario, both wages growth and underlying inflation pick up, but do so only gradually. The central forecast is for underlying inflation to be 1¾ per cent over 2022 and then 2¼ per cent over 2023. Growth in the Wage Price Index is expected to pick up gradually to 2¾ per cent over 2023, with growth in other measures of labour costs slightly higher than this. One source of forecast uncertainty here is that Australia has had little recent experience with the low unemployment rates that are being forecast. At the peak of the resources boom in 2008, the unemployment rate briefly got as low as 4 per cent, but before that the last time the unemployment rate was at 4 per cent was in the early 1970s. Our economy and our institutions were very different then than they are today, making it hard to draw any lessons. Notwithstanding the uncertainties, there are a number of factors that make it likely that the pickup in wages and inflation will be gradual. These include: enterprise agreements that run for a number of years; a business mindset that is very focused on cost control; inflation expectations that are low; relatively high ongoing rates of underemployment; and that it will take some time yet before the spare capacity in the economy is fully absorbed. Together, the factors help provide a basis for expecting that Australia can sustain an unemployment rate in the low 4s, but time will tell. That brings me to the final theme of the Statement on Monetary Policy – that is, the RBA’s 2/4 BIS central bankers' speeches package of monetary policy measures is providing substantial support to the Australian economy in the face of lockdowns and the expected resumption of the economic expansion. These monetary policy measures include: the Term Funding Facility a yield target for the April 2024 Australian Government bond of 10 basis points the bond purchase program under which the RBA is purchasing bonds issued by the Australian Government and by the state and territory governments a cash rate target of 10 basis points. I would like to provide the Committee with an update on each of these elements of the package. First, the Term Funding Facility. A total of $188 billion was drawn down by financial institutions under this facility before the deadline for final drawings of 30 June. The interest rate on most of these funds is 10 basis points and the funding does not have to be repaid for 3 years. This means that, even though the facility is now closed to new drawings, it will continue to support low funding costs in Australia out to mid 2024. At its July meeting, the Board considered the yield target and decided to retain the April 2024 Australian Government bond as the target bond, rather than extend it to the November 2024 bond. The target remains at 10 basis points, the same as for the cash rate. The target has played an important role in keeping funding costs low and reinforcing our forward guidance regarding the cash rate, and it will continue to play this role over the next few years. The decision not to extend the target to the next maturity reflects a shift in the probabilities regarding future movements in the cash rate. When the 3-year yield target was introduced last year, it was difficult to conceive scenarios in which the cash rate would be increased over the subsequent 3 years, which at the time ran to early 2023. Eighteen months on, there are now plausible scenarios in which the cash rate is increased over a 3-year horizon, which now runs until late 2024. Given this shift, the Board decided that it was not appropriate to extend the yield target to the end of 2024. At our July meeting, we also decided that we would continue purchasing government bonds following the completion of the second $100 billion program in early September. In addition, we decided that the purchases would be at a rate of $4 billion a week until at least November, rather than the current $5 billion a week. We also indicated that we had a flexible approach and could adjust the rate of purchases in either direction in response to economic news and changes in the outlook. At the Board’s meeting earlier this week we considered the case for delaying this tapering to $4 billion a week. The critical issue here is the outlook for the economy. As I discussed earlier, we are expecting a return to strong growth next year. Any additional bond purchases would have their maximum effect at that time and only a very small effect right now when the extra support is needed most. The Board also recognised that fiscal policy is the more appropriate instrument for providing support in response to a temporary and localised hit to income, and the Board welcomes the substantial fiscal response by governments in Australia. We will, however, keep the situation under review and are prepared to act in response to further bad news on the health front that affects the outlook for the economy over the year ahead. The final element of the package is the cash rate. As I have said previously, the Board will not be increasing the cash rate until inflation is sustainably in the 2 to 3 per cent range. We want to see results on inflation before we move, not a forecast of inflation in the target range. It will not be enough for inflation to just sneak across the 2 per cent line for a quarter or 2. We want to see inflation well within the target band and be confident that it will stay there. In making our 3/4 BIS central bankers' speeches assessments here, we will be paying close attention to growth in wages and broader labour costs. Under the central scenario, the condition we have set for an increase in the cash rate is not expected to be met before 2024. Finally, I would like to mention one other important area of the RBA’s operations; that is, our role as banker to the Australian Government. Over recent weeks we have worked very closely with Services Australia to make sure that the COVID Disaster Payments are made quickly. Once an application is made to Services Australia for assistance, the money can be in the person’s bank account in less than an hour. On a recent Sunday, Services Australia, with the assistance of the RBA, processed over 300,000 individual payments through Australia’s fast payment system, with the money available to people immediately on the weekend. These fast payments are possible because of both the RBA’s significant investment in our banking and payments infrastructure and our policy efforts over many years to encourage the banking system to develop a fast payments system. The RBA also operates the settlement system that transfers money between banks’ accounts in real time, 24 hours a day, 7 days a week. It’s pleasing to see how these systems can be used to directly and quickly help people who are in need. Thank you. My colleagues and I are here to answer your questions. 4/4 BIS central bankers' speeches | reserve bank of australia | 2,021 | 8 |
Address by Mr Christopher Kent, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to FX Markets Australia, Virtual Conference, 20 August 2021. | Christopher Kent: Updates to the FX Global Code Address by Mr Christopher Kent, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to FX Markets Australia, Virtual Conference, 20 August 2021. * * * I thank Matt Boge for his assistance in preparing this material. I also thank Matt and Jason Griffin for their extensive contribution to the work of the AXFC and the GFXC over the course of the review of the Code. Introduction I thank FX Markets Australia for the invitation to talk to you this morning. In July, the Global Foreign Exchange Committee (GFXC) updated the FX Global Code. Given its importance to the FX industry, I’ll take this opportunity to summarise the changes that were made. I’ll also discuss other aspects of the GFXC’s recent work and what it means for the industry. Three-year Review of the Code The FX Global Code was launched in 2017. Globally, almost 1,100 entities have signalled their adherence to the Code’s principles by posting a signed Statement of Commitment on a public register.1 This includes a wide range of participants in the Australian market. Take-up of the Code by sell-side market participants was fairly rapid, as was expected. But it has been pleasing to see that over time more and more entities on the buy-side have been confirming their adoption of the Code’s principles. In setting out standards for good practice, the Code is relevant to all participants in the wholesale market, not just liquidity providers. To ensure that the Code remains relevant and keeps pace with the evolution of the market, the GFXC committed itself to carefully reviewing the Code’s principles periodically. The first of these reviews has just been completed. The priorities for the review were established after surveying market participants in 2019 and following consultation with the GFXC’s member committees, including the Australian Foreign Exchange Committee (AFXC), which I chair. A consistent theme of the feedback was that the Code remained fit for purpose and changes should only be made as necessary. To this end, the GFXC identified some key areas requiring attention to ensure that the Code continues to provide appropriate guidance. The AFXC was heavily involved in the review process, not least because Guy Debelle – the Deputy Governor of the RBA – has been the Chair of the GFXC for the past two years. Other members of the AFXC participated in the GFXC’s working groups, which were instrumental in developing the new material. The recommendations of the working groups were reviewed by the GFXC’s member committees and published for public feedback. After careful consideration of the feedback, the GFXC released the updated Code last month. Some Key Changes to the Code In total, 11 of the Code’s 55 principles have been amended. I won’t go through all of the changes today. There is a summary on the GFXC’s website that steps through these.2 What I would emphasise is that the driver for many of the changes is the need for greater disclosure and transparency in an increasingly complex market. 1/4 BIS central bankers' speeches One area where the market has grown more complex is the methods of execution. Use of execution algorithms by FX market participants has increased significantly. The GFXC’s view is that the market would benefit from more detailed disclosures about these algos, as well as greater uniformity in the disclosures. This echoes recent findings by the Bank of International Settlements (BIS) Markets Committee that high-level and non-standard disclosures were making it difficult for algo users to compare different providers and make informed decisions.3 Some sophisticated clients may be able to overcome this problem, but it has not been conducive to market efficiency. Consequently, the Code has been updated to provide more guidance on the minimum set of information that algo providers should be disclosing. In addition, the GFXC is encouraging providers to make their disclosures in a standardised format. Accordingly, the GFXC has developed an Algo Due Diligence Template that market participants may use, as appropriate. This is available on the GFXC’s website. As the use of algos increases, it is important that market participants are able to evaluate their performance. But the barriers to conducting meaningful analysis on algos can be high. For this reason, the GFXC believes that Transaction Cost Analysis (TCA) would benefit from greater harmonisation of data reporting. At the session on TCA later this morning, I’m sure there will be some discussion of those challenges and how they might be overcome. The GFXC’s view is that standardised information could be particularly helpful for less sophisticated clients or those with limited resources. Recognising this, the GFXC has also published a TCA Data Template on its website that market participants may use. Not surprisingly, one other area where feedback pointed to a need for greater disclosure and transparency was anonymous trading. Electronic platforms used in the FX market can vary in the degree of anonymity offered to their participants. But the more anonymous participants are allowed to be, the harder it is for users to communicate expected standards of behaviour or monitor the actual behaviour of their counterparties. The Code has been amended to encourage greater disclosure by those operating anonymous platforms. This includes operators being transparent about their data policies, such as which users they are making data available to and with what latency. Additionally, these platforms are now encouraged to clarify whether or not their users have signed up to the Code. Disclosure Cover Sheets The importance being placed on disclosures is consistent with the Code being principles-based. Instead of narrowly prescribing specific behaviours, the Code emphasises the need for participants to make informed choices about their interactions in the market. Clear and accessible disclosures can help participants make those decisions. Since the publication of the Code in 2017, the content of FX disclosures has generally improved. Indeed, we have been receiving more detailed disclosures from our counterparties in recent years. Managing the increasing amount of information, however, can be a challenge. In particular, disclosures can vary considerably, both in terms of the topics that are addressed as well as the level of detail provided. The feedback the GFXC received was that many market participants faced similar challenges in accessing and evaluating information in disclosures. To address this, the Committee has developed standardised Disclosure Cover Sheets for liquidity providers and electronic trading platforms. The templates for these were published earlier this week on the GFXC’s website. 2/4 BIS central bankers' speeches The new Cover Sheets will assist liquidity providers and operators of trading platforms to meet the disclosure and transparency principles within the Code. To be clear, they do not ask for any additional disclosure beyond what is already encouraged by the Code. The Cover Sheets will simply allow market participants to see a summary of information on key topics, with links provided to the relevant underlying disclosures. The aim is to make it easier for participants to quickly access and navigate those disclosures. Market participants will be able to post their Cover Sheets alongside their Statements of Commitment on a public register, further supporting accessibility of disclosure. Guidance on Pre-hedging and Last Look Two practices where disclosures are particularly important are pre-hedging and last look. As these practices can be quite contentious, they received a lot of focus from the GFXC during its review of the Code. Specific principles within the Code describe good practice for those using pre-hedging and last look. The GFXC’s view was that the text of those principles remained appropriate. However, to meet demand for further clarity on the appropriate use of these practices, the GFXC has published guidance papers on both topics. The guidance papers are not part of the Code; they are intended to be read alongside the Code. For pre-hedging and last look, the Code provides the framework that market participants should be using, while the guidance papers discuss applications of those frameworks. As with the other materials developed by the GFXC, this was done in close consultation with industry and the member FXCs. The paper on pre-hedging describes some of the circumstances in which pre-hedging might be used in the FX market, and the controls and disclosures that could help align that activity with the Code. The paper clarifies that pre-hedging should be the exception, not the norm. It is one potential way of managing large orders. As specified in the Code, the key point remains that: as a risk management tool, pre-hedging should be designed to benefit the client. More generally, the heightened risks around large orders mean that it is especially important for liquidity providers and their clients to have clearly aligned expectations for their execution, whether pre-hedging is used or not. The guidance paper on last look published this week incorporates feedback received on the draft version. This was not the first time the GFXC has sought feedback on last look practices, and the GFXC will continue to watch developments in this field to see if more work needs to be done. The guidance paper clarifies a number of important issues. In line with the Code, the paper emphasises that, where it is used, last look is only for the price and validity check and not for other purposes. To minimise the uncertainty for the client, this price and validity check should be applied without delay. Also, information about trade rejections should be accurately recorded so that it can be shared with clients. As with pre-hedging, clients should always be able to evaluate whether the methods of execution are meeting their needs. Settlement Risk The GFXC has also focused on settlement risk. The most recent triennial survey of global FX market activity by the BIS, suggested that the value of trades not being settled on a paymentversus-payment (PVP) basis remained significant and may have actually been increasing as a share of total trades. The risks associated with FX settlement are potentially very significant and more work is being done to understand and monitor how these risks are being managed. The next BIS triennial survey in 2022 will contain more questions on settlement methods and many central banks – 3/4 BIS central bankers' speeches including the RBA – will begin collecting similar data in their regular, semi-annual surveys of their local markets. Recognising the importance of this issue, the GFXC agreed that the Code’s guidance on settlement risk should be strengthened. The Code now places greater emphasis on the use of PVP mechanisms where they are available. It also provides more detailed guidance on the appropriate management of settlement risk where PVP settlement is not used. In the local market, the AFXC’s assessment is that there is good awareness of settlement risk and how it can be mitigated, including among buy-side participants. The available data seems to suggest that this is being put into practice. But as I mentioned, further work will be done in this area, and we should soon have better data with which to monitor industry trends. In the meantime, I would encourage everyone to assess their settlement practices against the new text in the Code. Conclusion More broadly, it is important that all market participants review the updated Code and think through the implications for their own activities. This includes both sell-side and buy-side participants. The amendments to the Code’s principles will affect certain parts of the market, and certain types of participants, more than others. For those that are most affected, a positive signal that they have aligned their practices with the updated Code would be to renew their Statement of Commitment. Reaching this point may take time, perhaps as long as 12 months. At the Reserve Bank, we will be asking all our FX trading counterparties to provide us with renewed Statements in due course. We will also be undertaking an internal review of our practices and publishing a refreshed Statement when that process is complete. Finally, for all market participants, there is work to be done not only to enhance disclosures, but also to make good use of the information being disclosed. 1 See the GFXC’s Index of Public Registers at . 2 GFXC (2021) ‘Outcomes of the 3-year Review of the FX Global Code’, July. Available at . 3 Bank of International Settlements (2020) ‘FX Execution Algorithms and Market Functioning’, Markets Committee Study Group Report, October. Available at . 4/4 BIS central bankers' speeches | reserve bank of australia | 2,021 | 8 |
Speech by Mr Guy Debelle, Deputy Governor of the Reserve Bank of Australia, at Tradetech FX EU, Hybrid Conference, 8 September 2021. | Guy Debelle: The FX Global Code Speech by Mr Guy Debelle, Deputy Governor of the Reserve Bank of Australia, at Tradetech FX EU, Hybrid Conference, 8 September 2021. * * * Thanks to Matt Boge for his incredible assistance over my term as Chair, as well as Grigoria Christodoulou and the other members of the GFXC Secretariat. Tonight I will talk about the recently completed review and update of the FX Global Code. The updated Code was released on 15 July.1 Tonight I will remind you about the important role the Code plays in the foreign exchange (FX) market. I will summarise the parts of the Code that have been updated and talk about the accompanying papers on pre-hedging and last look. FX Global Code The FX Global Code was launched in May 2017. It was a direct and important response to the lack of trust the foreign exchange industry had been suffering on the back of a number of instances of misconduct in the market and the associated multi-billion dollar fines. This lack of trust was evident both between participants in the market and, at least as importantly, between the public and the market. The lack of trust was impairing market functioning. The market needed to move towards a more favourable and desirable location, and allow participants to have much greater confidence that the market is functioning appropriately. It is also important to remember what the alternative was in the aftermath of the scandals. There was a decent chance authorities could conclude that a substantial regulatory response was necessary to generate the desired improvement in market structure and conduct. But the Code provided the opportunity for the FX market to address the lack of trust and market dysfunction. The Code was developed through a public sector–private sector partnership. It was a joint effort of central banks and market participants drawn from all parts of the markets: from the buy side, including corporates and asset managers, and the sell side, along with trading platforms, ECNs and non-bank participants. The membership was also from all around the world, drawing from the various Foreign Exchange Committees (FXCs) across the globe comprising all the top 15 FX markets by turnover, both advanced and emerging markets. The Global Foreign Exchange Committee (GFXC) that maintains the Code has since expanded to 20 members. The Code set out global principles of good practice in the FX market to provide acommon set of guidance to the market. The 55 principles in the Code cover ethics, information sharing, aspects of execution including e-trading and platforms, prime brokerage, governance, risk management and compliance, and confirmation and settlement. The Code is principles-based rather than rules-based. There are a number of reasons why this is so but, for me, an important reason is that the more prescriptive the Code, the easier it is to get around. Rules are easier to arbitrage than principles. The more prescriptive and the more precise the Code, the less people will think about what they are doing. If it’s principles-based and less prescriptive then market participants will have to think about whether their actions are consistent with the principles of the Code. The Code is not a procedures manual. Rather, the Code articulates principles that need to be taken into account. Individual firms may then take these principles and reflect them in their own procedures manuals. Our aim in setting out these principles is to provide market participants with the framework in which to think about how they, for example, handle their orders. The emphasis here is very much on the word ‘think’. 1/6 BIS central bankers' speeches These principles of good practice have helped to restore confidence and promote the effective functioning of the wholesale FX market. In my view, the FX market is in a better place than it was a few years ago. That is confirmed by surveys of market participants too, including the one conducted by the GFXC a couple of years ago. The Code has also been adopted by a number of securities regulators round the world as the primary reference for their oversight of the FX market, including in the UK, in China and in my own market Australia. When we launched the Code, it was agreed that the Code would be reviewed by the GFXC every three years to ensure it remained appropriate and to also ensure it stayed current with the ongoing evolution of the FX market. Hence, around two years ago, the GFXC surveyed market participants to assess what areas of the Code needed to be reviewed.2 The primary response of market participants was that the Code remained fit for purpose and changes should only be made as necessary. The strong guidance was that changes to the Code should be contained to a few areas. The GFXC identified a few key areas requiring review to ensure that the Code continues to provide appropriate guidance and contributes to an effectively functioning market, and remains in step with the evolution of the market.3 The GFXC also saw the opportunity to provide greater consistency and usability in disclosures. Over the past 18 months, various working groups of the GFXC, drawing on a diverse group of market participants and central banks, have been working on the review. The proposed updates to the Code have been through a number of rounds of feedback with market participants through the FXCs round the world, as well as a public feedback process. I would like to thank the broad range of market participants who provided us with feedback. I would particularly like to thank the working groups for their hard work, especially given the challenging environment of the pandemic. The Review of the Code Following this process of review and consultation with industry, the GFXC has published the updated version of the Code. The July 2021 version of the Code replaces the earlier, August 2018 version. In total, 11 of the Code’s 55 principles have been amended. The GFXC has also developed disclosure cover sheets and templates for algo due diligence and transaction cost analysis (TCA) to assist market participants in meeting the Code’s principles for disclosure and transparency. Additionally, the GFXC has published guidance papers on the practices of Pre-Hedging and Last Look to support market participants in applying the Code’s principles in these areas. One area that reflects the development of the market is the role played by Anonymous Trading. The Code has been amended to encourage greater disclosure by those operating anonymous platforms, including of their policies for managing the unique identifiers (‘tags’) of their users. Anonymous trading platforms are also encouraged to make available the Code signatory status of their users. Recognising the value that data related to trading activity holds for market participants, the Code now states that FX e-trading platforms (including anonymous platforms) should be transparent about their market data policies, including which user types such data is made available to and at what frequency and latency. Platforms are also encouraged to disclose the mechanisms and controls by which they are managing or monitoring the credit limits of their users. The risks associated with FX settlement are potentially very significant and have come back into view again following the publication of the previous Triennial survey of FX turnover by the 2/6 BIS central bankers' speeches BIS.4 Consequently, the GFXC identified a need to strengthen the Code’s guidance on Settlement Risk. Amendments have been made to place greater emphasis on the usage of payment versus payment (PVP) settlement mechanisms where they are available and to provide more detailed guidance on the management of settlement risk where PVP settlement is not used. New language on the potential systemic consequences of a market participant’s failure to meet their payment obligations has been included to specifically discourage ‘strategic fails’. The Code’s guidance on the information that providers of Algorithmic Trading or aggregation services should be disclosing has been expanded to include the disclosure of any conflicts of interest that could impact the handling of client orders (such as those arising from interaction with their own principal market-making desk).5 More broadly, the GFXC believes the market would benefit from greater uniformity of disclosures in this area. To enable clients to more easily compare and understand the services being offered, market participants providing algorithmic trading services are now encouraged to share their disclosure information in a standardised format. To this end, the GFXC has published an Algo Due Diligence Template that market participants may use, as appropriate. Similarly, the GFXC believes that Transaction Cost Analysis would be aided by greater harmonisation of data reporting within the industry. TCA is central to determining the quality of execution received by users of algorithmic trading services. As the barriers to conducting TCA can be high, a standardised information set could be particularly helpful for less-sophisticated clients or those with limited resources. The GFXC has published a Transaction Cost Analysis Data Template that should assist in bringing about greater standardisation. Disclosure Cover Sheet and Templates for Algo Due Diligence and Transaction Cost Analysis Clear and accessible disclosures allow market participants to make informed decisions about the other market participants with whom they interact. A key area of focus for the GFXC was the challenges market participants faced in accessing and evaluating the large amount of varied disclosure information being made available to them.6 To address this, the GFXC has created standardised Disclosure Cover Sheets for liquidity providers and for FX e-trading platforms. They have been developed to improve the accessibility and clarity of existing disclosures. You should be able to more easily compare and contrast disclosures across a set of standardised information. The Code has also been expanded to include explicit references to the provision of information about trade rejections. Market participants should be making clients aware of the basis on which trades might be rejected, and should be keeping records of the reasons behind electronic trade rejections. The Disclosure Cover Sheet, the Algo Due Diligence Template and the TCA Data Template can support market participants in meeting the range of disclosure and transparency principles within the Code. They are available on the GFXC website and their use is voluntary. Market participants will be able to post their Disclosure Cover Sheet alongside their Statement of Commitment on participating public registers, further supporting accessibility of disclosure. Guidance Papers on Pre-Hedging and Last Look Principles 11 and 17 of the FX Global Code describe good practice for market participants using pre-hedging and last look. They continue to be areas that generate strong and sometimes diverse views across market participants. There was demand for further clarity on the appropriate usage of these trading practices. Hence, the GFXC has published separate guidance papers on these topics. These papers are intended to be read alongside the Code in its entirety. (That is, there are other principles in the Code that cover practices relevant to pre-hedging and 3/6 BIS central bankers' speeches last look, not just Principles 11 and 17.) The Guidance Paper on Pre-Hedging discusses the circumstances in which pre-hedging could be used in the FX market and the controls and disclosures that could help align pre-hedging activity with the Code. As the paper states, in utilising pre hedging, liquidity providers are expected to behave with integrity both in executing their client activities and in supporting the functioning of the FX market. While the intent of any liquidity provider conducting pre hedging should be to benefit the liquidity consumer in executing an anticipated order, there is no guarantee that it will always result in a trade, or a trade at a price that is beneficial to the liquidity consumer. Pre hedging done with no intent to benefit the liquidity consumer, or market functioning, is not in line with the Code and may constitute illegal front running. The Guidance Paper on Last Look has generated a larger volume of discussion and feedback than the other parts of the review. The guidance paper reinforces Principle 17 of the Code by emphasising that the last look be applied in a fair and predictable manner. The guidance paper does move the industry forward in providing greater clarity about the intent of Principle 17. In addition, the disclosure sheets provide liquidity consumers with the capacity to better assess in a consistent manner, the way they are being treated in the last look window. Last look is intended to be used for the price and validity checks only, and for no other purpose. LPs should apply the price and validity check without delay. Anything else that prolongs the last look window is contrary to the intent of the Code. At the end of the guidance paper, it outlines some areas that liquidity consumers should monitor to assess whether last look is being applied appropriately. We did consider whether to state what some of those other purposes might be that you should not use last look for. We have not done so for a number of reasons. First is that the Code is principles-based, not regulation, and the principle underlying last look makes it clear that there is no other legitimate purpose beyond price and validity checks. Second, if we had a description of some activities that we don’t regard as acceptable, then unless we had a completely exhaustive list, which is close to impossible, we run the risk of providing a safe harbour for anything that wasn’t on the list. In that regard, some have said we should be more prescriptive about last look. But again, I would remind you that the Code is principles-based. It is not regulation. Another area of debate was around the word ‘promptly’. Neill Penney, the co-vice chair of the GFXC, makes the point that the use of the word ‘immediate’ could be interpreted by the market as the GFXC indicating that all liquidity providers needed to upgrade their technology to move to a zero hold time. That’s not an outcome we are after. The disclosure cover sheets ask about the length of last look window. Because the technology has not yet been invented to run processes without taking any time at all, requiring that length to be zero would ban last look. Some people in the market use the term ‘hold time’ to mean length of last look window. In that sense a non-zero hold time is clearly consistent with the Code. Decisions should be prompt and may well be within small fractions of a second in many cases, but cannot truly be immediate. Others use hold time or additional hold time to mean a deliberate delay before starting the price and validity check. Such a delay is not consistent with the code; the guidance paper makes clear LPs should apply the price and validity check without delay. Because of the inconsistent use of hold time, the guidance paper and cover sheets have deliberately avoided relying on market participants having a single definition of it. If someone in the market talks to you about hold time, ask them to confirm what they mean before replying. Moreover, trying to define a time period doesn’t work because it’s going to differ in different circumstances, in different markets, with different latencies and different systems, so I don’t see 4/6 BIS central bankers' speeches that as feasible. At some level, this is semantics, but the combination of promptly and without delay, makes the intent clear in my view. As I mentioned, alongside the paper, the GFXC published standardised disclosure cover sheets for liquidity providers which includes a section on last look practices. The intent is to provide a standard form so that liquidity consumers can more easily compare and contrast the offerings from LPs. Liquidity providers adhering to these principles and providing transparency about their practices though the disclosure cover sheets should help to give their clients greater clarity about the process. Liquidity consumers should then use this information to evaluate their execution, ask questions of their liquidity provider’s last look process, and evaluate whether to trade with liquidity providers that are using last look. Finally, there is clearly continuing debate in the industry about the application of last look. The GFXC intends to continue to monitor the application of last look and the effect of the guidance paper, and take additional action if necessary. This may include providing further guidance going forward, potentially via updates to Principle 17. Statement of Commitments Almost 1,100 entities globally have signalled their adherence to the Code’s principles by signing a Statement of Commitment. With the publication of the updated Code, the GFXC is encouraging market participants to consider renewing their Statements of Commitment, having regard to the nature and relevance of the updates to their FX market activities. The GFXC acknowledges that the changes to the Code will affect certain parts of the market more than others. For those most affected by the changes, we would anticipate a period of up to 12 months for practices to be brought into alignment with the updated principles. We would expect that the disclosure cover sheets would be posted alongside the Statement of Commitments on a similar timeframe, if not sooner. Conclusion To conclude, the GXFC has completed the three-year review of the FX Global Code. The Code has been updated to remain current with the ongoing evolution of the FX market. It will continue to serve its important role of setting the standard for good practice. But to do so, it requires that you as market participants continue to reflect the principles of the Code in your activities in the FX market. I would strongly encourage you to familiarise yourself with the changes to the Code, and particularly to make good use of the disclosure templates. In the end, we all have a strong common purpose in ensuring that the FX market continues to operate effectively and with integrity. 1 GFXC (2021), ‘GFXC Updates FX Global Code, Publishes New Templates for Disclosures and Guidance Paper on Pre-Hedging’, Press Release, 15 July. Available at <www.globalfxc.org/press/p210715.htm>. 2 GFXC (2020), ‘GFXC Survey <www.globalfxc.org/docs/gfxc_survey_results_Jan20.pdf>. Results’, January. Available at 3 GFXC (2019), ‘GFXC Priorities for the 3-Year Review of the FX Global Code’, 6 November. Available at <www.globalfxc.org/events/20191204_summary_3_year_review_feedback.pdf>. 4 Schrimpf A and Sushko V (2019), ‘Sizing Up Global Foreign Exchange Markets’, BIS Quarterly Bulletin, December, pp 21–38. Available at <www.bis.org/publ/qtrpdf/r_qt1912f.htm>. 5/6 BIS central bankers' speeches 5 For more on algo trading, see BIS (2018), ‘Monitoring of Fast-Paced Electronic Markets’, report submitted by a Study Group established by the Markets Committee, September. Available at <www.bis.org/publ/mktc10.pdf>. 6 Hauser A (2019), ‘Run Lola Run! The Good, the Bad and the Ugly of FX Market Fragmentation – and What To Do About It’, Speech at TradeTech FX 2019, Barcelona, 13 September. Available <www.bankofengland.co.uk/speech/2019/andrew-hauser-panellist-at-trade-tech-fx-europe-barcelona>. 6/6 at BIS central bankers' speeches | reserve bank of australia | 2,021 | 9 |
Speech by Mr Guy Debelle, Deputy Governor of the Reserve Bank of Australia, at the ASIFMA (Asia Securities Industry & Financial Markets Association) Compliance Week 2021, Virtual Conference, 9 September 2021. | 9/10/21, 4:13 PM Priorities of EMEAP and Update on Global FX Code of Conduct | Speeches | RBA Speech Priorities of EMEAP and Update on Global FX Code of Conduct Guy Debelle Deputy Governor ASIFMA Compliance Week 2021 Virtual Conference – 9 September 2021 Thank you for giving me the opportunity to summarise the current focus areas of EMEAP. [ 1] I will also take the opportunity to talk about the recent update to the FX Global Code, in my capacity as Chair of the Global Foreign Exchange Committee (GFXC). Two focus areas of EMEAP are sustainable finance and fintech. Collectively as well as individually, the central banks of EMEAP are doing a lot of work in both of these spaces. Sustainable finance The central banks of EMEAP have been increasing their focus on sustainable finance for some time now. We are now all members of the Network for Greening the Financial System (NGFS). [ 2] A number of us have contributed to the output of the NGFS. Our work in sustainable finance has a number of elements: Conducting climate risk assessments. Increasingly, we are all integrating climate risk into our supervisory activities. In that regard, we are embarking on climate vulnerability assessments of the financial system using scenarios based on the NGFS scenarios. At our recent meetings we have shared insights from our experiences in developing and implementing climate risk stress tests and scenario analyses for banks, and discussed the challenges they pose. Taxonomies. There is a need to develop taxonomies that are appropriate to the various circumstances facing our economies, rather than having one being imposed that does not take into account the particular challenges facing economies in the EMEAP region. In particular, we are discussing the development of a transition taxonomy or taxonomies for https://www.rba.gov.au/speeches/2021/sp-dg-2021-09-09.html 1/5 9/10/21, 4:13 PM Priorities of EMEAP and Update on Global FX Code of Conduct | Speeches | RBA economies in the region, as it is necessary to not just invest in things that are currently ‘green’, but also to direct financing in a way that supports the transition to a sustainable future. Developing green finance. How we can facilitate the further development of green finance is one of the other main priorities of our sustainable finance agenda. As a start, EMEAP members have agreed to promote investment in green bonds through the Asian Bond Fund, such as revising the bond index rules. A common issue we have encountered in our work is the lack of data. This is being addressed at the global level by the International Monetary Fund (IMF) and the NGFS. Another issue is that stress testing and scenario analysis can be methodologically difficult because of the long time horizons associated with climate risks. But at the same time, climate change is having near-term implications in a number of our economies. While these exercises are challenging, we all agree that there is benefit in conducting them. It is important that the perfect doesn't get in the way of the good. Fintech EMEAP has been discussing a number of different aspects of Fintech in our recent meetings. One particular area of focus has been in cross-border payments. Many EMEAP members have initiatives underway to improve cross-border payments, including collaborations with other EMEAP members. We have been discussing how EMEAP could best contribute to the G20 roadmap on enhancing cross-border payments. While traditional services for cross-border payments have been costly, slow and non-transparent, we are seeing the emergence of some new technology-enabled providers of cross-border payments, which are bringing much needed innovation and competition to this market. But there are still some key challenges to improving cross-border payments. These include: (i) systems integration difficulties where countries are at very different stages of payments system development, and (ii) the cost of meeting regulatory compliance requirements, for example those relating to anti-money laundering and counter-terrorism financing (AML/CTF), as rules can vary greatly between payment originating and receiving jurisdictions. The latter is a particular issue when it comes to remittances. This poses challenges to some EMEAP economies and particularly some smaller nations in the Pacific area. We are working individually and collectively to try to address this challenging situation. One other noteworthy development is that several EMEAP members are collaborating with the Bank for International Settlements (BIS) Innovation Hub and each other to develop bilateral and multilateral linking of real-time retail payments systems. This will reduce the reliance on existing cross-border banking arrangements. There are a number of examples of this: Project Nexus provides a blueprint for scalable connectivity of countries' domestic fast payment systems, which will make cross-border payments faster, cheaper, easier to access and more transparent. [ 3] https://www.rba.gov.au/speeches/2021/sp-dg-2021-09-09.html 2/5 9/10/21, 4:13 PM Priorities of EMEAP and Update on Global FX Code of Conduct | Speeches | RBA The linkage of Singapore's PayNow and Thailand's PromptPay real-time retail payment systems. [ 4] Project Dunbar, which involves the RBA, Bank Negara Malaysia, the Monetary Authority of Singapore, the South African Reserve Bank and the BIS Innovation Hub. Project Dunbar will develop prototypes of a common multilateral settlement platform that will enable international settlements with digital currencies issued by multiple central banks (as opposed to reliance on existing payment systems). [ 5] FX Global Code The FX Global Code was launched in May 2017. The Code set out global principles of good practice in the FX market to provide a common set of guidance to the market. The 55 principles in the Code cover ethics, information sharing, aspects of execution including e-trading and platforms, prime brokerage, governance, risk management and compliance, and confirmation and settlement. The Code is maintained by the Global Foreign Exchange Committee (GFXC) which I currently chair. The GFXC consists of the various Foreign Exchange Committees (FXCs) across the globe. It comprises all the top FX markets by turnover, both advanced and emerging markets. The members of the GFXC are both central banks and market participants drawn from all parts of the markets: from the buy side, including corporates and asset managers, and the sell side, along with trading platforms, ECNs and non-bank participants. When we launched the Code, it was agreed that the Code would be reviewed by the GFXC every three years to ensure it remained appropriate and to also ensure it stayed current with the ongoing evolution of the FX market. Hence, around two years ago, the GFXC surveyed market participants to assess what areas of the Code needed to be reviewed. [ 6] The primary response of market participants was that the Code remained fit for purpose and changes should only be made as necessary. The GFXC identified a few key areas requiring review to ensure that the Code continues to provide appropriate guidance and contributes to an effectively functioning market, and remains in step with the evolution of the market. [ 7] Over the past 18 months, various working groups of the GFXC, drawing on a diverse group of market participants and central banks, have been working on the review. The proposed updates to the Code have been through a number of rounds of feedback with market participants through the FXCs round the world, as well as a public feedback process. Following this process of review and consultation with industry, the GFXC has published the updated version of the Code. [ 8] The July 2021 version of the Code replaces the earlier, August 2018 version. [ 9] In total, 11 of the Code's 55 principles have been amended. The GFXC has also developed disclosure cover sheets and templates for algo due diligence and transaction cost analysis (TCA) to assist market participants in meeting the Code's principles for disclosure and transparency. Additionally, the GFXC has published guidance papers on the practices https://www.rba.gov.au/speeches/2021/sp-dg-2021-09-09.html 3/5 9/10/21, 4:13 PM Priorities of EMEAP and Update on Global FX Code of Conduct | Speeches | RBA of Pre-Hedging and Last Look to support market participants in applying the Code's principles in these areas. Almost 1,100 entities globally have signalled their adherence to the Code's principles by signing a Statement of Commitment. With the publication of the updated Code, the GFXC is encouraging market participants to consider renewing their Statements of Commitment, having regard to the nature and relevance of the updates to their FX market activities. The GFXC acknowledges that the changes to the Code will affect certain parts of the market more than others. For those most affected by the changes, we would anticipate a period of up to 12 months for practices to be brought into alignment with the updated principles. We would expect that the disclosure cover sheets would be posted alongside the Statement of Commitments on a similar timeframe, if not sooner. To conclude, the GXFC has completed the three-year review of the FX Global Code. The Code has been updated to remain current with the ongoing evolution of the FX market. It will continue to serve its important role of setting the standard for good practice. But to do so, it requires that you as market participants continue to reflect the principles of the Code in your activities in the FX market. I would strongly encourage you to familiarise yourself with the changes to the Code, and particularly to make good use of the disclosure templates. Endnotes Executives' Meeting of East Asia-Pacific Central Banks. EMEAP is a co-operative forum of 11 central banks and monetary authorities in the East Asia and Pacific region comprising the Reserve Bank of Australia, the People's Bank of China, the Hong Kong Monetary Authority, Bank Indonesia, the Bank of Japan, the Bank of Korea, Bank Negara Malaysia, the Reserve Bank of New Zealand, Bangko Sentral ng Pilipinas, the Monetary Authority of Singapore and the Bank of Thailand. <https://www.ngfs.net/en> Monetary Authority of Singapore (2021), ‘BIS Innovation Hub and Monetary Authority of Singapore publish proposal for enhancing global real time retail payments network connectivity’, Media Release, 28 July. Available at <https://www.mas.gov.sg/news/media-releases/2021/bisih-and-mas-publish-proposal-for-enhancing-global-realtime-retail-payments-network-connectivity>. See also <https://nexus.bisih.org/>. Monetary Authority of Singapore (2021), ‘Singapore and Thailand Launch World's First Linkage of Real-time Payment Systems’, Media Release, 29 April. Available at <https://www.mas.gov.sg/news/mediareleases/2021/singapore-and-thailand-launch-worlds-first-linkage-of-real-time-payment-systems> Bank of International Settlements (2021), ‘BIS Innovation Hub and central banks of Australia, Malaysia, Singapore and South Africa will test CBDCs for international settlements’, Press Release, 2 September, available at <https://www.bis.org/press/p210902.htm> and Reserve Bank of Australia (2021), ‘BIS Innovation Hub and central banks of Australia, Malaysia, Singapore and South Africa will test CBDCs for international settlements’, Media Release 2021-18, 2 September. GFXC (2020), ‘GFXC 2019 Survey Results’, January. Available at <https://www.globalfxc.org/docs/gfxc_survey_results_Jan20.pdf>. https://www.rba.gov.au/speeches/2021/sp-dg-2021-09-09.html 4/5 9/10/21, 4:13 PM Priorities of EMEAP and Update on Global FX Code of Conduct | Speeches | RBA GFXC (2019), ‘GFXC Priorities for the 3-Year Review of the FX Global Code’, 6 November. Available at <https://www.globalfxc.org/events/20191204_summary_3_year_review_feedback.pdf>. Global Foreign Exchange Committee (2021), ‘GFXC updates FX Global Code, publishes new templates for disclosures and guidance paper on Pre-hedging’ Press Release, 15 July. Available at <https://www.globalfxc.org/press/p210715.htm> Global Foreign Exchange Committee (2021), ‘FX Global Code’. Available at <https://www.globalfxc.org/docs/fx_global.pdf> The materials on this webpage are subject to copyright and their use is subject to the terms and conditions set out in the Copyright and Disclaimer Notice. © Reserve Bank of Australia, 2001–2021. All rights reserved. The Reserve Bank of Australia acknowledges the Aboriginal and Torres Strait Islander Peoples of Australia as the Traditional Custodians of this land, and recognises their continuing connection to Country. We pay our respects to their Elders, past, present and emerging. https://www.rba.gov.au/speeches/2021/sp-dg-2021-09-09.html 5/5 | reserve bank of australia | 2,021 | 9 |
Address by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to the Anika Foundation, online, 14 September 2021. | 9/14/21, 1:55 PM Delta, the Economy and Monetary Policy | Speeches | RBA Speech Delta, the Economy and Monetary Policy Philip Lowe [ * ] Governor Address to the Anika Foundation Online – 14 September 2021 Thank you for joining us today to support the Anika Foundation. This afternoon, I would like to talk about the implications of the pandemic for the economy and for monetary policy. But before I do that, I want to acknowledge the impact of the pandemic on young people. The past 18 months have been very difficult for young Australians. Their support networks have been disrupted, leaving many young people feeling isolated and anxious about the future. Many have also missed out on events that would normally frame their lives, such as celebrating achievements with their peers. Their education has also been disrupted and, for many, it has been harder to get that valuable support that a one-on-one connection with a teacher can provide. So, our young people are paying a heavy price. This is evident in the increasing incidence of mental health issues and the sharp rise in calls to support services. It is important that we remember this high price when we conduct a full accounting of the costs of the pandemic and the containment measures. It is in this context that I want to thank you again for your support of the Anika Foundation. The Foundation is doing important work in supporting the welfare and mental health of young people. Thank you for being part of that work. I would now like to turn to the economy and then monetary policy. The economic outlook On the economy, our central message is that the Delta outbreak has delayed – but not derailed – the recovery of the Australian economy. The outbreak is a significant setback for the economy and it has introduced an additional element of uncertainty about the future. But there is a clear path out of the current difficulties and it is likely that we will return to a stronger economy next year. https://www.rba.gov.au/speeches/2021/sp-gov-2021-09-14.html 1/14 9/14/21, 1:55 PM Delta, the Economy and Monetary Policy | Speeches | RBA Prior to the Delta outbreak, the Australian economy had considerable positive momentum. Domestic final demand increased by 1.7 per cent in the June quarter to be more than 3 per cent above its prepandemic level. GDP was 0.7 per cent higher in the June quarter and nearly 10 per cent higher over the year (Graph 1). Graph 1 GDP Growth % % Year-ended Quarterly -4 -4 -8 -8 Source: ABS It was in the labour market, though, where the positive momentum was most evident. In June, the employment-to-population ratio reached a record high of 63 per cent and the unemployment rate fell to 4.9 per cent, the lowest it had been in more than a decade (Graph 2). The number of job vacancies had also reached a record high in May and there were increasing reports of labour shortages across the country. So things were looking pretty positive and, at the Reserve Bank, we were contemplating a further upward revision to our economic forecasts. https://www.rba.gov.au/speeches/2021/sp-gov-2021-09-14.html 2/14 9/14/21, 1:55 PM Delta, the Economy and Monetary Policy | Speeches | RBA Graph 2 Employment-to-population Ratio Seasonally adjusted, monthly % % Source: ABS But then Delta hit. The result is that the economy will now contract significantly in the September quarter. Domestic demand will contract sharply in the quarter, although stronger exports are expected to support the GDP figures. Our rough rule of thumb is that household consumption is around 15 per cent lower during a lockdown than would otherwise be the case. In addition, there have been disruptions to the construction sector and some investment plans have been delayed. The exact magnitude of the economic contraction in the September quarter remains to be determined but it is likely to be at least 2 per cent, and possibly significantly larger than this. This is a major setback, but it is likely to be only temporary. We expect the economy to be growing again in the December quarter, with the recovery continuing into 2022. The key drivers here are the increasing rate of vaccination and the easing of restrictions on economic activity. Australia has made significant progress on the vaccination front over the past month and further progress is expected over the weeks ahead. In the past couple of weeks, around 1¼ per cent of the population has been vaccinated each day, which is at the higher end of international experience. As a result, more than two-thirds of the eligible population has now had a single vaccination and more than 40 per cent are double vaccinated (Graph 3). https://www.rba.gov.au/speeches/2021/sp-gov-2021-09-14.html 3/14 9/14/21, 1:55 PM Delta, the Economy and Monetary Policy | Speeches | RBA Graph 3 COVID-19 Vaccinations* Share of eligible population % Cumulative % Daily 1.5 1.0 First dose 0.5 Second dose F M A M J J A S F M A M J J A S 0.0 * Seven-day moving average Sources: covid19data.com.au; Department of Health; RBA Governments have indicated that, as these figures continue to increase, restrictions on activity will be eased. When this happens, we can be confident that economic activity will begin to bounce back. While it is hard to be precise about the pace and timing of this bounce-back, in the RBA's central scenario, economic activity is expected to be back on its pre-Delta track by the second half of next year. One of the uncertainties here is the possibility of further significant restrictions on activity. These could come in response to new outbreaks of Delta, the emergence of a new strain of COVID-19 or a decline in the potency of the current vaccines. These possibilities represent the main downside risks to the economy. Another source of uncertainty is how Australians will respond to the easing of restrictions, given that the easing is likely to take place with COVID-19 still circulating in the community. This is quite different from our earlier experience, when the number of cases was close to zero, and there was a very quick bounce-back. Whether the same will be the case this time remains to be seen. Much will depend upon our attitude to risk and how our society deals with the ongoing rate of infection. The experience overseas, though, provides an encouraging reference point. This experience suggests that having COVID-19 circulating in the community does not prevent a quick bounce back in spending, provided the population is highly vaccinated. Most people are keen to do the things they https://www.rba.gov.au/speeches/2021/sp-gov-2021-09-14.html 4/14 9/14/21, 1:55 PM Delta, the Economy and Monetary Policy | Speeches | RBA used to and they will spend if they have the opportunity and the income. My expectation is that the same will be true here, although we still can't be sure exactly what living with COVID-19 will look like in Australia. Another factor underpinning the view that the economy will bounce back is the substantial income support being provided by the Australian Government and by the states and territories. While this support is different to that provided earlier, for many individuals the value of that support is similar to that provided earlier. So with consumption restricted by the lockdown, it is likely that the aggregate household saving rate will increase again in the September quarter (Graph 4). While the increase won't be as large as that of last year, it will mean that many people have more money in the bank than they did pre-Delta. Graph 4 Household Net Saving Rate* Quarterly % % -5 -5 * Estimate for the September quarter 2021 Sources: ABS; RBA It is also relevant that broader measures of household wealth have increased recently (Graph 5). Housing prices are 19 per cent higher than they were before the pandemic and Australian equity prices are around 10 per cent higher. This lift in the net wealth of the household sector is one of the things that suggest that once the restrictions are eased, households will be well placed to start spending again. https://www.rba.gov.au/speeches/2021/sp-gov-2021-09-14.html 5/14 9/14/21, 1:55 PM Delta, the Economy and Monetary Policy | Speeches | RBA Graph 5 Real Household Net Wealth* Year-ended growth with contributions % % Financial assets Consumer durables Dwellings Liabilities -10 -10 Total -20 -20 * Includes estimates for June and September quarters 2021 Sources: ABS; RBA For businesses, it is a mixed picture. Many of the businesses we talk to are expecting an easing of restrictions later this year. They also remember that the labour market was tightening just a few months ago and are alive to the possibility that this could be again the case next year. This possibility is creating a strong incentive to keep in close contact with employees; it doesn't make much sense to let workers go, only to have trouble hiring when restrictions are eased. Many large firms also have balance sheets that are in good shape and they have expansion plans based on the expected easing of restrictions. Business investment was on an upswing pre-Delta, and it is reasonable to expect that we will return to this as restrictions are eased, demand picks up again and uncertainty starts to recede. At the same time, many small and medium-sized businesses are facing very difficult conditions. Many are in ‘wait, survive and see’ mode, having experienced a large drop in revenue. Government assistance is helping, but the longer they have to wait before reopening, the more difficult things will become and the greater the potential damage to this important part of the economy. For some businesses, there is a limit to how long they can wait. So the sooner we can open safely the better. I would like to turn to the labour market, where the numbers are going to be difficult to interpret over coming months. Hours worked, rather than headcount, are likely to be the better guide, because the lockdowns have meant that many people are working reduced or zero hours. https://www.rba.gov.au/speeches/2021/sp-gov-2021-09-14.html 6/14 9/14/21, 1:55 PM Delta, the Economy and Monetary Policy | Speeches | RBA The data for the unemployment rate will be especially difficult to interpret. When people are stood down for more than 4 weeks without being paid by their employer, they are counted as either unemployed (if they are actively searching, and available for, other work) or not in the labour force. This is the case even when they still have an attachment to their employer and can return to their jobs when the lockdowns end. This is different from the JobKeeper period, when government support was paid via firms' payrolls and many employees on zero hours for extended periods were classified as employed. Nationwide, hours worked fell by 0.2 per cent in July, with a large decline in New South Wales offset by increases in other states, including Victoria, where lockdowns were briefly lifted (Graph 6). At the same time, overall employment was broadly steady. Looking ahead, total hours worked are expected to decline by 3–4 per cent in the September quarter. There is uncertainty about the unemployment rate for the reasons I just spoke about, but it would not be surprising to see readings in the high fives for a short period of time. Graph 6 Hours Worked January 2020 = 100, monthly index index Rest of Australia New South Wales Victoria J F M A M J J A S O N D J F M A M J J Sources: ABS; RBA It is a positive sign that forward-looking indicators of labour demand have held up well. The number of job advertisements fell only a little in July and August, especially in New South Wales, and are still at high levels. The decline so far has been modest compared with the decline of around 60 per cent during the 2020 lockdown (Graph 7). https://www.rba.gov.au/speeches/2021/sp-gov-2021-09-14.html 7/14 9/14/21, 1:55 PM Delta, the Economy and Monetary Policy | Speeches | RBA Graph 7 Job Advertisements Per cent of labour force % % National Skills Commission 1.5 1.5 1.0 1.0 ANZ 0.5 0.0 0.5 0.0 Sources: ABS; ANZ; National Skills Commission; RBA The experience differs considerably across industries. Hospitality, for example, has seen a similar decline in job advertisements to last year, although from a higher level (Graph 8). Meanwhile, the hiring markets for engineers, health workers and IT professionals have not been particularly affected. In the RBA's business liaison program we hear reports that firms are thinking twice before laying off staff. They recall the strong labour demand before the lockdowns and many have an expectation that activity will recover strongly when lockdowns end. But as I said earlier, this depends upon the easing of restrictions. https://www.rba.gov.au/speeches/2021/sp-gov-2021-09-14.html 8/14 9/14/21, 1:55 PM Delta, the Economy and Monetary Policy | Speeches | RBA Graph 8 Job Advertisements by Occupation* December 2019 = 100 index index Hospitality & food services Construction Professionals & administrative** Healthcare Other occupations M * ** J S D M J S D M J S Occupation groupings using two-digit ANZSCO level Includes managers, professional, clerical and administrative workers; excludes health and medical professionals Sources: National Skills Commission; RBA Monetary policy I would now like to turn to monetary policy, where I will focus my remarks on our bond purchase program and the outlook for the cash rate. First, though, I want to emphasise that the RBA's package of monetary policy measures is providing ongoing and important support to the Australian economy as it deals with the Delta outbreak. This package includes: a record low cash rate a target of 10 basis points for the April 2024 Australian Government bond a bond purchase program under which we have already purchased $200 billion of government bonds, with more to come; and the low-cost term funding facility for Australia's banks, under which $188 billion has been provided for 3 years. https://www.rba.gov.au/speeches/2021/sp-gov-2021-09-14.html 9/14 9/14/21, 1:55 PM Delta, the Economy and Monetary Policy | Speeches | RBA This monetary policy package is working by: keeping funding costs and lending rates low across the economy; ensuring that the financial system is very liquid; supporting household and business balance sheets; and contributing to an exchange rate that is lower than it would be otherwise. It is through these transmission mechanisms that our policies are supporting, and will continue to support, the recovery of the Australian economy over the months ahead. At the Reserve Bank Board meeting last week, we considered how the bond purchase program should evolve in response to the Delta outbreak and the change to the economic outlook. The conclusion was that we will purchase $4 billion of bonds each week, as previously announced, but that we will extend the period over which we do this until at least mid February next year. This conclusion reflected a number of considerations. The first and foremost is the delay in the economic recovery and the associated increase in uncertainty about the future. Given that the recovery has been delayed, we considered it appropriate that we delay any consideration of a further taper in our bond purchases until next year. By February we will know more about how the economy is responding to the easing of restrictions than we will know in November. We also took account of the fact that the delayed recovery means that it will take longer to achieve our inflation goals. Continuing with the bond purchases at the announced rate for a longer period will also provide some additional insurance against downside scenarios. A second consideration the Board discussed was the appropriate roles of monetary policy and fiscal policy in response to the nature of the shock we are experiencing. This shock is largely the result of government efforts to contain the movement of people and economic activity. It is also expected to be only temporary, given the expected easing of containment measures over coming months. Throughout the pandemic, the RBA has seen its role as being part of the national effort to build a bridge to the other side and make sure that the economy is well placed to rebound strongly when the time comes. As I discussed earlier, the package of policy measures introduced over the past year has helped build that bridge. Having already put that package in place, our assessment was that fiscal policy is the more effective policy instrument in responding to the Delta outbreak. This is because fiscal policy can use the public balance sheet to offset the hit to private incomes during the lockdowns. In contrast, monetary policy works mainly on the demand side and the effects on income are felt with a lag; realistically, there is little we can do to offset the hit to demand in the September and December quarters. This is the role of fiscal policy and indeed there has been a sizeable and welcome fiscal response. A third and related issue we considered was that by continuing to purchase government bonds at the rate of $4 billion a week we will be adding to the support provided to the economy during the recovery phase. The evidence suggests that the expected stock of central bank bond purchases matters more than how many bonds the central bank buys each week. By February, our cumulative purchases under the bond purchase program will have amounted to $275 billion. We will hold around 35 per cent of the Australian Government bonds on issue and 18 per cent of the state and territory bonds. The RBA's purchase program started later than that of most other central banks but recently https://www.rba.gov.au/speeches/2021/sp-gov-2021-09-14.html 10/14 9/14/21, 1:55 PM Delta, the Economy and Monetary Policy | Speeches | RBA has been expanding faster relative to the stock of bonds outstanding (Graph 9). This represents a substantial and ongoing degree of support to the economic recovery. Graph 9 Central Bank Government Bond Holdings* Per cent of eligible stock outstanding % % Japan Sweden UK Euro area** US Canada Australia NZ * ** Central government debt only for all countries except the euro area. Dashed lines represent forecasts based on announced purchase programs, recent pace of purchases, or market expectations in the case of US and Canada Holdings data for euro area only include bonds held as part of asset purchase programs; holdings for other central banks also include bonds held for operational or liquidity purposes Sources: Central banks; debt management offices; RBA; Refinitiv I would now like to turn to the more traditional part of our monetary policy package – that is, the setting of the cash rate. As I have discussed on previous occasions, 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. We want to see actual results, not forecasted results, before we lift the cash rate. Once we do see these results, forecasts of inflation will again have a role to play. But we have to get there first. In particular, 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 https://www.rba.gov.au/speeches/2021/sp-gov-2021-09-14.html 11/14 9/14/21, 1:55 PM Delta, the Economy and Monetary Policy | Speeches | RBA 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. Meeting this condition will require a tighter labour market than we have now. Our assessment is that wages will need to be growing by at least 3 per cent. We remain well short of this. Even in industries where there has been strong demand for labour, wage increases remain mostly modest. This assessment was confirmed by the latest reading of the Wage Price Index, which showed an increase of just 1.7 per cent over the year to the June quarter, with wages growth slower than this in the public sector (Graph 10). Graph 10 Wage Price Index Growth % Private sector % Public sector Year-ended Quarterly Source: ABS Our judgement is that it will take some time for wage increases to lift to a rate that is consistent with achieving the inflation target. There is a lot of inertia in the wage-setting process and the experience of the past decade is unlikely to be reversed quickly. This inertia comes from among other things: multi-year employment contracts; a strong cost-control mindset of Australian business; and low and stable inflation expectations. This judgement stands in contrast to the expected path of the cash rate implied by market pricing (Graph 11). The current OIS curve implies a cash rate of around 25 basis points by end of 2022, 60 basis points at the end of 2023 and close to 100 basis points at the end of 2024. These expectations are difficult to reconcile 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. While policy rates might be increased in other countries over this timeframe, our wage and inflation experience is quite different. https://www.rba.gov.au/speeches/2021/sp-gov-2021-09-14.html 12/14 9/14/21, 1:55 PM Delta, the Economy and Monetary Policy | Speeches | RBA Graph 11 Cash Market Rates % % Cash rate Corridor floor Implied cash rate – OIS Cash rate target 1.0 1.0 0.5 0.5 0.0 0.0 Sources: Bloomberg; RBA Finally, I would like to address the question of housing prices, as some analysts have suggested we might lift the cash rate to cool the property market. I want to be clear that this is not on our agenda. While it is true that higher interest rates would, all else equal, see lower housing prices, they would also mean fewer jobs and lower wages growth. This is a poor trade-off in the current circumstances. That is not to say that there aren't public policy issues to be addressed here. On the financial side, the issue is the sustainability of trends in household borrowing. We are continuing to watch this closely, with the Council of Financial Regulators discussing possible regulatory steps if lending standards deteriorate or credit growth accelerates too much. More broadly, society-wide concerns about the level of housing prices are not best addressed through increasing interest rates and curbs on lending. While monetary policy is contributing to higher housing prices at the moment, the way to address these concerns is through the structural factors that influence the value of the land upon which our dwellings are built. The factors include: the design of our taxation and social security systems; planning and zoning restrictions; the type of dwellings that are built; and the nature of our transportation networks. These are all obviously areas outside the domain of monetary policy and the central bank. Our job is to achieve the inflation target and support the return to full employment in Australia. The package of policy measures we have put in place has us on a path to do that. Delta is delaying progress, but it is not expected to derail our resilient economy. Thank you for listening and supporting the Anika Foundation. I am happy to answer your questions. https://www.rba.gov.au/speeches/2021/sp-gov-2021-09-14.html 13/14 9/14/21, 1:55 PM Delta, the Economy and Monetary Policy | Speeches | RBA Endnotes [*] I would like to thank Penny Smith for assistance in preparing this talk. The materials on this webpage are subject to copyright and their use is subject to the terms and conditions set out in the Copyright and Disclaimer Notice. © Reserve Bank of Australia, 2001–2021. All rights reserved. The Reserve Bank of Australia acknowledges the Aboriginal and Torres Strait Islander Peoples of Australia as the Traditional Custodians of this land, and recognises their continuing connection to Country. We pay our respects to their Elders, past, present and emerging. https://www.rba.gov.au/speeches/2021/sp-gov-2021-09-14.html 14/14 | reserve bank of australia | 2,021 | 9 |
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Panel remarks by Mr Philip Lowe, Governor of the Reserve Bank of Australia, at the Conference on Central Bank Independence, Mandates and Policies, organized by the University of Chile, Webinar, 22 October 2021. | Philip Lowe: Panel remarks – Conference on “Central Bank independence, mandates and policies” Panel remarks by Mr Philip Lowe, Governor of the Reserve Bank of Australia, at the Conference on Central Bank Independence, Mandates and Policies, organized by the University of Chile, Webinar, 22 October 2021. * * * Thank you for your invitation to participate in this conference. You are addressing important issues and I appreciate the opportunity to share Australia’s experience with you. At the outset, I want to acknowledge that there is no single right answer to the issues that are being discussed in this session: central bank mandates, the appropriate policy tools and coordination arrangements with the government. Ultimately, what matters are results. The evidence shows that the probability of a country achieving good results is enhanced by getting the structure right. This structure includes: the legal mandate of the central bank; the mechanisms for accountability; the way the political system works; and the process for appointing individuals to the central bank. The most effective combination of these elements will vary from country to country. In Australia’s case, the key elements of the central bank mandate were passed into law in 1959 and have remained unchanged since. The 1959 legislation set out three objectives for the RBA’s monetary policy:1 1. the stability of the currency (widely interpreted as low and stable inflation) 2. full employment 3. the economic welfare and prosperity of the Australian people. Under this legislation, we have had many different monetary policy regimes: a fixed exchange rate against the US dollar; a fixed exchange rate against the trade-weighted index (TW I); an adjustable peg against the TW I; monetary targeting; and, since the early 1990s, flexible inflation targeting. This experience illustrates that legislation is only part of the story, with our broad legislation accommodating a wide variety of monetary policy regimes. In Australia, the choice of exchange rate regime is one that is made by the government. In my view, this is as it should be, as this choice has wide-ranging implications for how a country’s economic system works. In our case, the decision by the government to float the Australian dollar in 1983 helped reshape the economy in a positive fashion. The floating exchange rate has also proven to be a great stabiliser of the economy, particularly in the face of large swings in Australia’s terms of trade caused by movements in commodity prices. While the Australian Government determines the exchange rate regime, it is the RBA that makes decisions about intervention in the market. We rarely intervene and are transparent regarding the conditions under which we would do so. In particular, we only intervene if: (i) market liquidity has significantly deteriorated during a period of stress; or (ii) the exchange rate has moved a long way from fundamentals, with damaging consequences for the overall economy. The last time the RBA intervened in the foreign exchange market was during the global financial crisis, more than 13 years ago. So intervention is very unusual. We do not have an objective for the exchange rate, nor would it make sense to do so. In my view, adding an exchange rate objective to the central bank’s other objectives would severely compromise the achievement of those other objectives and produce, on average, poorer results. 1/4 BIS central bankers' speeches Turning now to the inflation objective, Australia was an early adopter of flexible medium-term inflation targeting. From the outset, our target has been for CPI inflation to average between 2 and 3 per cent over time. We have focused on the medium term rather than the outcome in a particular year or over a specific forecast horizon. We never bought into the idea that the central bank needed to be placed into a straightjacket or surrounded by an electric fence to stop it from exploiting the short-run Phillips Curve. We have always had a flexible approach that allows for some variation in inflation from year to year. While financial markets are often concerned about whether inflation in a given year is 1.7 or 2.3 per cent, most people in the real economy rightly don’t focus too much on this. What matters for overall welfare is that people are confident that their savings and their income will not be eaten away by inflation. It is also important that saving and investment decisions can be made without inflation figuring prominently on people’s radar screens. There are various ways of achieving this, but we have found a flexible medium-term inflation target works well. In terms of the formalities, Australia’s inflation target is not set out in legislation. It was originally set by the central bank, but soon after was codified in a written agreement between the central bank and the government.2 This agreement is reviewed whenever there is a change of government or central bank governor. Over the 25 years since the first agreement was signed, the language has evolved considerably but the numerical target of 2 to 3 per cent has been maintained and so too has the focus on the medium term. From my perspective, this arrangement has a couple of advantages. First, it enhances the credibility of the monetary regime, as it demonstrates that the inflation target is owned by both the government and the central bank. Second, it offers a degree of flexibility, as the target is not set in stone. The target and the accompanying language can be changed if both the central bank and the government agree. The other elements of the RBA’s mandate are full employment and the economic prosperity of the people of Australia. In terms of full employment, we do not have a numerical target and I don’t think it makes sense to do so. Experience has taught us that the non-accelerating inflation rate of unemployment (NAIRU) moves over time and is influenced by many factors outside the control of the central bank. The same could be said for the estimate of the employment-to-population ratio that is consistent with full employment and stable inflation. Setting the wrong targets would create a conflict with the inflation target, which would lead to policy uncertainty and poor outcomes. Despite the difficulty of setting a numerical target here, I am a strong supporter of the RBA’s broad mandate, which includes not just full employment but also the economic welfare of the Australian people. I say this from two perspectives. The first relates to communication. I see a benefit in the central bank being able to communicate that it cares about more than just inflation control. To be clear, inflation control is, and always needs to be, core to what a central bank does. But ultimately, inflation control is only a means to an end; and that end is a productive economy, with people enjoying economic and financial stability, having jobs and achieving a high level of economic welfare. Having a broad mandate allows the central bank to pursue and articulate its goals in these broader terms. This can help build trust in the central bank and support public confidence in its decisions. That is not to say that a broad mandate is required for the central bank to speak in these terms, but I think it makes it easier to do so. The second perspective is that a broad mandate can provide an extra degree of freedom in 2/4 BIS central bankers' speeches responding to economic shocks. This is especially so in the case of supply shocks, where output and inflation move in different directions. A broad mandate allows the central bank more time to return inflation to target following shocks that push inflation below or above the target. Provided the inflation target is credible, this flexibility can be used in a way that does not prejudice the achievement of medium-term price stability. Importantly, this flexibility can help reduce the amplitude of cycles in activity and employment. It can also have the benefit of reducing financial stability risks, especially if cutting interest rates in response to a positive supply shock and lower inflation encourages excessive borrowing and asset overvaluation. Again, I want to make it clear that the central bank does not need a broad mandate to have this flexibility. It is possible that a central bank with only an inflation mandate would achieve the same results, especially if it has a flexible, rather than rigid, inflation target. The other topic of this session is the coordination arrangements with government. I have already spoken about the agreement on the inflation target, so I would like to touch on four other aspects of the relationship between the central bank and the government. First, the government appoints all the members of the Reserve Bank Board (which is the decision-making body for monetary policy). The Governor has a term of seven years and often serves a longer term. Other Board members are appointed for at least five years and often serve multiple terms. Besides the Governor and the Deputy Governor, all members of the Board are external and are prominent members of the business, academic or policy communities. The Secretary to the Australian Treasury (who is the most senior public servant in the Treasury Department) is also a full voting member of the Board. The Secretary participates as an economist in their own right, not as a representative of the government, but is able to share details of the government’s fiscal and other plans. The Board is apolitical and there is not a tradition of Board members stepping down following a change of government. Board members (including the Governor) can have their appointments terminated only if they: become permanently incapacitated; become bankrupt; miss too many meetings; or fail to satisfy their obligations regarding the governance of a public sector entity. These termination provisions have never been used and are not a point of controversy. Second, there is a frequent exchange of views between the Governor and the Treasurer. This exchange is mostly on an informal basis, as circumstances require. The Treasurer does not attend meetings of the Board, nor has the right to do so. The government and the opposition support the independence of the RBA and when the government is asked about monetary policy, the typical response is that monetary policy is a matter for the independent Reserve Bank. Third, the RBA is the transactional banker for the Australian Government. In that role, it provides the government with a small overdraft facility that can be used only to deal with unexpected mismatches in the timing of government payments and receipts. While there is nothing in Australia’s central bank law that prevents lending to the government, there is a longstanding written agreement that the central bank will not provide such finance. Furthermore, the government has no role to play in decisions about the RBA’s bond purchase program. These decisions are taken independently by the RBA. Fourth, the Reserve Bank Act 1959 includes provisions for dealing with a situation in which there is a fundamental difference of opinion between the government and the central bank.3 In such a circumstance, the law states that the central bank is required to set out its position in writing. The government could then order the Bank to adopt a particular policy. If the government did this, it would then need to set out all the relevant documents before both Houses of Parliament within 15 sitting days. So there would be a high level of transparency about what was going on. I want to point out that these provisions have never been used. They effectively operate as a 3/4 BIS central bankers' speeches safeguard against the possibility of the independent central bank pursuing a policy that would be damaging to the national interest. In my view, there is a strong case for such a safeguard in a parliamentary democracy, especially one in which there is both a focus on institutions being accountable to the Parliament and a long tradition of political respect for policymaking institutions. Exercising this power would be a major political step and would draw strong interest from the media and financial markets, so it is not something that would be done lightly. At its core, the relationship between the government and the central bank in Australia is one based on constructive dialogue. This is reflected in the agreement regarding the inflation target that I spoke of earlier and the frequent discussions on issues of mutual interest. The government also supports a high level of transparency by the RBA, including through publications and speeches and public appearances before parliamentary oversight committees. I want to finish where I started: that there is no right answer to the questions that Chile is grappling with. But Australia’s experience is that the combination of a freely floating exchange rate, a flexible medium-term inflation target and a broad mandate for the central bank can work well for a small open economy. Thank you. 1 Reserve Bank Act 1959 (Cth) s 10(2). Available at <www.legislation.gov.au/Details/C2020C00322>. 2 The Treasurer and the Governor of the Reserve Bank, ‘Statement on the Conduct of Monetary Policy’, 19 September 2016. Available at <www.rba.gov.au/monetary-policy/framework/stmt-conduct-mp-7-2016-0919.html>. 3 Reserve Bank Act 1959 (Cth) s 11. Available at <www.legislation.gov.au/Details/C2020C00322>. 4/4 BIS central bankers' speeches | reserve bank of australia | 2,021 | 10 |
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Address by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to the Australian Payments Network Summit 2021, online, 9 December 2021. | Payments: The Future? | Speeches | RBA Speech Payments: The Future? Philip Lowe [ * ] Governor Address to the Australian Payments Network Summit 2021 Online – 9 December 2021 Thank you for the invitation to speak at AusPayNet's annual Summit. This is the fifth time I have had the privilege of doing so. Each time, the world of payments has seemed more exciting and dynamic than it was a year earlier. No longer do people talk about payments as being the plumbing of the financial system. Instead, they talk about how what is happening in the world of payments is reshaping our financial systems and how it will continue to do so into the future. Today, I would like to talk about that future. Making specific predictions is difficult as none of us has a crystal ball. Even so, the general direction of change is reasonably clear, even if we don't know the final destination. This morning I would like to start by talking about this general direction of change. I will also discuss a number of specific near-term priorities and then look a little further into the future. I will finish with some comments on the importance of our regulatory arrangements being flexible enough to deal with this dynamic world. The direction of change I would like to highlight five trends that are evident in the payments system and that I expect will continue. These are: 1. The declining use of banknotes and the increasing use of electronic forms of payment. 2. The greater use of digital wallets. 3. The growing involvement of the ‘big techs’ in payments. 4. The increasing specialisation within the payments value chain and the emergence of new business models. https://www.rba.gov.au/speeches/2021/sp-gov-2021-12-09.html 1/9 Payments: The Future? | Speeches | RBA 5. The growing community and political interest in the security, reliability and cost of payments. These trends mean that anyone involved in this industry is very busy. The shift away from using banknotes was in place before the pandemic, but has accelerated over the past two years and is likely to continue. The RBA will conduct our regular survey of consumer payment methods next year, but the data on cash withdrawals from ATMs tell the story (Graph 1). The value of ATM withdrawals over the past six months was around 30 per cent lower than the comparable period three years ago. While banknotes are still used for many transactions, the trend here is clear. Graph 1 Total Value of ATM Withdrawals* Monthly, seasonally adjusted $b $b * Series break in 2018 due to reporting changes Source: RBA In contrast, there has been a trend increase in the number of electronic payments and this trend too is likely to continue. There has been particularly strong growth in debit card transactions as people have switched from credit to debit. There has also been strong growth in account-to-account transactions. Increasingly, these are being made through the New Payments Platform (NPP), rather than the direct entry system (Graph 2). It is therefore appropriate that the industry is considering when the direct entry system might be wound down and how we move to the more modern payments infrastructure of the NPP. https://www.rba.gov.au/speeches/2021/sp-gov-2021-12-09.html 2/9 Payments: The Future? | Speeches | RBA Graph 2 Account-to-Account Transfers Monthly, seasonally adjusted m NPP share, by number Number Direct entry credit transfers Share of all credit transfers Direct entry debit transfers NPP Share of all transfers % Source: RBA An increasing share of electronic payments is also being made through the digital wallets offered by the large technology companies, including Apple Pay, Samsung Pay and Google Pay. Many people are now choosing to make payments using their digital wallet, rather than using banknotes or a card from their physical wallet. I expect that this change has only started and has a long way to run yet. A related possibility is that digital wallets provide more than just access to existing bank and credit card accounts. In particular, they could contain digital tokens that could be used to make payments. As I will discuss later, these tokens could be issued by the central bank, or by a private bank or another entity. The final destination is not yet clear here, but it is highly likely that digital wallets will become more important. Another trend that is likely to continue is the increasing interest of ‘big tech’ firms in payments. The platforms used by these firms give them large networks that can be leveraged to quickly build a payments business. They are also able to combine payments data with other data from their platforms, often with cutting-edge technology. Some already provide digital wallets and are exploring how these digital wallets could be used for non-traditional payment methods. So it is highly likely that we will continue to see new business models emerge. At the same time, another trend is for smaller players to enter the market, focusing on specific elements of the payments value chain. This is bringing increased competition and making new business models possible. Over recent years, the ‘fintechs’ in Australia have driven innovation in areas such as online payments, point-of-sale acceptance technology, cross-border retail payments https://www.rba.gov.au/speeches/2021/sp-gov-2021-12-09.html 3/9 Payments: The Future? | Speeches | RBA and buy now, pay later (BNPL) services. Some of these companies already play a material role in facilitating payments and I expect that we will see further innovation in these areas. This rapid change in the world of payments has brought with it increased community and political interest in payments. I expect that this interest will intensify, rather than diminish, given the importance of the issues to the community. These issues include: 1. How to ensure that banknotes remain widely available for those who want to use them. As part of this, the RBA is currently undertaking a public consultation on banknote distribution arrangements. 2. How to keep downward pressure on the cost of electronic payments, particularly for small merchants. As more payments are made electronically, the focus on the cost of these payments will increase. 3. How to address competition issues that arise with the increased involvement of big techs in payments. One important issue here is the access arrangements for the devices and the digital wallets they offer. 4. How to ensure that the electronic payments system is secure and available when people want to use it. Our economy is increasingly dependent on our digital infrastructure, so we need to make sure it is resilient to cyber threats as well as other operational risks. As is evident from this quick tour, the world of payments is dynamic and there is a lot of community interest in it. So there is a lot to talk about. Some areas that need addressing I would now like to move from the general direction of change to five specific areas where the Payments System Board would like to see further progress. In each of these areas some progress has been made, but more is needed. The first of these is the new PayTo service on the NPP, which is expected to serve as a replacement for the current system of direct debits. The existing system of direct debits has worked well in some respects, but a more modern system is now needed. The PayTo service will allow households and businesses to authorise other entities to initiate payments out of their accounts, opening up a range of possibilities for innovation. We expect the industry to keep its commitment to a successful launch of the new system in July next year. The second area where we would like to see more progress is the ‘payment with document’ overlay on the NPP. This service, and particularly the ability to include a link to a document with a payment, would promote innovation and reduce costs. This service will aid reconciliation for recipients. And payers will find they need to devote fewer resources to managing customer queries. Unfortunately, progress by the industry has been slow here. Despite this, the RBA – as the Australian Government's banker – https://www.rba.gov.au/speeches/2021/sp-gov-2021-12-09.html 4/9 Payments: The Future? | Speeches | RBA is working with the government and with the Commonwealth Bank to introduce the payment with a document service. We encourage others to join this effort. Further progress is also needed to deliver the benefits from open banking. Open banking strengthens competition and promotes innovation by giving customers the right to control and share their banking data with accredited third parties. It can help customers have a ‘top down’ view of their financial position and manage their upcoming payments. It can also help to streamline the credit assessment processes and help consumers get a better deal. The banks are making progress with implementation, but some have not met the target dates. It is important that progress does not slip here, especially as the number of accredited data recipients continues to increase. The fourth area where it would be good to see further progress is the development of widely accepted digital identity services. When I spoke at this conference three years ago, I spoke about how the digital economy needs a strong form of digital identity. I did so because I was concerned that Australia was slipping behind global best practice in this area. Since then, two frameworks for interoperable digital identity services have been developed, but there has not been a large-scale rollout of a digital identity service that can be used for a wide range of online (including private sector) interactions. [ 1] So further progress on this front would be welcome. The final focus area I want to mention is cross-border payments. It still often costs about 5 per cent of the payment (and sometimes more) to send money internationally from an Australian bank and it usually takes more than one day to reach the recipient. We know from our discussions with the central banks of the South Pacific that too often it is disadvantaged people who pay the highest prices. This is an area where the financial sector is not serving the community as well as it could, or should. This is very much the sentiment of the G20's Roadmap to make cross-border payments cheaper, faster, more transparent and more accessible. [ 2] The RBA is contributing to this effort and working with the Reserve Bank of New Zealand and other South Pacific central banks on a possible regional Know Your Customer (KYC) utility. [ 3] We are looking for the Australian payments industry to support these and other initiatives to improve the existing infrastructure for cross-border payments. A large effort is required here, but it is one that we need to make to provide better services to customers and to meet our international commitments through the G20. So these are the five specific areas that I wanted to highlight – the PayTo service, payment with a document, open banking, digital identity and cross-border payments. All have a heavy technology focus and I recognise the challenges of coordinating and investing in many technology projects at the same time. So, it is a full agenda. Digital tokens and new forms of money? https://www.rba.gov.au/speeches/2021/sp-gov-2021-12-09.html 5/9 Payments: The Future? | Speeches | RBA I would now like to move beyond these specific initiatives and discuss another issue on our agenda, but where there is more uncertainty about the future. Earlier I talked about how digital wallets are replacing physical wallets and that this trend is likely to continue. It is also likely that these digital wallets will contain more than just digital representations of the cards that are in our physical wallets. In particular, I expect that they are likely to provide access to new token or account-based digital forms of money. This could allow day-to-day payments to be made by moving tokens around rather than moving banknotes or value between bank accounts. How far we go in this direction and what form these tokens might take are yet to be determined. One possibility is that the tokens are issued by, and backed by, the RBA, just as we issue and back Australian dollar banknotes. This would be a form of retail central bank digital currency (CBDC) – or an eAUD. I have said previously that the RBA is open to this possibly. To date, though, we have not seen a strong public policy case to move in this direction, especially given Australia's efficient, fast and convenient electronic payments system. It is possible, however, that the public policy case could emerge quite quickly as technology evolves and consumer preferences change. It is also possible that these tokens could offer a lower-cost solution for some types of payments than provided by the existing technologies. And, as I will discuss in a moment, there are advantages in digital payment tokens being backed by the central bank. All this means we have been continuing to examine closely the case for a retail CBDC and working with other central banks on this issue. We are working through the relevant technical issues, as well as the broader policy implications of any shift away from a payments system based on the movement of value between bank accounts, to one that uses tokens. As part of this effort, we are planning to work with Australia's new Digital Finance Cooperative Research Centre. We will also be working with the Treasury on these issues and welcome the Government's announcement yesterday. Another possibility is that payment tokens are issued and backed by an entity other than the central bank, though still denominated in Australian dollars. These could be a form of stablecoin. If this is how the system develops, it will be important that these tokens are backed by high-quality assets and that they meet high standards for safety and security. One reason I say this is that a lesson from history is that privately issued and backed money all too often ends in financial instability and losses for consumers. This is one reason why national currencies are today ultimately backed by the state. So if privately issued stablecoins are ultimately the way things head, it will be crucial that they meet very high standards. And if there were to be multiple stablecoins, there would be advantages in them being interoperable. The RBA is working with domestic regulators and our counterparts around the world on the policy issues here. https://www.rba.gov.au/speeches/2021/sp-gov-2021-12-09.html 6/9 Payments: The Future? | Speeches | RBA A third type of potential digital token is a cryptocurrency, not linked directly to the AUD or backed by a particular entity or assets. I remain sceptical that we will head in this direction for general purpose payments. It is likely that the asset used for the settlement of most transactions in the economy will remain some form of secure fiat currency with a stable value, rather than cryptocurrency with a volatile price. That is not to say there is no role for crypto-assets. They can help support innovation, especially where they are linked to smart contracts and used in decentralised finance (or DeFi) applications. There is value in experimentation to find out what works and what doesn't. But as the experiments are conducted, it is also worth considering whether the benefits of smart contracts and DeFi can be gained with some form of stablecoin or a CBDC, rather than a new unit of account with a volatile price. While on the topic of crypto-assets, I would like to repeat a point made recently by my colleague, Tony Richards. And that is, that anyone purchasing these assets should take care. There is still a lot of uncertainty about the long-term usefulness of these assets. Before investing, it is best to understand fully the underlying value proposition. Relevant considerations here include the usefulness to end-users of the underlying payments functionality, the security of the funds invested, price volatility, the stability of the intermediaries used and the ultimate backing of the asset – not to mention the significant energy consumption that is required to make a transaction using some of these crypto-assets. There is a lot to think about here before investing. I would now like to move to the wholesale side of the payments system. The RBA has been examining the case for some form of wholesale CBDC, which can be thought of as a new tokenised form of exchange settlement account balances. This could be used to settle transactions of tokenised assets on different blockchains. Yesterday, we released the report on Project Atom, which is a wholesale CBDC research project we conducted with four external parties. The project explored how access could be extended to a wide range of wholesale market participants and the suitability of distributed ledger technology for this kind of system. Overall, the project has confirmed that this is an area worth further research. The RBA is also in the midst of another significant wholesale CBDC project – Project Dunbar, which is being conducted with the BIS Innovation Hub and three other central banks – to explore the possible use of CBDC in cross-border payments. The regulatory environment I would now like to move to the regulatory challenges posed by this fast moving world of payments. With so much change taking place, regulators and the payments legislation can't stand still. The digital economy is very important to Australia's future and we need a regulatory system that encourages innovation and ensures the system is safe and stable. Given this, the RBA welcomes the government's response announced yesterday to three recent reports: https://www.rba.gov.au/speeches/2021/sp-gov-2021-12-09.html 7/9 Payments: The Future? | Speeches | RBA The Treasury Review of the Australian Payments System led by Scott Farrell. The report of the Select Committee on Australia as a Technology and Financial Centre. The Parliamentary Joint Committee's report on Mobile Payment and Digital Wallet Financial Services. There will be a lot of work for the Treasury and the other Council of Financial Regulators agencies to implement the recommendations that have been accepted by the government. I can't do justice to all the issues here but will touch briefly on some that relate directly to the Bank's responsibilities. The government's support for developing a strategic plan for the payments ecosystem is a positive step. Because payments systems are networks there is a need for coordination, which can be challenging amongst competitors. The Payments System Board sees part of its role as helping overcome these coordination challenges. Yesterday's announcement by the Treasurer will also help here. The RBA also supports the decision to introduce a new, tiered licensing regime for payment service providers. This should help encourage innovation and competition while promoting safe and resilient payment services. As part of this, we are keen to see the implementation of a new licensing framework for stored-value facilities, based on the model proposed by the Council of Financial Regulators a few years ago. We are also pleased to see the government's support for reviewing the Payment Systems (Regulation) Act 1998 to make sure it is fit for purpose. The payments ecosystem is becoming more complex and there are many more entities in the payments chain than there used to be. If the RBA is to meet its broad mandate to promote competition, efficiency and stability then we need to modernise the definitions that were included in the legislation more than two decades ago. Finally, I also want to note that the Council of Financial Regulators is continuing to review the regulatory treatment of different types of crypto-assets, including stablecoins. This is in line with the Senate Select Committee's view that we need a regulatory framework that better accommodates the various new digital assets. As I said earlier, if stablecoins and other types of privately issued digital payment tokens are to become more widely used for everyday payments, they need to be subject to a clear and effective regulation than encourages innovation and mitigates against risks to users and the financial system. Conclusion To conclude, our payments system is changing quickly. Both the regulators and the government understand this and are seeking to put in arrangements that encourage innovation and competition and make sure we have a secure and efficient system. We have work to do here, but are moving in the right direction. AusPayNet is a valuable partner in this work and plays an important role in the governance of the Australian payments industry. I look forward to continuing the cooperation between AusPayNet and https://www.rba.gov.au/speeches/2021/sp-gov-2021-12-09.html 8/9 Payments: The Future? | Speeches | RBA the Reserve Bank as we grapple with the challenges ahead and seize the opportunities offered by new technologies. Thank you for listening and I am happy to answer some questions. Endnotes [*] I would like to thank my colleagues in Payments Policy Department for assistance in the preparation of this talk. The Government's Trusted Digital Identity Framework and the private-sector Trust ID framework. For more details, see <https://www.fsb.org/2020/10/enhancing-cross-border-payments-stage-3-roadmap/>. This facility would have inbuilt KYC compliance workflows that ensure entities using the facility can perform KYC compliance checks to a high standard and can demonstrate this to banks and regulators. The materials on this webpage are subject to copyright and their use is subject to the terms and conditions set out in the Copyright and Disclaimer Notice. © Reserve Bank of Australia, 2001–2021. All rights reserved. The Reserve Bank of Australia acknowledges the Aboriginal and Torres Strait Islander Peoples of Australia as the Traditional Custodians of this land, and recognises their continuing connection to Country. We pay our respects to their Elders, past, present and emerging. https://www.rba.gov.au/speeches/2021/sp-gov-2021-12-09.html 9/9 | reserve bank of australia | 2,021 | 12 |
Address by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to the CPA Australia Riverina Forum, Wagga Wagga, 16 December 2021. | 12/16/21, 10:38 AM The RBA and the Australian Economy | Speeches | RBA Speech The RBA and the Australian Economy Philip Lowe [ * ] Governor Address to CPA Australia Riverina Forum Wagga Wagga – 16 December 2021 I would like to thank the CPA for inviting me to your Riverina Forum. It is a great pleasure for me to be able to join you here in Wagga Wagga, where I grew up. I had the good fortune of attending Sacred Heart Primary School in Kooringal, St Michael's and then Trinity Senior High School. It was at Trinity, though, where I first became interested in economics. And that was thanks to an inspiring teacher, Mrs King. In her classroom she explained how economics could be used to address the world's problems and how the right combination of the invisible hand of the market and government regulation could maximise the welfare of our society. I remember being struck by these powerful ideas and they have stayed with me through the years. In Wagga, I also learnt the value of hard work and the challenges of running a small business. During my high school years, my father had a petrol station and auto accessories shop at the bottom of Fitzmaurice St. It was an old-style, full service petrol station and I spent many hours on cold winter mornings and hot summer afternoons pumping petrol. The valuable life lessons I learnt there complemented those that I learnt in the classroom. Given that I am back here today as the Governor of the RBA, I would like to begin by saying a few words about what the RBA does and then turn to some of the current economic issues we are working through. The Reserve Bank of Australia You might be thinking that you know what the RBA does: it sets interest rates and conducts monetary policy. That would be correct, but our functions are much broader than that. As Australia's central bank, we print and issue Australia's banknotes. Our colourful polymer banknotes are some of the best in the world and include cutting-edge security features to guard https://www.rba.gov.au/speeches/2021/sp-gov-2021-12-16.html 1/16 12/16/21, 10:38 AM The RBA and the Australian Economy | Speeches | RBA against counterfeiting. These notes are printed at our print works in outer Melbourne, where we also operate a mega vault. Today, there is around $100 billion of banknotes on issue, which is almost $4,000 for every person in Australia. The banknotes are being used less for day-to-day transactions than in the past, but there is still very strong demand for them as a store of value. Reflecting this demand, there are nearly 40 $50 bills on issue for every Australian and 18 $100 bills! (Graph 1). Graph 1 Banknotes in Circulation Per Capita No No $5 $10 $20 $50 $100 Sources: ABS; RBA The RBA also has a broad responsibility for the stability of the Australian financial system. Through our operations, we ensure that liquidity in the overall financial system is adequate and we have the capability to act as the lender of last resort in an emergency. We do not directly regulate the banks, but we work closely with the prudential regulator, APRA, on issues that affect the stability of the financial system. The RBA is the Australian Government's banker. When you receive a Medicare refund, it is from a government account at the RBA. And when you pay your tax, it is to the Australian Tax Office's account at the RBA. The RBA also processed all the JobKeeper and COVID-19 disaster payments during the pandemic. The disaster payments were made through our infrastructure that allows payments to be made 24 hours a day, seven days a week. The RBA also operates the settlement system that is at the core of Australia's payments system. All banks have accounts at the RBA and these accounts are used to move money from one bank to another. Without this system, the economy simply wouldn't work. https://www.rba.gov.au/speeches/2021/sp-gov-2021-12-16.html 2/16 12/16/21, 10:38 AM The RBA and the Australian Economy | Speeches | RBA In addition, we regulate important parts of Australia's payments system, including the credit and debit card systems and ATMs. At present, we are exploring the possibility of a new form of digital money that could be used from a digital wallet. The RBA also regulates core elements of Australia's financial market infrastructure, which are central to trading in financial instruments, including on the ASX. We also manage Australia's foreign exchange reserves. We do this with around 1,400 people. We have offices in most capital cities in Australia as well as in New York, London and Beijing and we have an extensive business and community liaison program. We have a large balance sheet, which has grown a lot during the pandemic and now stands at $623 billion (Graph 2). Graph 2 RBA Balance Sheet Total assets, weekly $b $b Source: RBA We are owned by the public, with the Reserve Bank Board appointed by the Australian Government. We have both operational and policy independence from the government and I have a seven-year term as Governor. So that is the Reserve Bank of Australia. As an organisation, we seek to be transparent, accountable, analytical and independent, and always act in the public interest. It is a huge privilege to have the role that I have. The RBA is doing important work to help maximise the economic welfare of our society and we take our job very seriously. https://www.rba.gov.au/speeches/2021/sp-gov-2021-12-16.html 3/16 12/16/21, 10:38 AM The RBA and the Australian Economy | Speeches | RBA The economic recovery I would now like to turn to the Australian economy and cover three issues that we have been focused on recently: the economic recovery, the housing market, and inflation. You might recall that back in March last year we were standing on the edge of an abyss. There were credible predictions that tens of thousands of Australians would lose their lives, the health system wouldn't cope, there would be mass unemployment, and that the economy would suffer deep scars. Since then, there have been many difficult days, but we have avoided these dire predictions. This is thanks to a combination of unprecedented public health measures, rapid scientific breakthroughs, very large fiscal and monetary policy support, and the underlying resilience and adaptability of Australian households and businesses. Now, as 2021 draws to a close, the economy is in recovery mode. This follows a setback in the September quarter when GDP declined by 1.9 per cent due to the measures taken to contain the Delta outbreak (Graph 3). In the quarter, there were sharp declines in household consumption and hours worked. But on a more positive note, spending was more resilient than we had expected, providing further evidence that households and businesses are adjusting to living with the virus. Graph 3 GDP Growth % % Year-ended Quarterly -4 -4 -8 -8 Source: ABS It would not come as a surprise to many of you in this room that the farm sector has been one of the bright spots in the economy. Farm output has increased by more than 40 per cent over the past https://www.rba.gov.au/speeches/2021/sp-gov-2021-12-16.html 4/16 12/16/21, 10:38 AM The RBA and the Australian Economy | Speeches | RBA year and rural exports are up by 50 per cent (Graph 4). Incomes have also been boosted by multiyear highs in the prices for many agricultural commodities. So it is a positive story. Graph 4 Farm GDP Growth Year-ended % % -20 -20 -40 -40 Sources: ABS; RBA More broadly, with lockdowns being lifted, spending is bouncing back quickly, especially on services. The Omicron outbreak does, though, represent a downside risk and it is difficult to know how things will develop from here. But we do expect the positive momentum in the economy to be maintained through the summer, underpinned by the opening up of the economy, the high rates of vaccination, significant fiscal and monetary support, and the strengthening of household and business balance sheets over the past year or so. Typically, in an economic downturn households dip into their savings. This downturn has been different – instead of dipping into their savings, households have added to them in a material way. In the September quarter, the household saving rate surged to near 20 per cent as governments supported incomes at a time when it was hard to spend (Graph 5). We estimate that the total additional savings by households during the pandemic has amounted to more than $200 billion and many businesses have also increased their cash reserves. Provided people have the ability to spend – and the confidence to do so – these additional savings will support strong growth in consumption over coming months. https://www.rba.gov.au/speeches/2021/sp-gov-2021-12-16.html 5/16 12/16/21, 10:38 AM The RBA and the Australian Economy | Speeches | RBA Graph 5 Household Saving Ratio* Quarterly % % -5 -5 * Saving as a share of disposable income, net of depreciation Sources: ABS; RBA The recovery in the economy is also evident in the sharp rise in the number of job advertisements and job vacancies (Graph 6). There are also increasing reports that firms are finding it difficult to find workers. This is especially so in a range of professional services, the construction industry, agriculture and parts of the hospitality industry. https://www.rba.gov.au/speeches/2021/sp-gov-2021-12-16.html 6/16 12/16/21, 10:38 AM The RBA and the Australian Economy | Speeches | RBA Graph 6 Job Vacancies and Advertisements Per cent of labour force % % 2.5 2.5 Advertisements (National Skills Commission) 2.0 2.0 Vacancies* (ABS) 1.5 1.5 1.0 1.0 0.5 0.5 0.0 0.0 * This survey was suspended between May 2008 and November 2009 Sources: ABS; National Skills Commission; RBA Here in the Riverina, the number of job ads is also at a very high level, with the surge in ads larger than it has been in the capital cities and in many other regional communities (Graph 7). https://www.rba.gov.au/speeches/2021/sp-gov-2021-12-16.html 7/16 12/16/21, 10:38 AM The RBA and the Australian Economy | Speeches | RBA Graph 7 Job Advertisements By region group, January 2018 = 100 index index Riverina and Murray Regional* Capital cities * Regional includes ACT and NT Sources: National Skills Commission; RBA The unemployment rate has also come down significantly in regional Australia and is now below that in the capital cities by a wide margin, which is unusual (Graph 8). And here in the Riverina, the unemployment rate is substantially below the national rate and is also very low in absolute terms. https://www.rba.gov.au/speeches/2021/sp-gov-2021-12-16.html 8/16 12/16/21, 10:38 AM The RBA and the Australian Economy | Speeches | RBA Graph 8 Unemployment Rate By region group, seasonally adjusted % % Regional* Capital cities Riverina** * ** Regional includes ACT and NT Smoothed using a 12-month trailing average Sources: ABS; RBA Regional Australia is benefiting from two significant changes. The first is a re-evaluation of where, and how, people want to live following the pandemic. And the second is the advances in technology and changes in work practices that have reduced the need to be physically located in a workplace in a capital city. These changes are positive for many regional communities, creating new opportunities for growth and expansion. But they are also causing growing pains that need to be managed. Nationally, the labour market is expected to tighten further over the next couple of years. The RBA's central scenario is for the unemployment rate to reach 4¼ per cent by the end of 2022, and 4 per cent by the end of 2023 (Graph 9). If we could achieve this, these would be good outcomes – Australia has not experienced a sustained period of unemployment at levels this low since the early 1970s. As the unemployment rate declines and workers become harder to find, greater attention will need to be paid to training and skills development than has been the case over the past few decades. https://www.rba.gov.au/speeches/2021/sp-gov-2021-12-16.html 9/16 12/16/21, 10:38 AM The RBA and the Australian Economy | Speeches | RBA Graph 9 Unemployment Rate* % Forecast % * Actual data is reported on a monthly basis; forecast is as at the November 2021 SMP and is projected for each quarter Sources: ABS; RBA The housing market I would now like to turn to the second topic – the housing market. Housing prices have been rising very briskly across most of the country over the past year, although there are signs of some slowing recently in the largest capital cities. Rising housing prices have been a global phenomenon – from New York to Seoul to here in Wagga. This reflects both the low level of interest rates and a shift in preferences for how and where people want to live. The available data suggest that average housing prices in Wagga have increased by around 20 per cent over the past year, similar to the average increase in the capital cities (Graph 10). https://www.rba.gov.au/speeches/2021/sp-gov-2021-12-16.html 10/16 12/16/21, 10:38 AM The RBA and the Australian Economy | Speeches | RBA Graph 10 Housing Prices Seasonally adjusted, January 2020 = 100 index index Wagga Wagga Capital cities Sources: CoreLogic; RBA Another recent feature of many regional housing markets is a decline in the availability of rental accommodation. I understand that this is a problem here in the Riverina, with the published vacancy rate now at a very low level (Graph 11). This is one of the growing pains that I mentioned earlier, with the supply side of the housing market struggling to keep up with the sudden increase in demand. https://www.rba.gov.au/speeches/2021/sp-gov-2021-12-16.html 11/16 12/16/21, 10:38 AM The RBA and the Australian Economy | Speeches | RBA Graph 11 Rental Vacancy Rates Seasonally adjusted, monthly % % Sydney Riverina Sources: RBA; REINSW More positively, the supply side is adjusting. Over recent months, residential building approvals in Wagga have been at very high levels (Graph 12). In time, this will add to the stock of housing and aleviate some of the pressures that are currently being felt. A challenge here, as I mentioned before, is finding the workers to build these extra homes. https://www.rba.gov.au/speeches/2021/sp-gov-2021-12-16.html 12/16 12/16/21, 10:38 AM The RBA and the Australian Economy | Speeches | RBA Graph 12 Private Residential Building Approvals* New houses, by region group ’000 no Wagga Wagga Capital cities Regional * Smoothed using a three-month trailing average Sources: ABS; RBA In terms of the RBA's responsibilities, we do not target housing prices, nor would it make sense to do so. While higher interest rates over the past couple of years would have meant smaller increases in housing prices, they would have also meant that fewer people had jobs and wages growth would have been slower. That is not an attractive trade-off, nor is it one that is within our mandate to make. The solution to concerns about the high levels of housing prices isn't higher interest rates, but rather reforms that address the underlying balance of supply and demand. The RBA's focus, instead, has been on the sustainability of trends in household borrowing. It is important that during a time when interest rates are the lowest on record people do not borrow too much. At some point in the future, interest rates will increase from these record lows. The RBA has been working with APRA to require banks to factor appropriate buffers for higher interest rates into their calculations when deciding how to much to lend. It is important that both banks and households pay attention to these buffers. Inflation The third topic that I want to cover is inflation. After many years in which inflation was very low, it has recently increased sharply in the United States and Europe in the wake of the pandemic. In the United States, CPI inflation is currently at 6.8 per cent, the highest rate in almost four decades (Graph 13). This reflects a combination of https://www.rba.gov.au/speeches/2021/sp-gov-2021-12-16.html 13/16 12/16/21, 10:38 AM The RBA and the Australian Economy | Speeches | RBA higher energy prices, a decline in the number of people seeking work, which has boosted wages, and a supply side that has had trouble keeping pace with very strong demand for goods during the pandemic. These factors are expected to wane over the year ahead and inflation is expected to come down, although it is still uncertain by how much. Graph 13 Consumer Price Inflation Year-ended % United States % Australia* Trimmed mean Headline -2 2021 2011 -2 * The trimmed mean measure excludes deposit & loan facilities Sources: ABS; RBA; Refinitiv The situation here in Australia is quite different. In underlying terms, inflation is 2.1 per cent and has only just returned to the 2–3 per cent target range for the first time in six years. In headline terms, it is higher than this at around 3 per cent, largely due to higher prices for petrol and constructing a new home. Nevertheless, headline inflation in Australia is much lower than it is in the North Atlantic. Two factors help explain much of this difference. The first is the different dynamics in electricity and gas prices. Here in Australia, electricity prices have declined, while, in contrast, they have increased sharply in a number of countries. The second factor is that wages growth remains relatively low in Australia. While aggregate wages growth has picked up recently, it has only returned to the low rates prevailing before the pandemic (Graph 14). There are certainly hot spots in which wages are increasingly briskly, but most workers are still receiving wage increases starting with a two, and sometimes lower than this. The RBA is expecting wages growth to pick up further but, at the aggregate level, to so do only gradually. This https://www.rba.gov.au/speeches/2021/sp-gov-2021-12-16.html 14/16 12/16/21, 10:38 AM The RBA and the Australian Economy | Speeches | RBA partly reflects elements of Australia's wage-setting processes, which create inertia in aggregate wage outcomes. These processes include enterprise agreements that tend to only get renegotiated once every two to three years, the annual review of award wages by the Fair Work Commission and public sector wages policies. Graph 14 Wage Price Index Growth* % % Year-ended Quarterly * Total hourly rates of pay excluding bonuses and commissions Source: ABS The expected pick-up in wages growth is forecast to be associated with a steady but gradual increase in inflation in underlying terms. In the RBA's central scenario, published in early November, underlying inflation is expected to increase to 2½ per cent over 2023. So, we are in quite a different position from the United States. Monetary policy I would like to finish with a couple of points about monetary policy. The first relates to the RBA's bond purchase program, which has provided important additional support to the economy during the pandemic. It has led to lower funding costs, supported asset values and led to a lower exchange rate than would otherwise have been the case. The Board will consider the future of this program at its next meeting in February. Ahead of that decision, we had a preliminary discussion of three options at our meeting last week, with all three options based on the premise that the economy does not experience another serious setback: https://www.rba.gov.au/speeches/2021/sp-gov-2021-12-16.html 15/16 12/16/21, 10:38 AM The RBA and the Australian Economy | Speeches | RBA The first option discussed was to further taper the bond purchases from the current rate of $4 billion a week, with an expectation that the purchases would come to an end in May. The second was to taper further and then review the situation again in May. The third option was to cease bond purchases altogether in February. In deciding between these options, the Board will use the same three criteria that it has used since the outset: the actions of other central banks, how the Australian bond market is functioning, and most importantly, the actual and expected progress towards the goals of full employment and inflation consistent with the target. We have made no decision yet. Much will depend upon the news we receive between now and when we meet in February. Importantly, we will receive further readings on inflation and the strength of the labour market (including the labour force survey later this morning) and learn about the strength of spending in the economy over the summer. We will also learn more about the actions of other central banks and the effects of the Omicron variant. The first option, namely to reduce the pace of purchases from mid-February with an expectation of a likely end point in May, is broadly consistent with the Bank's forecasts in November for employment and inflation. If better-than-expected progress towards the Board's goals was made, then the case to cease bond purchases in February would be stronger. Alternatively, if progress is slower than expected, or if the outlook becomes more uncertain, the case for retaining flexibility and reviewing again in May would be stronger. The second point that I want to make is that the Reserve Bank Board will not increase the cash rate until actual inflation is sustainably in the 2–3 per cent target range. We are still a fair way from that point. In our central scenario, the condition for an increase in the cash rate will not be met next year. It is likely to take time for that condition to be met and the Board is prepared to be patient. Thank you for listening. I am happy to answer your questions. Endnotes [*] I would like to thank Fiona Price and Penny Smith for their assistance in preparing this talk. The materials on this webpage are subject to copyright and their use is subject to the terms and conditions set out in the Copyright and Disclaimer Notice. © Reserve Bank of Australia, 2001–2021. All rights reserved. The Reserve Bank of Australia acknowledges the Aboriginal and Torres Strait Islander Peoples of Australia as the Traditional Custodians of this land, and recognises their continuing connection to Country. We pay our respects to their Elders, past, present and emerging. https://www.rba.gov.au/speeches/2021/sp-gov-2021-12-16.html 16/16 | reserve bank of australia | 2,021 | 12 |
Address by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to the National Press Club of Australia, Sydney, 2 February 2022. | Speech The Year Ahead Philip Lowe [ * ] Governor Address to National Press Club of Australia Sydney – 2 February 2022 This is the fourth time that I have addressed the National Press Club. Thank you for having me back. As I've done on each of the three previous occasions, I have titled my remarks ‘The Year Ahead’. I will talk about our latest forecasts, the outlook for monetary policy and yesterday's decision by the Reserve Bank Board to end the bond purchase program. In summary, I remain optimistic about Australia's prospects. Our economy has weathered the pandemic much better than was expected, jobs growth is strong and unemployment is low, household and business balance sheets are generally in good shape and wages growth is picking up. These are all welcome developments. At the same time, though, the country faces challenges. The pandemic is not yet behind us and the sharp pick-up in inflation in some parts of the world, particularly in the United States, has added a new element of uncertainty to the outlook. We also face the challenge of lifting productivity growth, including through investing in the workforce skills and technologies that are needed to generate sustained increases in real wages. And over time and as conditions allow, we will need to navigate a return to more normal settings of monetary policy. A useful place to start is to look to the year just past for lessons. To do this, the table below shows the outcomes for the key economic variables in 2021 as well as the RBA's central forecasts at the start of last year. Table 1: Key Economic Variables – 2021 Per cent Outcome Forecast Difference (percentage points) GDP Growth 5* 3½ 1½ Unemployment Rate 4.2 −1¾ CPI Inflation 3.5 1½ +2 Underlying Inflation 2.6 1¼ +1¼ Wage Price Index 2¼* 1½ +¾ (a) * Estimate based on available data. Sources: ABS; RBA The picture is pretty clear. The economy performed significantly better last year than we had expected – GDP growth is likely to have been around 5 per cent, compared with our forecast of 3½ per cent. This is despite the setback caused by the Delta outbreak. The unemployment rate also declined by more than we had expected and now stands at 4.2 per cent, the lowest rate since the peak of the resources boom. These stronger GDP and labour market outcomes have translated into higher inflation than we were expecting. We had expected underlying inflation to be 1¼ per cent over 2021, yet the actual outcome was 2.6 per cent. Headline inflation was higher still at 3.5 per cent, boosted primarily by a sharp increase in petrol prices and the cost of constructing new homes. Wages growth was also higher than we were expecting, although the difference here is smaller than for the other variables and wages growth remains low. This experience is a reminder of the difficulty of economic forecasting in a pandemic, but also points to three broader observations. The first is that the economy has been remarkably resilient. The second is that the link between the strength of the real economy and prices and wages remains alive. And the third is that the supply side matters for both economic activity and prices. These three observations are also relevant for the year ahead. We will be releasing a full set of updated economic forecasts on Friday in the quarterly Statement on Monetary Policy. Ahead of that, I can summarise the key elements of our forecasts. I will start with GDP. Our central forecast is for the economy to grow by 4¼ per cent this year and around 2 per cent over 2023 (Graph 1). Graph 1 GDP Growth % Forecast % Year-ended Quarterly -4 -8 -4 -8 Sources: ABS; RBA One source of ongoing uncertainty here is the possibility of further virus outbreaks, with the past month or so reminding us of the risks. Prior to Omicron, the economy had established strong positive momentum, bouncing back quickly following the easing of the Delta restrictions. This momentum wasn't sustained into the new year, with Omicron leading to many people having to isolate, interrupting supply chains and affecting spending as people sought to limit their activities. Yet, once again, the resilience of the economy has been on display. Australians have adjusted and adapted, and we still expect GDP to grow in the March quarter, although only modestly. The worst of the disruptive economic effects from Omicron now appear to be behind us, with supply chain and workforce management problems gradually being addressed. As case numbers trend lower, we expect a strong bounce-back over the months ahead. While Omicron has delayed the recovery of the Australian economy, it has not derailed it. That recovery is being underpinned by a number of factors. These include household balance sheets that are in generally good shape, with households having accumulated more than $200 billion in additional savings over the past two years. An upswing in business investment is also underway and there is a large pipeline of residential building to be completed over the next year or so. Macroeconomic policy settings are also supportive of growth, with governments planning significant infrastructure spending and monetary policy very accommodative. Turning now to the labour market, the outlook has continued to improve. The unemployment rate has declined to the low fours earlier than we had expected and a further reduction is expected. Our central forecast is for the unemployment rate to decline to around 3¾ per cent by the end of this year and be sustained at around this rate during 2023 (Graph 2). If this comes to pass, it would be a significant achievement. Australia has not experienced unemployment rates this low in the past half century – the last time we had the unemployment rate below 4 per cent was in the early 1970s. Graph 2 Unemployment Rate* % Forecast % * Actual data is reported on a monthly basis; forecast is projected for each quarter. Sources: ABS; RBA The decline in the unemployment rate has been accompanied by a welcome decline in underemployment, which is at its lowest rate in 13 years. It has also been associated with a rise in labour force participation. This stands in stark contrast to the United States and the United Kingdom, where labour force participation has declined (Graph 3). In Australia, the share of working age Australians with a job has never been higher than it is now. Graph 3 % Underemployment and Participation Underemployment rate Participation rate % Australia United Kingdom United States 2021 2011 Sources: ABS; RBA; Refinitiv The forward-looking indicators suggest that the demand for workers remains strong. Job vacancies reached a record high in November and job advertisements have also increased strongly (Graph 4). The information from our business liaison program is that Omicron has not changed this story. More than half of businesses still report that they intend to increase headcount over the coming months and very few expect to reduce their workforces. There has also been an increase in staff turnover and ongoing reports of difficulties finding workers for certain roles. Graph 4 Job Vacancies and Advertisements Per cent of labour force % % 2.5 2.5 Advertisements 2.0 2.0 Vacancies* 1.5 1.5 1.0 1.0 0.5 0.5 0.0 0.0 * The survey was suspended between May 2008 and November 2009. Sources: ABS; National Skills Commission; RBA Once the labour market disruptions from Omicron have dissipated, we expect some of the additional demand for labour to be met with a further rise in labour force participation. We also expect an increase in average hours worked as part-time workers wanting additional hours have more success in finding the hours they are seeking. Turning now to inflation, there has also been an upside surprise (Graph 5). The pick-up in inflation reflects both the strength of the economic recovery and the significant disruptions on the supply side. Headline inflation, in particular, has been boosted by the 32 per cent increase in petrol prices over the past year and the 7½ per cent increase in the cost of constructing new dwellings. There have also been larger price increases for a wide range of consumer durables. In the December quarter, there was also less discounting because firms faced very strong demand as most of the country emerged from lockdowns at a time when inventories were low and firms had trouble filling their shelves. Graph 5 Inflation % Headline* % Trimmed mean Year-ended Quarterly -2 -2 * Year-ended series is not seasonally adjusted. Sources: ABS; RBA Looking ahead, we expect underlying inflation to increase further over coming quarters, largely reflecting the ongoing difficulties on the supply side, including currently from Omicron (Graph 6). As these problems are resolved, some moderation in inflation is expected. Then, over time, stronger growth in labour costs is expected to become the more important driver of inflation. The central forecast is for underlying inflation to be around 2¾ per cent over both this year and next. Graph 6 Trimmed Mean Inflation Year-ended % Forecast % Sources: ABS; RBA Wages growth has picked up as well, but it has only just returned to the rates prevailing prior to the pandemic (Graph 7). A further pick-up is expected, though there is substantial inertia in aggregate wage outcomes even if there are large wage increases in some pockets. This inertia stems from multi-year enterprise agreements, the review of award wages that takes place on an annual basis and public sector wages policies. Our central forecast is for the Wage Price Index to increase by 2¾ per cent this year and 3 per cent over 2023. Broader measures of labour costs, which also matter for inflation, are expected to be growing at a faster rate than this. This reflects the increase in superannuation contributions and pay increases that arise from job switching and job reclassifications in a tight labour market. Graph 7 Wage Price Index Growth* Year-ended % Forecast % * Total hourly rates of pay excluding bonuses and commissions. Sources: ABS; RBA So that is a summary of our central forecasts. I would like to return, though, to a point I made at the outset: that actual outcomes can be quite different from the central forecasts. This is especially so in a global pandemic, with all its uncertainties. We still can't be certain how the pandemic will evolve and how people will respond to further outbreaks. There are also major geopolitical uncertainties at present and our major trading partner, China, is going through a difficult adjustment in its property market. Domestically, one issue that we will be watching closely is how households use all the savings accumulated over the past two years. On the inflation and wages fronts there are also a range of significant uncertainties. These partly stem from the uniqueness of the period in which we are living. Over the past two years there has been very strong demand for goods globally just at the time that the ability of the economic system to produce and distribute goods was impaired. This strong demand colliding with impaired supply means higher prices and higher published inflation. [ 1] It is still unclear as to whether, and at what pace, the demand for goods will normalise as infection rates decline. There is also uncertainty as to how quickly the supply and distribution problems will be resolved, although there has been positive news on some fronts recently. We can't rule out the possibility that some of the recent price increases are reversed as a more normal balance between supply and demand is re-established. In any case, for inflation to be sustained at current rates the prices of many goods would have to keep increasing at their recent rates, not just settle at higher levels. All of this means that there are significant uncertainties as to the persistence of the recent price pressures. They may be the start of a period of persistently higher inflation, but they could also simply be a shift in the level of prices as a result of this unique period. There are also uncertainties regarding the supply side of the labour market and how wages respond. We are experiencing a unique combination of record labour force participation, a pandemic preventing some people from working, and a gradual reopening of our international borders after they have been closed for two years. In addition, we have no contemporary experience as to how labour costs will evolve in a world where the national unemployment rate is below 4 per cent. We do know, though, that wages growth remained modest a number of years ago when the unemployment rates in New South Wales and Victoria were temporarily around 4 per cent. The point here is that there are many unanswered questions. We are unlikely to know the answers quickly. There are many moving parts on both the demand side and the supply side of the economy and it will take time for these various issues to be resolved. This is relevant to the Board's deliberations about monetary policy to which I will now turn. Monetary policy I want to start with the decision the Board took yesterday to end the bond purchase program. The final purchases under this program will take place on Thursday 10 February. In taking this decision, the Board considered the three criteria that have guided it from the outset: (i) the actions of other central banks; (ii) the functioning of our own bond market; and (iii) most importantly, the actual and expected progress towards our goals of full employment and inflation consistent with the target. All three criteria pointed to the same conclusion: that is to bring the bond purchase program to an end. Most other central banks have already completed their programs, or will shortly do so. The Federal Reserve has announced that it will end its program in March and the Bank of Canada, the Bank of England, the Riksbank and the Reserve Bank of New Zealand have all ended their programs. This is relevant because one of the reasons we introduced our program was that other central banks were buying bonds. If we hadn't also done this, our bond yields and exchange rate would have been higher than they have been and this would have impeded the recovery from the pandemic. In terms of the second criterion, our bond market is continuing to function reasonably well and the RBA's stock lending activities are supporting this. But there have been some pressure points recently. This is evident around the three-year mark, where there has been a gap between the price of the physical bonds and the futures contract. Among the range of bonds we are purchasing, the RBA owns 42 per cent of Australian Government Securities on issue and 60 per cent of some individual bond lines (Graph 8). Our assessment is that the market could accommodate further purchases by the RBA, but that there would be a rising probability of additional strains emerging. Graph 8 Australian Government Bond Holdings Share of outstanding held by RBA % Jul-22 Nov-22 Apr-23 Apr-24 Nov-24 Apr-25 Nov-25 Apr-26 Sep-26 Apr-27 Nov-27 May-28 Nov-28 Apr-29 Nov-29 May-30 Dec-30 Jun-31 Nov-31 May-32 Nov-32 Apr-33 All* % * All bonds in RBA’s purchase range. Sources: AOFM; RBA The most important consideration was the third one – that is, the actual and expected progress towards our goals. Since November, we have made better progress than we were expecting, which is good news. The unemployment rate now stands at 4.2 per cent and underlying inflation is at 2.6 per cent. For the first time in some years, the achievement of our goals is within sight. In these circumstances, the Board judged that now was the right time to draw the bond purchase program to a close. There are four additional points that I would like to make. The first is that our bond purchase program has played an important role in achieving this progress towards our goals, complementing our other monetary policy measures. The purchases have lowered funding costs, supported asset values and led to a lower exchange rate than would otherwise have been the case. As a result, more people have jobs and inflation is closer to the target. The second point is that the cessation of our bond purchases does not represent a tightening of monetary policy. The accumulated international evidence is that it is the stock of bonds purchased, not the flow of purchases, that provides the economic support. By mid-February, the RBA will have purchased over $350 billion of government bonds under our various programs and our balance sheet will have more than tripled since the start of the pandemic to around $650 billion (Graph 9). These purchases and the expansion of our balance sheet are providing ongoing support to the Australian economy. Graph 9 RBA Balance Sheet Total assets, weekly $b $b Source: RBA The third point is that we have not yet made a decision about reinvesting the proceeds of maturing bonds. Unlike many other countries, there are not maturities of government bonds in Australia every week or month (Graph 10). The large gaps in the maturity profile mean that we have more time to make a decision. The next maturity of an Australian Government bond is in July 2022. [ 2] Ahead of this, the Board will consider its approach to reinvestment at its meeting in May, with the key considerations being the state of the economy and the outlook for inflation and unemployment. Graph 10 Maturing Government Bonds On RBA balance sheet; quarterly* $b $b AGS Semis Mar-22 Jun-22 Sep-22 Dec-22 Mar-23 Jun-23 Sep-23 Dec-23 Mar-24 Jun-24 Sep-24 Dec-24 Mar-25 Jun-25 Sep-25 Dec-25 Mar-26 Jun-26 Sep-26 Dec-26 * Face value of outright holdings. Source: RBA The fourth and final point is that the decision to end the bond purchase program does not mean that an increase in the cash rate is imminent. I recognise that in a number of other countries the ending of the bond purchase program has been followed closely, or is expected to be followed closely, by an increase in the policy rate. This is in contrast to earlier episodes of quantitative easing and reflects their current circumstances, which are quite different from our own. While inflation has picked up in Australia, it remains substantially lower than the 7 per cent rate in the United States, 5.4 per cent in the United Kingdom, and 5.9 per cent in New Zealand, and it has not been accompanied by strong wages growth as is the case in the United States and the United Kingdom (Graph 11). These are important differences. Our lower rate of inflation and low wages growth are key reasons we don't need to move in lock step with others. Graph 11 Headline Inflation Year-ended % % New Zealand United States Australia Canada Euro area United Kingdom -2 -2 Sources: ABS; RBA; Refinitiv As I have said on previous occasions, the Board will not increase the cash rate until inflation is sustainably within the 2 to 3 per cent range. Given the recent inflation data and the forecasts I discussed earlier, I would like to provide some additional detail on our thinking here. We do not have a specific definition as to what ‘sustainably in the target range’ means. The actual rate of inflation is relevant as are the trajectory and the outlook. So too is the breadth of price increases and the factors driving them. Based on the evidence we have, it is too early to conclude that inflation is sustainably in the target range. In terms of underlying inflation, we have just reached the midpoint of the target range for the first time in over seven years. And this comes on the back of very significant disruptions in supply chains and distribution networks, which would be expected to be resolved over the months ahead. It also comes at a time when aggregate wages growth in Australia remains low and is at a rate that is unlikely to be consistent with inflation being sustained around the midpoint of the target range. As I discussed earlier, there is a range of significant uncertainties here that will take time to resolve. We are in the position where we can take some time to obtain greater clarity on these various issues. Countries with higher rates of inflation have less scope here. The Board is prepared to be patient as it monitors the evolution of the various factors affecting inflation in Australia. It is also relevant that Australia is within sight of a historic milestone – having the national unemployment rate below 4 per cent. This is important because low unemployment brings with it very real economic and social benefits for many Australians and their communities. Full employment is one of the RBA's legislated objectives and the Board is committed to playing its role in achieving that objective, consistent with also achieving the inflation target. As we navigate towards full employment, we have scope to take the time to distil the balance between supply and demand in the economy. Over the course of this year, we will be watching how the various supply-side problems resolve and the effects on prices. We will be watching consumption patterns and whether they normalise. We will also be looking for further evidence that labour costs are growing at a rate consistent with inflation being sustained within the target range. We expect this evidence to emerge over time, but it is unlikely to do so quickly. Finally, I want to make it clear that the RBA is committed to achieving the inflation target, which remains at the centre of our monetary policy framework. We don't want to see inflation too low or too high. We will do what is necessary to maintain low and stable inflation, which is important not only in its own right but also as a precondition for a sustained period of full employment. To conclude, the year ahead will no doubt have its challenges and its surprises. But standing here in early February, we are closer to full employment and achieving the inflation target than we had anticipated. It has been a difficult few years for the country, but our economy has proven to be resilient and Australians are adapting to living with the virus. This augurs well for the future. I wish you all the best for the year ahead. Thank you for listening. I look forward to answering your questions. Endnotes [*] I would like to thank Penny Smith for assistance in the preparation of this talk. Lowe P (2021), ‘The RBA and the Australian Economy’, Speech to CPA Australia Riverina Forum, Wagga Wagga, 16 December. The small holdings of semis maturing in March and April will not be reinvested. The materials on this webpage are subject to copyright and their use is subject to the terms and conditions set out in the Copyright and Disclaimer Notice. © Reserve Bank of Australia, 2001–2022. All rights reserved. The Reserve Bank of Australia acknowledges the Aboriginal and Torres Strait Islander Peoples of Australia as the Traditional Custodians of this land, and recognises their continuing connection to Country. We pay our respects to their Elders, past, present and emerging. | reserve bank of australia | 2,022 | 2 |
Opening statement by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Sydney, 11 February 2022. | Philip Lowe: Opening statement to the House of Representatives Standing Committee on Economics Opening statement by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Sydney, 11 February 2022. * * * Chair Members of the Committee Good morning. My colleagues and I look forward to the day where we can return to in-person hearings. We hope that will be for the next hearing. I would like to focus my introductory remarks today on three issues: the economic recovery; the outlook for inflation; and the RBA’s monetary policy decisions. The economic recovery At the time of the previous hearing in August, we were in the early days of the Delta lockdowns and were expecting a strong bounce-back when the restrictions were eased. This bounce-back did eventuate and the economy had strong momentum late last year. Then Omicron hit, which has been a significant setback for many people and businesses. Yet, once again, the economy has proven to be resilient. Despite the disruption caused by Omicron in January, we still expect positive growth in GDP in the March quarter, with spending and hours worked already recovering. Reflecting this resilience, the outlook for the Australian economy has improved since we last met. We estimate that GDP increased by around 5 per cent over 2021 and are expecting GDP growth of around 4¼ per cent over 2022 and 2 per cent over 2023. This outlook is being underpinned by a number of factors. These include household balance sheets that are in generally good shape, with households having accumulated more than $200 billion in additional savings over the past two years. An upswing in business investment is also under way and there is a large pipeline of residential building to be completed over the next year or so. Macroeconomic policy settings are supportive of growth, with governments planning significant infrastructure spending and monetary policy remaining very accommodative. The resilience of the economy is evident in the Australian labour market, where the outlook has continued to improve. A year ago, our central forecast was that the unemployment rate would be close to 6 per cent at the end of 2021. The outcome was much better than this: 4.2 per cent. There has also been a welcome decline in underemployment as many people have been able to obtain additional hours. Labour force participation has increased and the share of the working age population with a job has never been higher than it is now. The forward-looking indicators suggest further growth in jobs over the months ahead with vacancies at a very high level. Our central forecast is for the unemployment rate to decline to below 4 per cent later this year and remain below 4 per cent next year. If this comes to pass, it would be a significant milestone. Australia has not experienced unemployment rates this low since the early 1970s, almost half a century ago. The main source of uncertainty about the outlook continues to be COVID-19. The pandemic is not yet behind us and it is entirely possible that there will be more outbreaks. It also remains to be seen how households use all those savings that they have accumulated over the past two years. There are major geopolitical uncertainties and our largest trading partner, China, is working through a difficult adjustment in its property market. The sharp pick-up in inflation in parts of the 1/4 BIS central bankers' speeches world, especially in the United States, has come as a surprise and is an additional source of uncertainty about the outlook. Inflation For the first time in several decades, inflation has become a major issue in the global economy, although it is worth noting that inflation rates in most of Asia remain low. In the United States, CPI inflation is running at more than 7 per cent and in the United Kingdom it is expected to be at a similar rate soon. In Germany, inflation is 5.7 per cent and in New Zealand it is 5.9 per cent. These are the highest rates in decades and the higher inflation is turning out to be more persistent than earlier expected. This lift in inflation largely reflects the surge in global demand for goods during the pandemic coinciding with a reduced ability of the global economic system to produce and distribute goods. A related factor in a few countries, including the US and the UK, has been a decline in labour force participation, which has reduced the supply of labour and contributed to stronger wages growth. Higher prices for petrol, electricity and gas have also pushed inflation up in many countries. In Australia, we too have had higher inflation than we and others expected, although the increase here is smaller than in many other countries. In headline terms, inflation is 3½ per cent and in underlying terms it is 2.6 per cent. We are feeling the effects of global supply-chain problems and higher oil prices, but we have not seen the same increases in goods prices as have occurred in the United States. It is also relevant that the prices that Australian households pay for utilities are little changed and have not gone up sharply like the prices of utilities in Europe. Rent inflation has also been lower in Australia than elsewhere. Looking ahead, we expect a further lift in underlying inflation. There is also likely to be a shift in the drivers of inflation. Our central forecast is that underlying inflation will increase to 3¼ per cent in the coming quarters, before easing to around 2¾ per cent. This increase in the short term primarily reflects the ongoing effects of supply-side disruptions, most recently due to Omicron, at a time of strong demand. As these supply-side pressures are resolved, some of the current upward pressure on prices is expected to abate. An offset to this, though, is expected to be stronger growth in labour costs due to the tighter labour market. Wages growth has picked up recently, but only to the low rate prevailing before the pandemic. The vast bulk of Australians are still experiencing wages increase of no more than 2 point something per cent, although there are areas where the increases are much larger than this and non-wage benefits are also increasing. A further pick-up in overall wages growth is expected, although this is likely to be a gradual process given the institutional features of our labour market – including multi-year enterprise agreements, an annual review of award wages and publicsector wages policies. We are also expecting broader measures of labour costs to pick up faster than the Wage Price Index. There is, however, more than the usual degree of uncertainty around the outlook for inflation and wages. It is still unclear as to whether, and at what pace, the demand for goods will normalise as infection rates decline. The speed at which the supply side of the economy can respond to changes in the demand side is also uncertain. And we have no contemporary experience to assess how wage outcomes will evolve at a national unemployment rate below 4 per cent. A broader uncertainty is the extent to which other central banks will have to increase interest rates to return inflation to lower rates. Central banks and financial markets expect that a decline in inflation to target can be achieved without real policy interest rates returning to positive territory. It is entirely possible, though, that countries with higher inflation rates will need a bigger adjustment in interest rates than currently anticipated. If so, this could result in an abrupt adjustment in financial conditions. 2/4 BIS central bankers' speeches Monetary policy I would now like to turn to Australian monetary policy, where there have been a number of significant developments since we last met, including the discontinuation of the yield target, the cessation of the bond purchase program and a change in the outlook for interest rates. The yield target for the April 2024 bond was discontinued in early November. Up until that point the target had played an important role in anchoring the yield curve and keeping funding and borrowing costs low in Australia. In early October, the yield on the target bond was sitting at close to zero per cent. But then, a flow of stronger-than-expected data, both here and abroad, resulted in a shift in the distribution of possible future outcomes for the cash rate. In particular, these data implied that there was a reasonable probability of an increase in the cash rate before 2024. This assessment was reached by both the RBA and financial market participants and it was reflected in market prices. In these circumstances, the Board judged that there were more costs than benefits in seeking to continue to anchor the yield on the April 2024 bond at 10 basis points. The removal of the target was associated with volatility in the bond market. The RBA is conducting a review of the whole experience with the yield target and the results will be published later this year. In terms of the bond purchase program, the final purchases were made yesterday. All up, across the various programs, the RBA has purchased $350 billion of bonds issued by the Australian Government and by the states and territories. These purchases have lowered funding costs, supported asset prices and led to a lower exchange rate than otherwise. As a result, more people have jobs and inflation is closer to target. The stock of bonds purchased will also continue to support accommodative financial conditions in Australia. The decision to end the bond purchase program followed a review of the three considerations we have used from the outset: (i) the actions of other central banks; (ii) the functioning of our bond market; and (iii) the actual and expected progress towards our goals. All three considerations pointed to the same conclusion – to end the program. Of these three considerations, the most important was that faster-than-expected progress has been made towards our goals of full employment and inflation consistent with the target. The final development has been the change in expectations about the future path of interest rates. Since the onset of the pandemic, the Board has said that it will not increase the cash rate until inflation is sustainably in the 2 to 3 per cent range. When we last met, this condition was not expected to be met before 2024 in the RBA’s central scenario. Since then, the economy has performed better and inflation has been higher than in that scenario. As a result, interest rate expectations have moved higher. It is too early, though, to conclude that inflation is sustainably in the target range. In underlying terms, inflation has just reached the midpoint of the target band for the first time in over seven years. And this comes on the back of very large disruptions to supply chains and distribution networks, which are expected to be only temporary. It also comes at a time when aggregate wages growth is no higher than before the pandemic, which was associated with inflation being persistently below target. In these circumstances, the Board is prepared to be patient. We have scope to wait and see how the data develop and how some of the uncertainties are resolved. Countries with higher inflation rates have less scope here. I recognise that there is a risk to waiting but there is also a risk to moving too early. Over the period ahead we have the opportunity to secure a lower rate of unemployment than was thought possible just a short while ago. Moving too early could put this at risk. At the same time, we are committed to maintaining low and stable inflation and will do what is necessary to achieve this important goal. The stronger the economy and the more upward pressure on prices and wages, 3/4 BIS central bankers' speeches the stronger will be the case for an increase in interest rates. I would like to end with a brief reflection about the past couple of years. Throughout the pandemic, the RBA has had to make decisions in a highly uncertain environment in which there have been many moving parts. Over the two years, we have sought to provide the support the Australian economy needed and to play our role in building the bridge to the other side. Our actions have also been motivated by providing the country with insurance against the possibility of large downside risks that could have damaged the economy and hurt the welfare of the Australian people. Throughout this period, some things have worked out as expected but there have been plenty of surprises along the way. The RBA is committed to fully examining this experience in an open and transparent manner and to drawing lessons for the future. I will close on that note. In the interests of time, I will not make any introductory remarks regarding the many payments system issues that the RBA is working on, but we would welcome the opportunity to talk about these during the hearing, if that were possible. Thank you. My colleagues and I are here to answer your questions. 4/4 BIS central bankers' speeches | reserve bank of australia | 2,022 | 2 |
Remarks by Mr Christopher Kent, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to the Australian Financial Markets Association, Sydney, 22 February 2022. | reserve bank of australia | 2,022 | 2 |
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Speech by Mr Philip Lowe, Governor of the Reserve Bank of Australia, at the Australian Financial Review's (AFR) Business Summit, Sydney, 9 March 2022. | Philip Lowe: Recent economic developments Speech by Mr Philip Lowe, Governor of the Reserve Bank of Australia, at the Australian Financial Review’s (AFR) Business Summit, Sydney, 9 March 2022. * * * Thank you for the invitation to participate in this year’s AFR Business Summit. It is very good to be with you again. I would like to cover four issues today: 1. The resilience of the Australian economy and some of the major uncertainties, including the invasion of Ukraine by Russia. 2. The journey towards full employment in Australia. 3. The recent inflation data. 4. The implications of these developments for monetary policy in Australia. The resilience of the Australian economy Last week we received further evidence of the resilience of the Australian economy. In the December quarter, GDP increased by 3.4 per cent, which was one of the biggest quarterly increases on record. Over the final months of the year, there was a very strong bounce-back in household consumption following the mid-year Delta lockdowns. Over 2021 as a whole, the economy grew by 4.2 per cent, taking the level of GDP to 3½ per cent above its pre-COVID19 level (Graph 1). This is a very good outcome by global standards, which is something we should not forget. 1/1 BIS central bankers' speeches | reserve bank of australia | 2,022 | 3 |
Speech by Mr Philip Lowe, Governor of the Reserve Bank of Australia, Sydney, 3 May 2022. | Philip Lowe: Today’s monetary policy decision Speech by Mr Philip Lowe, Governor of the Reserve Bank of Australia, Sydney, 3 May 2022. * * * Thank you for joining us this afternoon. I would like to use this opportunity to explain the Reserve Bank Board’s decision today and to answer your questions. Today, the Board decided to increase the cash rate target by 25 basis points to 35 basis points and to increase the rate paid on Exchange Settlement balances from 0 per cent to 25 basis points. It also decided to not reinvest the proceeds of the Bank’s government bond holdings as they mature. These decisions reflect a judgement by the Board that it is now time to begin withdrawing some of the extraordinary monetary support that was put in place to help the Australian economy during the pandemic. Two considerations are particularly relevant here. The first is that the economy has been very resilient, unemployment is low and economic growth is expected to be strong this year. The second is that inflation has picked up more quickly, and to a higher level, than was expected and there is evidence that labour costs are increasing more quickly. In these circumstances, the Board judged that it was appropriate to start the process of normalising monetary conditions. I acknowledge that this increase in interest rates comes earlier than the guidance the Bank was providing during the dark days of the pandemic. During that period, especially in 2020, the national health situation was precarious and the economic outlook was dire and clouded by great uncertainty. The Board wanted to do everything it could to help the country get through that difficult period. In those unprecedented times, we judged that the economic damage from the pandemic was likely to require that interest rates remain at very low levels for years. As things have turned out, the economy has been much more resilient than was expected, which is clearly a welcome development. The combination of fiscal and monetary support has worked and the development of vaccines in record time has allowed our society to return to more normal functioning earlier than was thought possible. Australians have also proven to be resilient and have adapted to the changed circumstances. As a result of these developments, unemployment has come down quickly. The unemployment rate now stands at 4 per cent. It is expected to decline further to around 3½ per cent over the course of this year, which would be the lowest level in nearly 50 years. Labour force participation has also risen to a record level and a higher share of working-age Australians has jobs than ever before. The economy is expected to grow strongly this year, with our central forecast being for GDP growth of a little above 4 per cent. This resilience of the economy means that the record low interest rates are no longer needed. The other major development has been on the inflation front. Over the year to the March quarter, CPI inflation was 5.1 per cent and in underlying terms inflation was 3.7 per cent. These numbers are lower than inflation rates in most other advanced economies, but they are higher than we have experienced for many years and higher than we were expecting. The main driver of the higher inflation has been global developments, with a series of major global supply shocks pushing prices up. Over the past two years, COVID-19 has interrupted supply chains and continues to do so, with the recent lockdowns in some Chinese cities again disrupting production and transport. On top of this, Russia’s invasion of Ukraine has resulted in sharp increases in the prices of oil and gas, base metals and many agricultural commodities. These shocks to global prices inevitably flow through to higher inflation in Australia. But the higher inflation outcomes have a domestic component as well. There are a number of 1/3 BIS central bankers' speeches areas where strong demand is putting pressure on available capacity, with many firms reporting difficulty in hiring workers with the right skills. This pressure on capacity is reflected in the broadening of the areas in which prices are rising more quickly than they have for some time. Firms in a range of industries are now indicating that they are prepared to pass cost increases through to consumer prices. Looking forward, we expect a further increase in the inflation rate as the effects of global developments wash through the year-ended figures. We then expect inflation to start moderating as some of the supply disruptions are resolved and/or as prices settle at a higher level – for inflation to stay high, prices need to keep increasing at a fast rate, not only settle at a high level. An offsetting influence over time will be stronger growth in labour costs as the labour market tightens. Our central forecast – which is based on an assumption of further interest rate increases – is that underlying inflation will decline to the top of the target band in 2024. If interest rates were to remain unchanged, inflation would be higher than this. Over recent years, the Board has placed considerable emphasis on trends in growth in labour costs when making its decisions. This is because, over the medium term, there is a strong link between the inflation rate and the rate of growth of labour costs. Given that we operate a flexible medium-term inflation target, we are generally prepared to look through year-to-year variability in the inflation rate caused by supply-side shocks or exchange rate movements. This is because if these shocks do not flow through to a persistent change in growth of labour costs, inflation should return to a lower rate once the effect of the shock passes. But if supply-side shocks do lead to a persistent shift in labour cost growth, inflation will not return to where it was before. This focus on trends in labour costs was evident in the Board’s communication after the previous meeting when we stated that over coming months we would be assessing important additional evidence on both inflation and the evolution of labour costs. The evidence that we have received since then on inflation is clear. It was high. And higher than expected. On labour costs, while the various data on labour costs for the March quarter compiled by the ABS are yet to be released, other evidence received over the past month through our business liaison and various business surveys has indicated that there is now stronger upward pressure on labour costs and that this is likely to continue. We expect to see this in the ABS data in the period ahead. In a tight labour market, some firms are paying higher wages to attract and retain staff. This is especially so given that inflation is high and workers are experiencing cost of living pressures. There is still considerable inertia in the wages system from multi-year enterprise agreements and current public sector wages policies, but the direction of change is now clear. Given this evidence on inflation and wages and the very low level of interest rates, the Board decided that now was the right time to start the process of normalising interest rates. We also decided that we would not reinvest the proceeds of maturing government bonds. This means that our bond holdings and balance sheet will decline as bonds mature. Our balance sheet will also decline substantially in 2023 and 2024 as banks repay the funding made available under the Term Funding Facility. This contraction of our balance sheet will contribute to some tightening of financial conditions in Australia and so assist with the return of inflation to target. The Board currently has no plans to sell the government bonds it purchased during the pandemic and intends to allow the portfolio to run down in a predictable way as bonds mature. This decision to proceed with quantitative tightening does not rule out a return to quantitative easing sometime in the future, should circumstances require that. Given the outlook for the economy and inflation, further normalisation of interest rates will be required. In making its decisions, the Board will continue to be guided by the evidence on both inflation and the labour market. We will also continue to be flexible and responsive to changing circumstances. We will do what is necessary to ensure that inflation outcomes are consistent 2/3 BIS central bankers' speeches with the medium-term inflation target. This does not require an immediate return of the inflation rate to target because our monetary policy framework intentionally allows for flexibility and some variability in inflation from year to year. But we do need to ensure that the inflation rate tracks back to the target range of 2 to 3 per cent over time. This would be harder to achieve if the inflation psychology in Australia were to shift in a durable way due to the recent higher inflation outcomes. The decision to move today, rather than wait, should help on this front. In making our decisions over coming months, we need to navigate through some considerable uncertainties. Globally, it remains uncertain how the supply-side problems will be resolved and developments in Ukraine are unpredictable. Another source of uncertainty is how household spending in advanced economies responds to the decline in real wages, as wages growth has not kept pace with the higher inflation. Also, we have no contemporary experience to guide us with how labour costs and prices in Australia will behave at an unemployment rate below 4 per cent. It is also relevant that households have much more debt than previously, and many households have never experienced rising interest rates. So this is another aspect that we will be watching carefully. Notwithstanding these uncertainties, I expect that further increases in interest rates will be necessary over the months ahead. The Board is not on a pre-set path and will be guided by the evidence and data as it takes the necessary steps to achieve the medium-term inflation target and support full employment in Australia. Thank you for listening. I am happy to answer your questions. 3/3 BIS central bankers' speeches | reserve bank of australia | 2,022 | 5 |
Speech by Mr Christopher Kent, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, at the KangaNews DCM Summit, Sydney, 23 May 2022. | 23/05/2022, 13:03 From QE to QT – The next phase in the Reserve Bank's Bond Purchase Program | Speeches | RBA Speech From QE to QT – The next phase in the Reserve Bank's Bond Purchase Program Christopher Kent [ * ] Assistant Governor (Financial Markets) KangaNews DCM Summit Sydney – 23 May 2022 Introduction It is great to be here in person. Last year at this event, I discussed the Bank's Term Funding Facility (TFF). Today, I'm going to focus on the Bank's bond purchase program. At its meeting earlier this month, as well as raising the cash rate target, the Board decided not to reinvest the proceeds from bonds as they mature from the Bank's portfolio. This signals the next phase in the bond purchase program. The initial phase in which the Bank built up its stock of bond holdings is often referred to as ‘quantitative easing’, or QE for short. That phase ended in February this year. We have now entered the phase known as ‘quantitative tightening’, or QT. By allowing our bond holdings to gradually diminish over time as they mature, the initial stimulatory effects of those holdings – namely, downward pressure on government bond yields and the Australian dollar exchange rate – will gradually unwind. In my presentation today, I'll explain the reasoning behind the decision to begin QT. I'll then discuss some of the implications of QT for financial conditions, and explore what it means for the Bank's balance sheet and the operation of monetary policy through the cash rate. But first, I'll briefly recap the QE phase of the program. Background The Bank introduced the bond purchase program in November 2020 to provide additional support to the Australian economy in the early and still very uncertain stage of its economic recovery from the COVID-19 shock. This was a new element to the package of policy measures adopted at the outset of the pandemic. The very low cash rate target was already anchoring the front end of the yield 1/11 23/05/2022, 13:03 From QE to QT – The next phase in the Reserve Bank's Bond Purchase Program | Speeches | RBA curve. The Bank's forward commitment on the cash rate and the three-year bond yield target were tying down the yield curve a few years out. In this context, the bond purchase program was designed to further ease financial conditions by lowering bond yields further out the curve and contributing to downward pressure on the exchange rate. The program was introduced at a time when the unemployment rate was close to 7 per cent and expected to rise even higher. Inflation was low, at only 1¼ per cent in underlying terms, and was widely anticipated to rise only gradually. Indeed, most of the market economists that we regularly survey were forecasting that underlying inflation would remain well below 2 per cent until at least the end of 2022. In addition, the central banks of other major advanced economies had been purchasing significant amounts of their governments' bonds for some time under pandemic-related asset purchase programs (Graph 1). While those programs had led to an easing in financial conditions in global financial markets, they had also contributed to upward pressure on the Australian dollar. By October 2020, these central banks held close to 30 per cent or more of their governments' bonds on issue – by contrast, the Reserve Bank held only around 9 per cent of Australian Government Securities (AGS) outstanding, following purchases to restore market function in the early months of the pandemic and in support of the Bank's three-year yield target. Graph 1 2/11 23/05/2022, 13:03 From QE to QT – The next phase in the Reserve Bank's Bond Purchase Program | Speeches | RBA Financial market participants anticipated a substantial amount of purchases under the program – of both AGS and bonds issued by the state and territory governments (semis) of 5–10 years maturity. Under the bond purchase program, the Bank has acquired almost $224 billion of AGS and $57 billion of semis. These were purchased in the ‘secondary market’ between November 2020 and February 2022, when the Board decided to cease purchases. By then, the Bank's share of AGS outstanding had risen to around 35 per cent, which was above the equivalent share for the US Fed, but still below other central banks like the Reserve Bank of New Zealand and the Bank of Canada. The share of our holdings relative to GDP has been consistently lower than other advanced economy central banks, reflecting the relatively low level of Australian public debt as a share of GDP. Our estimates suggest that the bond purchase program reduced longer term AGS yields by around 30 basis points and lowered the spread of yields on semis to AGS by between 5 and 10 basis points. [ 1] Not surprisingly – given the forward-looking nature of bond markets – most of these effects appear to have been associated with the announcements related to the purchases (and the subsequent expectations of market participants about the stock of bonds the Bank would eventually hold), rather than with the actual purchases taking place; this was broadly in line with international experience. The decline in bond yields helped to lower financing costs for borrowers, contributed to a lower exchange rate than otherwise, and supported asset prices and balance sheets of businesses and households. The start of QT The precursor to QT was the decision in February 2022 to end QE by ceasing purchases under the bond program. That decision was made on the basis of three criteria. First, by the time of the February meeting, most other central banks had concluded their pandemic purchase programs, or were flagging that they would do so shortly. Second, while the Australian bond market had been functioning reasonably well, some pressure points had emerged. These were related to the high share of some bond lines that were held by the Bank, though they were being mitigated in part by our stock-lending activities, which have been focused largely on bonds in the three-year futures basket (Graph 2). Third, and most importantly, there had been significant progress towards our goals, with the unemployment rate declining to 4.2 per cent and inflation rising in underlying terms to be close to the centre of the 2 to 3 per cent target range for the first time in seven years. 3/11 23/05/2022, 13:03 From QE to QT – The next phase in the Reserve Bank's Bond Purchase Program | Speeches | RBA Graph 2 By the time of the May Board meeting, the economy was looking stronger still – and stronger than had been forecast just three months prior. Unemployment had declined to a very low level, one which had not been seen for a very long time. Inflation in the March quarter was high. It was also higher than had been expected. In part, that was due to the effect of the invasion of Ukraine on commodity prices, particularly oil prices. But high inflation had also become more broadly based, with underlying inflation rising to 3.7 per cent and pressures building in a number of non-tradable categories. There was also evidence – from the Bank's liaison program, as well as business surveys – that there had been a further lift in the growth of labour costs in March and April. The Wage Price Index for the March quarter (based on information obtained in mid-February) subsequently showed a further pick up in the year-ended rate of growth of wages, with pockets of stronger wages growth in parts of the economy. Given that background, the Board's assessment in May was that it was time to begin raising interest rates and to start the process of QT. The decline in our bond holdings will be gradual over this year and next. The first major maturities from the Bank's portfolio will be about $2 billion worth of the July 2022 Australian Government bond, 4/11 23/05/2022, 13:03 From QE to QT – The next phase in the Reserve Bank's Bond Purchase Program | Speeches | RBA followed by $2 billion of the November 2022 bond. The maturity of the April 2023 bond is much larger, at slightly over $13 billion (Graph 3). Maturities will then step up again to be more sizeable from 2024. Graph 3 The average maturity of the Bank's holdings is a little lower than for most other advanced economy central banks (Graph 4). This largely reflects the fact that the Bank did not buy bonds beyond those in the 10-year futures basket, in contrast to other central banks like the Bank of England, the US Fed and the Bank of Canada that purchased bonds at maturities of beyond 20 years. Also in contrast to the Reserve Bank, those central banks have bonds maturing in the near term that had been purchased as part of earlier asset purchase programs, prior to the pandemic. 5/11 23/05/2022, 13:03 From QE to QT – The next phase in the Reserve Bank's Bond Purchase Program | Speeches | RBA Graph 4 Some central banks have decided to sell bonds in order to run down their portfolio faster than otherwise, or have indicated that they will consider that option. [ 2] However, the Reserve Bank Board noted that it currently has no plans to sell bonds from its portfolio. This decision reflected a number of considerations. First, the Board judged that raising the cash rate was the best way of reducing the extent of monetary stimulus in the economy. In particular, it is easier to adjust policy and influence financial conditions by calibrating one instrument rather than two in response to evolving conditions. Second, sales of bonds by the Bank into the market could potentially complicate the task of issuance by the federal, state and territory authorities, including by adding to volatility in bond markets. Third, should a bond buying program be needed in the future to provide support to the economy, it would be likely to be more effective if sales are avoided this time around. Setting a precedent of sales in the QT phase of the current program could reduce the effectiveness of a given value of any future bond purchases. That's because the effect of those purchases on bond yields and the exchange rate would arguably be lessened if the market anticipates a fast run down of holdings next time around. In short, the market would probably assume ‘once a seller, always a seller’. Now that the process of QT has started, the path of the Bank's bond holdings is clear. So long as markets are sufficiently forward looking, this means that yields today should reflect all of the information available about the steady decline in the Bank's holdings. 6/11 23/05/2022, 13:03 From QE to QT – The next phase in the Reserve Bank's Bond Purchase Program | Speeches | RBA The effect that our purchase program has had on bond yields (and the exchange rate) will persist while we hold those bonds, but it will gradually diminish over time. [ 3] In particular, the effect of the extra demand in the market associated with the Bank's purchase of bonds gradually falls as those bonds move towards and eventually reach maturity in a very predictable way. [ 4] Of course, many other forces, including global developments, will be affecting bond yields at the same time. But the key point is that, as the Bank's holdings gradually mature, their contribution to lower bond yields will slowly diminish. While that reduction in stimulus is appropriate given the economic circumstances, as I mentioned already, reducing the very substantial monetary policy stimulus put in place at the outset of the pandemic will be a task best served by increases in the cash rate. The balance sheet and the operation of monetary policy The Bank's bond portfolio will remain substantial for some years to come, and so too will the Bank's balance sheet. By April 2024, about $47 billion worth of bonds purchased in support of the yield target and market functioning will have matured. And the last of the $188 billion provided to banks under the TFF is due at the end of June 2024 (Graph 5). Despite these substantial declines up to that point, the Bank's balance sheet will still be at least twice as large as what it was just prior to the pandemic. It will decline gradually thereafter, with bond maturities of between $35 billion and $45 billion every year for some time. 7/11 23/05/2022, 13:03 From QE to QT – The next phase in the Reserve Bank's Bond Purchase Program | Speeches | RBA Graph 5 One of the consequences of the Bank's bond purchase program, and other policy measures adopted in response to the pandemic, is the abundance of Exchange Settlement (ES) balances. [ 5] These are held by commercial banks (and other financial institutions) at the Reserve Bank and are used to settle transactions between banks. Banks can also lend them to others in the overnight cash market, with those transactions determining the cash rate. As expected, the abundance of ES balances led to a noticeable decline in the demand to trade cash overnight. It has also been unsurprising that the cash rate has traded slightly below the cash rate target since late-March 2020 (Graph 6). While ES balances will decline as the various monetary policy measures adopted during the pandemic unwind, as discussed, that process will take a number of years. 8/11 23/05/2022, 13:03 From QE to QT – The next phase in the Reserve Bank's Bond Purchase Program | Speeches | RBA Graph 6 Recently, the Board considered options to reduce ES balances more quickly. [ 6] If we were to do that, banks would have more of an incentive to borrow funds overnight, since their ES balances would once more become relatively scarce. Hence, such a change would encourage more trading in the overnight cash market, with the cash rate trading closer to, and eventually around, the cash rate target. However, the benefits of reducing ES balances quickly were judged to be modest compared with the risks, including the potential to create volatility in a range of financial markets. Moreover, while the abundance of ES balances affects the behaviour of the cash rate relative to the cash rate target, it does not impair the ability of the Bank to achieve the desired stance of monetary policy via adjustments to the cash rate target and the rate paid on ES balances. In particular, because ES balances will remain abundant for some time, the cash rate will tend to be priced as a margin above the ES balance rate. This is because the ES balance rate is the opportunity cost for banks considering whether to lend spare cash overnight or leave it sitting with the Reserve Bank. But, given that the gap between the ES balance rate and the cash rate target is just 10 basis points, this also means that the cash rate is only trading a little below the cash rate target. Moreover, banks borrowing cash have little need to pay more than the cash rate target – they know that there should be many banks willing to lend cash at that price and, if needed, they can obtain similar liquidity themselves via the Reserve Bank's open market operations at a similar (term-matched) rate. [ 7] 9/11 23/05/2022, 13:03 From QE to QT – The next phase in the Reserve Bank's Bond Purchase Program | Speeches | RBA When considering the framework, the Board saw value in continuing to set and communicate both the remuneration rate on ES balances and the cash rate target in policy announcements. It also agreed to maintain the current margin of 10 basis points between the ES rate and the cash rate target (subject to periodic review, as the appropriate margin could change over time as market conditions evolve). In the current environment, that modest difference helps to ensure effective control of the cash rate. Conclusion In May, the Board began to remove some of the extraordinary monetary policy stimulus put in place to help support the economy through the pandemic. The focus of most observers at that time was on the 25 basis point increase in the cash rate target and the rate paid on ES balances. That's as it should be. But at the same time, the Bank also decided to proceed with quantitative tightening – by allowing its bond holdings to mature in a steady and predictable way over time. The bond purchase program was adopted in late 2020 to provide additional support to the Australian economy at the same time that the cash rate was reduced to its effective lower bound. The bond purchases helped to reduce yields further out the curve and contributed to a lower value of the Australian dollar than otherwise. As the Bank now takes steps to remove the considerable monetary stimulus, increases in the cash rate are the tried and tested measure that will do most of the work, including because they can be easily calibrated to evolving economic conditions. The end of the TFF and the gradual process of QT will also play a role in this task, but a predictable and modest one. Because the Bank's bond portfolio will mature gradually, the Bank's balance sheet and commercial banks' ES balances will remain large for some years. This means that the cash rate will continue to trade slightly below the cash rate target, but above the rate paid on ES balances. Most importantly though, the Bank will continue to be able to maintain effective control over the cash rate as it withdraws monetary policy stimulus in the period ahead. Endnotes [*] I thank Nick Stenner for his help in preparing this material. See Finlay R, D Titkov and M Xiang (2021), ‘An Initial Assessment of the Reserve Bank's Bond Purchase Program’, RBA Bulletin, June; Finlay R, D Titkov and M Xiang (forthcoming), ‘The Yield and Market Function Effects of the Reserve Bank of Australia's Bond Purchases’, RBA Research Discussion Paper. The Reserve Bank of New Zealand decided to sell NZ$5 billion of its portfolio to New Zealand Debt Management (the issuer of New Zealand Government bonds) each year and has a government indemnification against losses on the QE program. The Bank of England is considering bond sales and also has a government indemnification against losses on its bond purchase program. For a discussion of the different channels through which bond purchases can influence bond yields and financial conditions more generally, see Debelle G (2021), ‘Monetary Policy During COVID’, Shann Memorial Lecture, Online, 6 May. 10/11 23/05/2022, 13:03 From QE to QT – The next phase in the Reserve Bank's Bond Purchase Program | Speeches | RBA When thinking about the theory, there are two interesting cases to consider in terms of the effects of monetary stimulus and the bond purchase program on bond yields. In the first case, let's assume that the economy would have eventually recovered from the shock of the pandemic even without any additional support from unconventional policies. In this case, the economy returns to the pre-pandemic equilibrium (and bond yields), but additional monetary policy stimulus, including the bond purchase program, helps this process to occur much sooner than otherwise. In the second case, let's assume that the economy is affected by hysteresis. Monetary policy in this case can help to avoid a permanently weaker equilibrium (say with unemployment too high and inflation and inflation expectations too low), in which case the bond purchase program can have a persistent effect on yields, even once it has ended; like the first case, additional policy support helps to restore the equilibrium that existed prior to the adverse shock. See Dowling S and S Printant (2021), ‘Monetary Policy, Liquidity, and the Central Bank Balance Sheet’, RBA Bulletin, June. See RBA (2022), ‘Minutes of the Monetary Policy Meeting of the Reserve Bank Board’, Hybrid, 5 April. See Kent C (2022), ‘Changes to the Reserve Bank's Open Market Operations’, Remarks to the Australian Financial Markets Association, Sydney, 22 February. 11/11 | reserve bank of australia | 2,022 | 5 |
Keynote speech by Ms Luci Ellis, Assistant Governor (Economic) of the Reserve Bank of Australia, to the Urban Development Institute of Australia 2022 National Congress, Sydney, 25 May 2022. | Speech Housing in the Endemic Phase Luci Ellis [ * ] Assistant Governor (Economic) Keynote Speech to the UDIA 2022 National Congress Sydney – 25 May 2022 I would like to thank UDIA for the opportunity to speak to you today. I'd originally been invited to the same congress two years ago, but the event was cancelled for obvious pandemic-related reasons. Suffice to say, the talk I'm giving today is very different from the one I had written and planned to give in March 2020. Two years of pandemic and ongoing recovery have profoundly affected every aspect of how we live and work, but few more so than our housing choices. In fact, things have changed so much on this front that the focus of my talk is almost solely the drivers of housing outcomes. There is that much to talk about! I won't have anything to add about monetary policy, beyond what has already been published in recent weeks in the Governor's media conference, the Statement on Monetary Policy, and the Board Minutes. And I'm not going to say much about the prices of established homes. Rather, I plan to focus on some of the underlying drivers of housing demand, their likely persistence, and the capacity of the construction industry to meet that demand. The shift in space It is no surprise that the pandemic has changed how we think about our homes. There is nothing quite like being confined to your home for months on end to make you appreciate having a home that meets your needs, or rankle at one that does not. Spurred by the experience of lockdown and self-isolation, many people understandably wanted a bit more space, and perhaps a garden. Some also needed space where they could work, or perhaps just fewer flatmates to share that space with. This shift towards wanting more space has changed many people's living arrangements – the full extent to which will be revealed in the 2021 Census results to be released from late June. Until then, there are some intriguing and suggestive results from survey data, which show that average household size has fallen since the pandemic began (Graph 1). The share of group households declined in 2020 and has remained at this lower level. By contrast, while some young adults moved back in with their parents at the onset of the pandemic, that shift has since reversed. On the question of who you would rather be locked down with, at least some Australians have voted with their removalists' van, by moving out of their share house and in with their partner. Graph 1 Household Dynamics* no Average household size Living arrangements % Share of households Live with partner 2.6 2.5 Live with parents Other 2.4 Live alone Share housing * Based on self-reported survey data; six-month moving average. Sources: RBA; Roy Morgan Single Source The decline in average household size increased the demand for homes (by number). This helps explain why rental vacancy rates quickly returned to low levels even though the international border was closed and population growth declined to be close to zero. Roughly speaking, the decline in population growth meant that there were up to 200,000 households that didn't arrive in Australia over the past two years, who would have done so if population growth had stayed where it was before the pandemic. [ 1] But the decline in the average size of households that were already here broadly offset this. Across the whole Australian population of more than 25 million people, a decline in average household size of the extent shown in Graph 1 would add about 140,000 households. This is a necessarily rough calculation and, as I mentioned, we will know more when the Census results are released. In broad terms, though, these two factors have roughly offset each other. This suggests that the number of homes demanded didn't changed much throughout the pandemic. There's a broader point to be made here: things always adjust. If average household size hadn't declined, there would have been fewer households to fill the new homes being built. Instead of the result being a swathe of empty homes, though, prices would have adjusted – in this case, rents. This would have induced the demand needed to match the supply. I am reminded of the predictions that population ageing would result in a shrinking labour force, because people aged over 65 are less likely than younger people to be employed. But, as I have noted in the past, participation of older workers, and female workers in most age groups, increased and more than offset the effect of ageing. [ 2] The lesson here is that we shouldn't focus only on the original shock – but rather how people will react to that shock. People's housing choices changed over the past two years. Homes with some outdoor space became even more attractive relative to small apartments. This shift in preferences was evident both in rental and purchase markets. Rents and prices of apartments weakened relative to those for detached houses during the early phase of the pandemic, especially in the largest cities. Renovation activity also increased. The desire for more space is one thing; the ability to get it is another. For some, this choice became more feasible due to other pandemic-related shifts. As I first described some years ago, people's choices around housing represent a trade-off between space, place and price. [ 3] The widespread shift to working from home reduced the premium on place. If you don't need to commute to employment centres as often, living further out becomes more tenable. It then becomes more feasible to get more space for a similar price, by trading off place. A lower relative advantage of central locations will show up in their relative price. And that is exactly what has happened. The relative premium paid to be closer to the city centre, both in rents and purchase prices, narrowed during the pandemic (Graph 2). Housing prices increased over the two years to April this year across almost all neighbourhoods in the major cities; however, in general, price increases were stronger in the outer suburbs than in inner-urban regions. The premium for being close to the centre remains, but it is much smaller now and is closer to the premium for being in a middle-ring suburb. Graph 2 House Price Premiums* Inner and middle city ring prices, relative to outer capital city prices ratio ratio Sydney Melbourne Brisbane Perth 1.75 1.75 December 1.50 1.50 April 2022 1.25 1.00 Inner Middle Inner Middle Inner Middle Inner Middle 1.25 1.00 * Inner refers to 0–15 km from CBD; middle refers to 30–60 km from CBD. Sources: CoreLogic; RBA It should be noted that the desire for more space has likely been more widespread than the ability and willingness to trade-off place. While a large fraction of the population has experienced long lockdowns, and more than a few of us have had to self-isolate, not everyone can make the location trade-off. Many people cannot work from home because of the nature of their work. ABS data from the Characteristics of Employment survey showed that more than 60 per cent of managers and professionals were working from home in August last year, but only around 20 per cent of people in sales or the community and personal services sector. And even those who can work from home at least part of the time will not be in a position to do so full-time. The ‘laptop class’ of people who can mostly work from home on an ongoing basis are in fact a small minority – a minority, who, prior to the pandemic, were not evenly distributed across geography. Rather, they were concentrated in inner-urban, higher-priced areas. Data from the 2020 HILDA survey suggests that around 60 per cent of people who lived within 5 kilometres of a city centre could work from home, but less than 40 per cent of those who lived more than 20 kilometres out could do so. As a result, a shift in the location of some of the laptop class will be more noticeable than if they had initially been more evenly spread. Some effects will wane In considering the effects of the pandemic on the housing market, we need to remember that only some of these shifts might last. The desire for more space further from the office might wane over time as the memories of lockdown start to fade. Not everyone who sought a ‘tree change’ in the regions will find that to be the right choice in the long term. More importantly, many of the shifts of population between locations were less a change in people's decisions than a simple interruption of the normal flows. In broad terms, the usual pattern of net population flows is that migrants from overseas are more likely to arrive in Sydney and Melbourne, and this net flow into those cities more than offsets the usual net outflow of residents to other parts of Australia, especially Queensland. There are variations around this trend, such as the shifting net flows into and then out of Western Australia as the mining boom peaked and declined. But these net flows mask much larger flows in both directions from each region (Graph 3). People move for all sorts of different reasons. Graph 3 Population Change ’000 Sydney Melbourne Brisbane ’000 Perth Total Natural increase 20/21 19/20 18/19 -100 20/21 -100 19/20 -50 18/19 -50 20/21 19/20 18/19 20/21 19/20 18/19 Net internal migration Net overseas migration Sources: ABS; RBA During the peak of the pandemic, some of these gross flows were impeded. As well as the flow of overseas migration coming to an effective halt while the international borders were closed, people from parts of Australia that were not in lockdown at the time tended not to move to cities that were in lockdown. So this wasn't so much about city people wanting tree changes, but rather the interruption of the longstanding trend of others moving to the big smoke. Regardless of the source of the change in population flows, though, it is undeniable that in many regional housing markets, prices and rents have increased considerably. This is impinging on the budgets of existing residents. It is important to be mindful of that. With the inflow all but stopped and outflows continuing, population growth in Australia's largest cities over the last two years was much weaker than in the rest of the country. These shifts are now unwinding, with internal migration returning to a more typical pattern and overseas migration slowly starting to pick up. Overall population growth is now expected to revert to close to pre-pandemic patterns by 2024. It will take a little while for students and other migrants to return in the numbers that were seen before the pandemic. Importantly, official projections do not embody any catch-up from the period of closed borders. This implies that the population level is on a permanently lower track than would have been expected had the borders not been closed. While the local market implications of this will be important, it is also worth considering the national picture. The sharp decline in population growth stemming from pandemic-related border closures occurred at the same time as the housing stock continued to expand (Graph 4). Much of the additional supply will have been absorbed by the decline in household size noted earlier. Even so, the net effect is likely that housing supply has for a number of years been running ahead of what would normally be thought of as trends in demand. Graph 4 Population and Dwelling Stock* Year-ended growth % % Dwelling stock 2.0 2.0 1.5 1.5 Population 1.0 1.0 0.5 0.5 0.0 0.0 * Dashed lines represent forecasts; the population growth forecast is broadly in line with the profile set out in the Australian Government Budget 2022–23. Sources: ABS; Australian Treasury; RBA Treasury forecasts imply that, over time, the population growth rate is likely to revert to something closer to its pre-pandemic trend. But what about the flow of new housing supply? Our expectation is that construction of new homes will remain solid for the next couple of years. The housing stock will therefore continue to expand as a result. We expect it will expand at rates similar to the first decade of this century, but not as much as during the boom in apartment building in the second half of the 2010s. This is likely to still be enough to keep the housing stock growing faster than the population. Solid rates of home-building have been encouraged by a range of public policy measures, including the low level of interest rates. Also important has been the raft of subsidies and other incentives for home construction, as well as support for first home buyers during the pandemic. In combination, these subsidies have been quite sizeable in some cases (Graph 5). Graph 5 Maximum Grants Available* New home construction $’000 New South Wales Victoria % $’000 Queensland Western Australia % H2 2020 HomeBuilder (LHS) First home owner grant (LHS) H2 2020 Other** (LHS) Per cent of median housing price*** (RHS) * Subject to eligibility criteria including first-home-buyer status, income and property price caps. ** Other includes regional bonuses in Victoria and Queensland, and the Western Australian Building Bonus grant. *** Median price of all new and established dwellings at the end of the reference period. Sources: CoreLogic; federal and state governments; RBA It is difficult to disentangle how much of the increase in demand for housing has reflected temporary subsidies and the current low level of mortgage rates versus the shift in preferences. However, it is clear that the time-limited nature of HomeBuilder and some other subsidies induced a temporary surge in building approvals for detached homes and renovations (Graph 6). We estimate that about one-quarter of building approvals during this period were supported by HomeBuilder, though many of these would have happened anyway. Graph 6 Private Residential Building Approvals* Monthly ’000 Detached ’000 New dwellings Higher-density $b $b Alterations & additions 1.0 1.0 $25,000** 0.8 0.8 0.6 0.4 0.6 $15,000** * ** 0.4 Smoothed lines are 13-period Henderson trends. Grant value by phase of the HomeBuilder program. Sources: ABS; RBA Even now, after eligibility for these subsidies has closed, these categories of building approvals have remained higher than immediately before the pandemic. This suggests that the extra demand induced by the subsidies wasn't entirely pulled forward from this year and next year, which would have left a ‘hole’ in activity. Rather, the combined effect of low interest rates and preference shifts is continuing to support demand. Over time, though, that additional surge in building approvals from HomeBuilder and other subsidies will have been worked through and will no longer be a support for the level of dwelling construction. But not yet, because – as I'll explain – the construction industry appears to be at capacity. Construction at capacity Despite the surge in demand and building approvals, the data on housing completions have not yet picked up in the same way (Graph 7). This is why current and expected growth in the housing stock is around the same rate as in the first decade of the century. The large number of detached approvals have mostly started construction, but there is now an unusually large pipeline of detached homes that are yet to be completed. Graph 7 Residential Pipeline ’000 Quarterly activity Commencements Dwellings approved but not yet completed ’000 Higher density Approvals Completions Detached 2022 2002 Sources: ABS; RBA All the signs point to the fact that the residential construction industry is at capacity and cannot work down this pipeline any faster. To be clear, this has nothing to do with land availability or governments approving enough homes. The land has been made available and the building project is already approved. The issue is how fast these projects can be completed. We hear from liaison contacts in the construction industry that delays are common. Normally, a detached home takes about six months to build. Currently, they are telling us that it is averaging around nine months. The divergence in the relationship between dwelling investment and its usual drivers also suggests that construction is at capacity. Normally, dwelling investment can be reasonably well explained by factors such as recent building approvals, population growth and interest rates. But lately, actual outcomes have been significantly weaker than those usual relationships would imply (Graph 8). Graph 8 Pipeline Model – Total New Dwelling Investment $b $b Actual Model $b $b Change in backlog, four-quarter rolling sum Higher density Detached -5 -5 Sources: ABS; RBA Some of these delays relate to the availability of materials. The supply chain disruptions around the world have impinged on a range of building materials, especially steel and timber, but also everything from tiles to appliances. Around one-fifth of firms are reporting that the availability of materials is a significant constraint on their output (Graph 9). This is far higher than reported over the past three decades. Based on the feedback from our liaison contacts, many of these firms are in the construction industry, including residential construction. Availability of labour is also an issue, especially in Western Australia, but this is not specific to construction. Graph 9 Availability of Materials as a Constraint on Output Share of firms reporting significant or minor constraint % % Minor constraint Significant constraint Sources: NAB; RBA It is worth noting that residential construction is also affected by conditions in other parts of the broader construction sector. Non-residential construction activity by the private sector is not unusually strong at the moment, but the pipeline of work yet to be completed is at the upper end of its normal range relative to the size of the economy (Graph 10). The pipeline of planned public infrastructure projects is also quite large. There are some inputs and skills that are specific to one sub-industry – there isn't much call for tunnel engineers or crane drivers in detached homes construction, for example. But in broad terms, it seem that all segments of the construction industry are making a relatively large call on the same material and labour resources at the same time. It is therefore not surprising that the pipeline is remaining large, cost pressures are squeezing margins, and delays are longer than usual. That is a big part of the reason why we expect dwelling investment to remain high for some time, as this pipeline is worked down. Graph 10 Building and Engineering Pipeline Per cent of nominal GDP % % Building pipeline Public buildings Private buildings % % Engineering pipeline Public infrastructure Private infrastructure Sources: ABS; RBA The backwash from the wash-out Over time, the short-term fillip to demand from HomeBuilder and other temporary support measures will work its way out of the pipeline. As interest rates increase, the boost to demand from the current low interest rates will also wane. And the shifts in demand stemming from the pandemic will have worked their way through. As these more transitory factors wash out, what will this mean for the housing and construction markets? The first observation to make is that prices will also shift, and this will both reflect and produce some of the adjustment in quantities. The cost of building a new detached home has increased markedly in recent quarters, and so has the price of the land it sits on (Graph 11). The combination of large rises in the cost of materials and the high level of demand represented by recent commencements has seen to that. Prices of existing homes have been easing in some cities, so the relative attractiveness of building a new one is reduced. In this environment, it is likely that buyer interest in new homes will ease as well. The current pipeline will sustain activity for quite a while, but the backlogs and strained capacity will ultimately work themselves out. Exactly when that will happen is hard to know. But when it does, we can expect some of the current rate of cost escalation and squeeze on margins to ease. Graph 11 New Dwelling Inflation and Costs % Building commencements* % (quarterly growth) New dwelling inflation** (year-ended) % Greenfield land prices (per m²) (RHS, year-ended) Building materials inflation (LHS, year-ended) % -6 -12 * ** Six-quarter average lagged by one quarter. Adjusted for the tax changes of 1999–2000. Sources: ABS; RBA; Research4 The second observation is that the decisions to rent or buy and who to live with are important margins of adjustment. HomeBuilder and other subsidies lifted the number of first home buyers for a period. At the margin, this reduced the number of people wanting to rent. At least some of the people who moved out of share houses to live with their partner would have done so in a newly purchased home. Rents have been growing slowly for some time. This is not that surprising given that yields on other assets are also generally quite low (Graph 12). Some rental contracts are probably still being affected by discounts offered earlier in the pandemic. In addition, the subdued level of rents was likely one of the factors that induced the decline in average household size I mentioned earlier. Graph 12 Rental Market Indicators % Rental and bond yields Rental yield % 10-year real AGS yield index index Rents March 2008 = 100 CPI Advertised Sources: ABS; CoreLogic; RBA; Yieldbroker There is, however, some suggestion that rents could be on the rise. Vacancy rates in Sydney and Melbourne have declined recently, and in other capital cities vacancy rates remain around historical lows. Certainly advertised rents have increased quickly of late, though it will take some time to flow through to the stock of actual rents. It's natural to focus on the opening of the borders and resumption of population growth as potential drivers of higher rents. But it turns out that similar surges in advertised rents are evident in the United States and the United Kingdom. [ 4] Actual rents paid have been rising there, and in these and some other countries, such as Canada, CPI rental inflation is now running at the fastest pace in many years. We aren't seeing this here in Australia, at least not yet. It is something to watch out for. Even so, if we do see a broad surge in rents here, we know that – as with all these deep shifts – other things will adjust in response. Concluding remarks In thinking about the landscape for housing now that we are more-or-less past the acute pandemic phase of the health crisis and into the endemic phase, I'd like to conclude with a few observations and lessons to draw from recent experience. First, the importance of home and a sense of place has been emphasised by the experience of the past two years, and this could carry into the medium term. In predicting what this means for overall outcomes, we should consider what people do want in a home, not an idealised concept of what they ought to want. Second, policy matters, especially in the short term. Whether it's time-limited subsidies bunching demand and boosting prices, or the interplay between low yields globally and rental yields locally, policy can have pervasive effects on housing outcomes. Third, everything has a limit, at least in the short term. We've seen this in the ability of global supply chains to supply materials, and in the capacity of the construction industry to deliver a volume of projects. When capacity limits are reached, prices can shift very quickly, at least until people find ways to expand those limits. Or, as the next point highlights, until people find ways to stop pushing on those limits. Finally, we should be mindful that there are many margins of adjustment. For this reason, the medium term doesn't always resemble the short term. Whether it is a shift between flatmates and partners, renting and owning, or even short-term holiday rentals versus long-term rentals, the housing system does not stand still in the face of a shock. It is tempting to focus on a single outcome, such as prices of established homes in particular areas. A better question to ask – if a more difficult one to answer – is how the whole system will adjust. Thank you for your time. Endnotes [*] I would like to thank Connor Butterfield, Tomas Cokis, Amelia Gao, Rob Gao, Fred Hanmer, Neya Suthaharan and Sally Wong for their contributions to the material in this speech. This assumes that the average size of new migrant households is not that different from that for existing residents. This a strong assumption, so the 200,000 figure should be treated as an upper bound. Ellis L (2019), ‘Lumps, Bumps and Waves’, Address to the Ai Group, Geelong, 4 October. Ellis L (2014), ‘Space and Stability: Some Reflections on the Housing–Finance System’, Address to the Citi Residential Housing Conference, Sydney, 15 May. These are the only economies for which comparable data on advertised rents or new rental contracts are available to us. | reserve bank of australia | 2,022 | 5 |
Speech by Ms Michele Bullock, Deputy Governor of the Reserve Bank of Australia, at the ESA (QLD) Business Lunch, Brisbane, 19 July 2022. | Speech How Are Households Placed for Interest Rate Increases? Michele Bullock [ * ] Deputy Governor ESA (QLD) Business Lunch Brisbane – 19 July 2022 Thank you for the opportunity to speak with you today. It was only nine months ago that I was speaking about the risks emerging in a very buoyant housing market. Funding costs and interest rates were at historic lows, housing prices were growing at a fast pace, and concerns were centred on the potential macro-financial risks stemming from high and rising levels of household debt. To address the building systemic risks, the Australian Prudential Regulation Authority (APRA) had announced an increase in the interest rate buffer that it expected banks to use in assessing potential borrowers. Since then, there have been a number of developments. The economy has turned out to be very resilient. Once pandemic-related restrictions were removed, the economy rebounded strongly. Consumption of services has grown and demand for goods has held up. The labour market is tight with the unemployment rate at multi-decade lows and vacancies at historical highs. As in many other countries, inflation in Australia has risen and it is now higher than it has been since the early 1990s. Global factors, such as COVID-19-related supply disruptions and Russia's invasion of Ukraine, account for much of this increase. But domestic price pressures have also been building. Together, this has contributed to the highest rate of core inflation for many years. Over recent months, therefore, the Reserve Bank Board has been withdrawing the extraordinary monetary policy stimulus that was put in place to support the Australian economy against the effects of the pandemic. The cash rate target has been increased by 125 basis points since May to 1.35 per cent and the Board expects further increases in the cash rate will be needed in the months ahead. Just how high and how fast the cash rate is raised will depend on many factors, but in making this assessment one of the areas the Board will be closely observing is how households respond to the combination of rising interest rates and prices. Today I will talk about the implications of rising interest rates for the household sector with a focus on the potential implications for financial stability. In our last couple of Financial Stability Reviews, we talked about the potential build-up of systemic risk as housing prices and credit grew strongly through 2021. Now we are facing quite different circumstances. Interest rates are rising, housing prices and other asset prices are declining and inflation is increasing the cost of living for everyone. The effect of these developments on households and the way they respond will have implications not only for the broader economy, they will also highlight the financial vulnerabilities that have been building in the household sector. My focus here is therefore going to be mainly on indebted homeowners. Around one-third of all households have housing debt. This is not to suggest that other households are unaffected by rising interest rates and inflation – clearly there are implications for renters and those who own their homes outright – but indebted households pose more direct potential risks to the financial sector. And as I have discussed previously, they might also react to interest rate rises in ways that exaggerate housing price and consumption cycles. So the impacts on, and reaction of, indebted households to higher interest rates is going to be important in understanding how the economy and the financial sector might be affected. I will first set out some facts on household balance sheets at an aggregate level. Then I will talk about the distribution of debt and where some of the vulnerabilities might lie. Finally, I will present some simple scenarios on the potential financial impact of increasing interest rates. I will finish with a few concluding remarks. Households in aggregate are well positioned … First a bit of scene setting. If you have been reading our Financial Stability Reviews over the past few years you would be familiar with the theme of high household debt. The household credit-to-income ratio is currently around 150 per cent (Graph 1). [ 1] This is high relative to the early 1990s. Most of the run-up was through the 1990s and the first half of the 2000s. This reflected a combination of lower inflation, financial deregulation, a decline in real interest rates and strong income growth – all of which allowed households to service higher levels of debt. [ 2] Since then it has remained relatively steady at a high level as nominal incomes have largely kept pace with increased debt. Graph 1 Household Credit % Household credit-to-income ratio* % % % Housing credit growth** * ** Sum of housing credit and personal credit; housing credit is net of redraw balances. Six-month-ended annualised terms. Sources: ABS; APRA; RBA The high level of debt held by Australian households might, on its own, suggest that many households will face difficulties as interest rates rise, with implications for their ability to service that debt, consumption and the economy more broadly. However, there are a number of factors that suggest considerable resilience in the household sector to rising interest rates. First, aggregate household balance sheets are in very good shape. While households have high levels of debt, this is accompanied by sizeable holdings of assets (Graph 2). Strong growth in housing prices over 2021 and early 2022 has boosted asset values for many homeowners, with housing assets now comprising around half of household assets. The small decline in housing prices in recent months has only marginally eroded some of the large increases seen over past years. Graph 2 Household Balance Sheet Share of disposable income % Assets % Liabilities 1,000 1,000 Housing 2022 1992 Superannuation Deposits Other* * Other assets include financial assets held outside of superannuation or deposits, consumer durables and all other non-housing non-financial assets; other liabilities includes personal credit, student loans and all other non-housing liabilities. Sources: ABS; APRA; RBA Furthermore, households have saved a large amount of money since the onset of the pandemic – around $260 billion. These savings have been put into redraw facilities as well as offset and deposit accounts. This reflects a couple of factors. Considerable government support was provided to households and their employers during the pandemic. This meant that incomes held up very well. The banking system also helped households and businesses to weather the crisis by providing payment holidays and working with their customers to recommence repayments as their situation permitted. Both of these factors were good for household cash flows. At the same time, consumption opportunities were curtailed, particularly for discretionary services. Even though expenditure on goods increased, households were still spending less than they were prior to the pandemic. As a result, the household saving rate rose sharply (Graph 3) and many households therefore built up large liquidity buffers, including those households with mortgages. Very low interest rates also helped many households add to their savings through reduced interest payments. Since the start of the pandemic, payments into offset and redraw accounts have been substantial, totalling around 3½ per cent of disposable income (Graph 4). The accumulated stock of these savings could help to ease the transition to higher mortgage payments for many borrowers, allowing them to sustain higher levels of consumption than otherwise. Graph 3 Household Saving Ratio Share of household disposable income % % Scheduled mortgage principal payments Additional mortgage payments* Other saving** -5 * ** Sum of net flows into redraw and offset accounts. Net of depreciation. Sources: ABS; APRA; RBA -5 Graph 4 Flows into Housing Loan and Offset Accounts* Share of disposable income, quarterly % % Interest Scheduled principal Offset and redraw * Seasonally adjusted and break-adjusted. Sources: ABS; APRA; RBA This large stock of mortgage prepayments is relevant to our assessment of household indebtedness and the risks it presents. Large buffers allow households to smooth their spending and maintain required debt payments when faced with lower income or cash flows or higher expenses. In fact, if we take these savings into account, the ratio of household credit to income is actually a fair bit lower than the headline figure and is around the same as its 2007 level (Graph 5). Graph 5 Household Credit-to-income Ratio % % Household credit net of offset accounts Household credit* * Sum of housing credit and personal credit; housing credit is net of redraw balances. Sources: ABS; RBA This is all at an aggregate level. But we also see similar trends from disaggregated data on individual mortgages, as revealed in the Reserve Bank's securitisation dataset and survey data. The ratio of liquid assets to income has increased substantially among indebted households over recent decades, and borrowers with the most debt also tend to have the highest liquidity buffers. [ 3] Among households with variable-rate owner-occupier mortgage debt, around half have accumulated enough prepayments to service their current loan repayments for almost two years or longer. These payment buffers help to protect against the risk that, as interest rates rise, households will find themselves unable to meet debt repayments. Second, the strength of lending standards in recent years gives us reason to be confident in the ability of many households to absorb some increase in interest rates. For many years, banks have been required to stress test new borrowers' ability to meet repayments with interest rates that are significantly higher than the rate on the loan they have applied for. In 2019, APRA indicated to banks that, in assessing loan applications, it expected them to apply a ‘serviceability buffer’ of at least 2.5 percentage points. In October 2021, they increased this to a minimum of 3 percentage points. As a result, many borrowers should have some spare servicing capacity built into their financial margins. Finally, the household sector as a whole has accumulated sizeable equity via higher housing prices over recent years. Rising housing prices have benefited borrowers with existing mortgages. Furthermore, the share of new borrowers that have borrowed at high loan-to-valuation ratios (LVR > 90) has declined markedly. The combination of these factors meant that the share of loan balances in negative equity was around 0.1 per cent in May 2022, down from around 2¼ per cent prior to the pandemic (Graph 6). While housing prices have started falling in recent months, they would have to fall a fair way for negative equity to become a systemic concern. Scenario analysis based on loanlevel data suggests that a decline in housing prices of 10 per cent would raise the share of balances in negative equity to 0.4 per cent, which is still much lower than its peak of 3¼ per cent in 2019. Even a fall of 20 per cent in housing prices would only increase the share of balances in negative equity to 2.5 per cent. This low incidence of negative equity reduces the likelihood that borrowers will enter into default, as well as the size of losses incurred by lenders if they did. [ 4] Graph 6 Outstanding LVR Distribution* Share of balances % In negative equity % May 2022 2.0 2.0 1.5 1.5 1.0 1.0 0.5 0.5 January 2020 0.0 LVR 0.0 * Loan balances adjusted for redraw and offset account balances; property prices estimated using SA3 price indices. Sources: ABS; Core Logic; RBA; Securitisation System But some indebted households are more vulnerable So far I have focused on household debt in aggregate and made the point that there are a number of factors suggesting that indebted households will be quite resilient to at least some rise in interest rates. But not all borrowers are alike – the distribution also matters. In particular, what do we know about the incomes of the people that hold the debt? If we look at the households that have debt, almost three-quarters of debt outstanding is held by households in the top 40 per cent of the income distribution; indebted households in the bottom 20 per cent of the income distribution hold less than 5 per cent of the debt (Graph 7). Furthermore, households with high debt-to-income ratios (DTIs) who might be most affected by a rise in interest rates also tend to be high-income households. Higher income households can typically devote a higher share of their incomes to debt servicing because their other living expenses tend to account for a smaller share of their income. This suggests that a large number of households are likely to be able to handle somewhat higher interest rates. Graph 7 Distribution of Household Debt* By income quintile, 2019/20 % Share of total debt owed ratio Median debt-to-income 1.5 1.0 0.5 0.0 Income quintile * Only includes households with debt. Sources: ABS; RBA Nevertheless, some households are more likely to face financial stress than others. Highly indebted households are especially vulnerable in the event of a loss of real income through higher inflation, particularly if combined with rising interest rates, and a decrease in housing prices. Recent borrowers are more vulnerable than earlier cohorts, as they are more likely to have borrowed at high DTIs, have had their serviceability assessed at lower interest rates (albeit with larger interest rate buffers) and have had less time to accumulate equity and liquidity buffers. Government policies to improve housing market accessibility for first home buyers (FHBs) during the pandemic also means that FHBs are more highly represented among this group of recent borrowers than they are in earlier cohorts. Historically, FHBs have tended to have persistently higher LVRs and lower liquidity buffers than other borrowers, making them more vulnerable to a given house price or cash flow shock. [ 5] The increase in high-DTI borrowing is one area that raises concerns about risks as interest rates rise. While lending standards have generally improved over recent years, the latest housing cycle saw a significant increase in the share of loans at DTI ratios above 6 (Graph 8), partly reflecting the very low interest rates at that time and hence the belief that the debt servicing burden of these loans was manageable. On the face of it, such loans are more risky than loans at lower DTIs. If the borrower were to experience a fall in income or an increase in expenses, they might find it more difficult to service the loan. And in an environment of increasing interest rates, there is a risk that households with high DTIs will find it more difficult to service their debt. Graph 8 ADIs’ Housing Loan Characteristics Share of total new lending % % DTI ≥ 6 LVR ≥ 90 LVR* > 90 * LVR series breaks at March 2018 due to reporting changes. Sources: APRA; RBA We know, however, that other characteristics matter as well. [ 6] The size of liquidity buffers and the income and wealth of the borrower also impacts the riskiness of the loan and the probability of borrowers ending up in financial difficulty. Broadly, investors with high-DTI loans are more likely than other borrowers to have high liquidity buffers; they also tend to be wealthier and have higher incomes. This group of high-DTI borrowers has historically been less likely to experience mortgage stress than other borrowers. On the other hand, there is a group of borrowers with high-DTI loans that have lower liquidity buffers and lower incomes – these borrowers are more at risk of mortgage stress. So the bottom line is that high-DTI lending is something to watch. But in and of itself, a high-DTI loan is not necessarily more risky in a rising interest rate environment. The impact on individual borrowers will be varied But what can we say about the impact of interest rate rises on individual borrowers? We can use data on individual anonymised loans from our securitisation database to do some scenario analysis on the potential impact of interest rate rises on the borrowers in that dataset. For the purposes of this analysis, we assume that variable mortgage rates rise by around 300 basis points, which is broadly informed by recent market pricing to mid-2023. The data suggest that over one-third of variable-rate borrowers have already been making average monthly loan payments (including irregular payments to redraw and offset accounts) sufficient to meet the resulting rise in required repayments (Graph 9). In other words, there is limited impact on these borrowers. On the other hand, just under 30 per cent of borrowers would face relatively large repayment increases of more than 40 per cent of their current payments. Graph 9 Repayment Increases for Variable-rate Loans Changes in repayments in response to a 300 basis point increase in interest rates* % % None 0 to 10 to 20 to 30 to <10 <20 <30 <40 Increase in repayments (%) 40+ * Changes between new required repayments and average monthly payments over the past year; share of variable-rate loans (excluding split loans) as at May 2022. Sources: RBA; Securitisation System Another issue that we have been thinking about is whether borrowers that took advantage of very low interest rates on fixed-rate products in recent years are particularly susceptible to higher interest payments when fixed-rate terms expire. The extremely low interest rates on these products through 2020 and 2021 led many people to take them up, resulting in the share of housing credit on fixed mortgage rates increasing from 20 per cent at the start of 2020 to a peak of nearly 40 per cent in early 2022. The majority of currently outstanding fixed-rate loans are due to roll off within the next two years, with the greatest concentration of loans due to expire in the second half of 2023 (Graph 10). So these borrowers are shielded for the time being from interest rate rises. Graph 10 Projected Expiration of Fixed-rate Loans* Outstanding loans as at May 2022, by expiry month % % Average lending rate Scenario variable rate** Balance-weighted fixed rate % % Share of total fixed-rate loans*** M J S D M J S D M J S D * ** Assumes fixed-rate loans are not repaid early or refinanced. Assumes future variable rates increase by 300 basis points to mid-2023; timing of rate increases broadly informed by market expectations. *** Another 13 per cent of fixed-rate loans will expire beyond 2024. Sources: RBA; Securitisation System What is the potential impact though when they do roll off? Using information from the securitisation database, and again using some assumptions about the path of interest rate increases, we can get an idea of the magnitude of the impact on borrowers' interest payments as their fixed rates roll off. Assuming all fixed-rate loans roll onto variable mortgage rates and new variable rates are broadly informed by current market pricing, estimates suggest that around half of fixed-rate loans (by number) would face an increase in repayments of at least 40 per cent (Graph 11). Borrowers with fixed-rate loans that are due to expire by the end of 2023 would experience a median increase of around $650 (or 45 per cent) in their monthly repayments. This is slightly more than the rise in payments that variable-rate borrowers would experience over this time. These scenarios suggest large increases in debt-servicing for many of those with expiring fixed-rate loans. But unlike borrowers who hold variable-rate loans, we have very little visibility of how much saving those with fixed-rate loans have been doing in recent years. Many of these borrowers have contractual restrictions on their ability to channel their savings into mortgage prepayments. But given the very low interest payments and the broad-based increase in household saving rates, it is likely that many of these borrowers will have accumulated savings outside their mortgages ahead of any potential increase in repayments. Some borrowers also have split loans – part variable, part fixed – which will have allowed them to accumulate buffers on the variable part of the loan. Some fixed-rate loans also allow borrowers to make at least some excess repayments. To the extent that this is the case, it is likely to mitigate the rise in debt servicing requirements. Graph 11 Repayment Increases for Fixed-rate Loans Changes in required repayments under rising interest rate scenario* % Percentage change Dollar change By expiry month 75th percentile $ 1,000 Median 25th percentile <0 0 to 20 to 40 to 60+ M J S D M J S D M J S D M <20 <40 <60 * Assumes future variable rates increase by 300 basis points to mid-2023; timing of rate increases broadly informed by market expectations; excludes loans that will expire beyond 2024. Sources: RBA; Securitisation System It is important to note that these scenarios don't take into account future economic conditions. At the moment, for example, employment is growing strongly and unemployment is at its lowest level in nearly 50 years. Having a job is the best way of ensuring that you can continue to meet repayments on your loan. How much the Board decides to raise rates will depend on developments in the economy, including how borrowers respond to higher rates. And we will continue to assess where the risks might materialise. Concluding remarks In the title of this speech I posed the question ‘How are households placed for interest rate increases?’ There are a number of ways to come at this question – aggregate data, disaggregated data and scenarios. On balance, though, I would conclude that as a whole households are in a fairly good position. The sector as a whole has large liquidity buffers, most households have substantial equity in their housing assets, and lending standards in recent years have been more prudent and have built in larger buffers for interest rate increases. Much of the debt is held by high-income households that have the ability to service their debt and many borrowers are already making repayments well above what is required. Furthermore, those on very low fixed-rate loans have some time to prepare themselves for higher interest rates. While in aggregate it seems unlikely that there will be substantial financial stability risks arising from the household sector, risks are a little elevated. Some households will find interest rate rises impacting their debt servicing burden and cash flow. While the current strong growth in employment means that people will have jobs to service their mortgages, the way the risks play out will be influenced by the future path of employment growth. This, along with the Board's assessment of the outlook for inflation, will be important considerations in deciding the size and timing of future interest rate increases. Thank you and I look forward to your questions. Endnotes [*] I am grateful to Amelia Gao, Marcus Robinson and Michelle Wright for excellent assistance with this speech. Household credit is a subset of total household debt. It excludes debt of unincorporated enterprises and HECS debt. Kearns J, M Major and D Norman (2020), ‘How Risky is Australian Household Debt?’, RBA Research Discussion Paper No 2021-05. See Wang L (2022), ‘Household Liquidity Buffers and Financial Stress’, RBA Bulletin, June. See Bergmann M (2020), ‘The Determinants of Mortgage Defaults in Australia – Evidence for the Double-trigger Hypothesis’, RBA Research Discussion Paper No 2020-03. Alfonzetti M (2022), ‘Are First Home Buyer Loans More Risky?’, RBA Bulletin, March. See RBA (2022), ‘Box B: How Risky is High-DTI and High-LVR Lending?’, Financial Stability Review, April. | reserve bank of australia | 2,022 | 7 |
Speech by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to the Australian Strategic Business Forum 2022, Melbourne, 20 July 2022. | null | reserve bank of australia | 2,022 | 7 |
Speech by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to the Anika Foundation, Sydney, 8 September 2022. | Speech Inflation and the Monetary Policy Framework Philip Lowe[*] Governor Speech to the Anika Foundation Sydney – 8 September 2022 I would like to begin by thanking everybody who is attending today in support of the Anika Foundation. It’s been a hard time for young people over the past couple of years, so the Foundation’s work supporting young Australians is more important than ever. Thank you for your support. Last year, this event was held online as we were in the midst of the Delta outbreak. At the time, the economy was contracting, inflation was below the target band and the normalisation of monetary policy still seemed to be in the distance. A year on, a lot has changed. We are no longer in lockdowns, the economy has performed well, unemployment is at a 50-year low, inflation is the highest it has been in years and interest rates are being increased quickly. Today, I would like to focus my remarks on the pick-up in inflation. After a number of years in which inflation was below target, it is now considerably above target and is expected to go higher still in the short term. The extent of this turnaround in inflation has come as a surprise to many, including us. So, I would like to begin by exploring some of the lessons from this surprising burst in inflation. I will then discuss why, in my view, flexible inflation targeting remains the appropriate monetary policy framework for Australia. I will conclude with some remarks on the importance of returning inflation to target over time and how the RBA’s recent monetary policy decisions will help achieve this. A very large inflation surprise First, to the very large surprise in inflation. When I spoke at the Anika Foundation event last year, CPI inflation in Australia had been below 2 per cent for a number of years and, in underlying terms, was just 1.6 per cent (Graph 1). Today, CPI inflation has risen to 6.1 per cent and underlying inflation is 4.9 per cent. These are the highest rates in many years. Graph 1 Consumer Price Inflation* Year-ended % % Headline Trimmed mean -2 -2 * Excludes interest charges prior to the September quarter of 1998; adjusted for the tax changes of 1999–2000. Sources: ABS; RBA This lift in inflation has come as a surprise. A year ago, the RBA was forecasting that inflation over 2022 would be just 1¾ per cent. Now, we are expecting CPI inflation this year to be around 7¾ per cent. This is a very big change and a very large forecast miss. The RBA has plenty of company in not predicting this lift in inflation. This next graph shows our forecasts of underlying inflation a year ago, as well as the range of forecasts from private-sector economists (Graph 2). Some forecasters were certainly expecting higher inflation than we were, but the magnitude of the pick-up in inflation has taken everybody by surprise. Graph 2 Trimmed Mean Inflation Forecasts Year-ended % % August 2022 Actual August 2021 Range of economist forecasts* * Based on the RBA Survey of Market Economists. Sources: ABS; RBA R E S E R V E B A N K O F AU S T R A L I A The same is true internationally. This next graph shows Consensus forecasts for headline inflation in August last year for the United States, the euro area, the United Kingdom and Canada (Graph 3). In all four cases, inflation was expected to be close to 2 per cent by now. Instead, the latest readings of CPI inflation in these four areas are 8.5 per cent, 9.1 per cent, 10.1 per cent and 7.6 per cent. Graph 3 Headline Inflation Forecasts % US Actual Consensus, year-ended Euro area % Latest Aug 2021 % UK % Canada Sources: Consensus Economics; RBA Forecast misses of this scale should lead to soul-searching by forecasters and they certainly have at the RBA. It is important that we learn from this and improve our understanding of the inflation process. One starting point for understanding the unexpected surge in inflation is the big lift in energy prices stemming from Russia’s invasion of Ukraine and various problems in the production of energy around the world. Analysis by the European Central Bank suggests that around three-quarters of the surprise in inflation in the euro area reflects unexpected developments in the markets for oil, gas and electricity.[1] In the United Kingdom, the Bank of England estimates that higher energy prices will directly boost CPI inflation by 6½ percentage points this year. And in Australia, the price of petrol at the bowser increased by 32 per cent over the past year (Graph 4). The direct effect of this alone has been to add 1.2 percentage points to Australia’s CPI inflation, and on top of this there are second-round effects of higher fuel prices. Graph 4 Automotive Fuel Inflation Year-ended % % -20 -20 -40 -40 Sources: ABS; RBA While this lift in energy prices explains some of the surge in inflation, it is by no means the full story. We can make some further progress in understanding this surge by using the standard workhorse models of inflation, which explain inflation by inflation expectations and the aggregate output gap. Strong demand at a time of impaired supply – and thus a closure of the output gap – certainly helps explain part of the recent higher inflation. But these models fall well short of explaining the magnitude of the lift in inflation and, in my view, face some real challenges. One of these challenges is that the focus on the aggregate output gap is insufficient in a world in which shocks are highly uneven across sectors. We need to pay more attention to developments in individual sectors. One of the distinguishing features of the past two years is that the shocks have been highly asymmetrical. In 2020 and 2021 there was a huge increase in demand for goods and a decline in demand for services. This was particularly evident in the United States, where the demand for goods surged by close to 20 per cent in less than a year and the demand for many services was weak (Graph 5). A similar, although less pronounced, pattern was evident in Australia. R E S E R V E B A N K O F AU S T R A L I A Graph 5 Consumption December 2019 = 100 index United States index Australia Goods Services Sources: ABS; RBA; Refinitiv This surge in demand for goods occurred at the same time as the supply side was constrained. This was partly because COVID interrupted production. But it goes beyond this. Even in good times, the supply side would have had trouble coping with a 20 per cent surge in demand in a short period of time. Just-in-time inventory management and long supply chains had made the system less resilient and less able to respond to rapid and unexpected shifts in demand. The result was that many industries quickly found themselves on the sharply upward sloping part of the supply curve, and prices increased. And there was no offsetting deflation in those parts of the economy where demand was weak. One lesson here is that what is happening at the sectoral level is important in influencing the overall inflation dynamics in our economy – it’s not just the aggregates that matter.[3] Resources don’t move freely between sectors, which means that the composition of demand and supply is important, not just the overall level of demand. One relevant example in Australia has been in the home-building sector. Over the past year, the cost of building a new home has increased by 20 per cent (Graph 6). This alone has added close to 2 percentage points to headline inflation. Very strong demand in this sector – partly due to low interest rates and government grants totalling up to $35,000 for some first home buyers – came up against COVID-related problems on the supply side. The result was a big jump in prices, which has had a material impact on the overall inflation rate in Australia. Graph 6 New Dwelling Inflation Year-ended % % -5 -5 Sources: ABS; RBA The other element in the workhorse models of inflation is inflation expectations. Inflation expectations have picked up a little, but the measures derived from financial prices suggest there is a high degree of confidence that inflation will return to target (Graph 7). This suggests that a pick-up in inflation expectations is not a primary driver of the sharp rise in inflation. Graph 7 Inflation Expectations Australia, inflation swaps measure % % 5–10 years ahead 1–5 years ahead Sources: Bloomberg; RBA There is something here, though, that is worth watching that is not easily captured in our standard models – and that is the general inflation psychology in the community. By this, I mean the general willingness of businesses to seek price increases and the willingness of the community to accept price increases. Prior to the pandemic, it was very difficult for a business person to stand in the public square and say they were putting their prices up. And a common theme from our liaison was that, because most businesses had trouble putting their prices up, wage increases had to be kept modest. That was the mindset. R E S E R V E B A N K O F AU S T R A L I A Today, business people are able to stand in the public square and say they are putting their prices up, and they can point to a number of reasons why. The community doesn’t like it, but there is a begrudging acceptance. And with prices rising, it is harder to resist bigger wage increases, especially in a tight labour market. So the psychology shifts. Or as the Bank for International Settlements put it in its recent annual report: when inflation is high, it becomes a coordinating mechanism for pricing decisions.[4] In other words, people really start to pay attention to changes in costs and prices. The result can be faster and fuller pass-through of cost shocks and more frequent price and wage adjustments. There is some evidence that is already occurring, which is contributing to the strength of the pick-up in inflation. So, it is something to watch. Flexible inflation targeting I would now like to turn to the monetary policy framework, as this framework guides the Reserve Bank Board’s decisions about interest rates each month. At a very high level, the RBA’s job is to support the maximisation of the economic welfare of Australians, with the tools and responsibilities of a central bank. Delivering medium-term price stability is fundamental here. Since the early 1990s, our operating definition of ‘price stability’ has been that inflation averages 2 point something per cent. At this level, inflation is something that most people don’t normally need to worry about. In terms of the policy framework, we adopted a flexible inflation targeting framework around three decades ago and this has been supported by successive governments. Under that framework, our operating objective has been to have consumer price inflation average between 2 and 3 per cent over time. I would like to highlight two aspects of this formulation. The first is the focus on 2 to 3 per cent. This focus has provided an important nominal anchor for inflation expec tations in the Australian community. While the inflation rate has varied from year to year, it has always returned to the 2 to 3 per cent range. It has also averaged 2 point something per cent since the early 1990s. The second is the on average, over time aspect of the target. This formulation has provided the Board with the flexibility to pursue price stability in a way that, in its judgement, best contributes to full employment and the general welfare of the Australian people, which are both legislated objectives of the RBA. The RBA was an early adopter of flexible inflation targeting, eschewing the hard-edged stricter versions of inflation targeting that were popular in the 1990s. That was the right call. I note that the recent reviews by the Federal Reserve, the European Central Bank and the Bank of Canada have all concluded that some form of flexible inflation targeting is the preferred monetary policy regime in their countries. In my view, flexible inflation targeting has served Australia well and remains the best monetary policy regime for Australia. It is certainly worth examining alternatives as part of the current Review of the RBA, but I do not see a strong case for a move away from this broad approach. Flexible inflation targeting is not a perfect monetary policy regime, but it is hard to do better. Any monetary policy regime is likely to face challenges in today’s changing world. Our economies are adjusting to the ageing of the population, the emergence of new digital technologies, climate change, slower productivity growth and a less interconnected global economy. These changes are affecting the dynamics of inflation and will continue to do so. As our economy continues to adapt, the strong nominal anchor and the flexibility provided by flexible inflation targeting will both be very helpful. These attributes are difficult (although not impossible) to replicate with another monetary policy regime. There are, though, some elements of the design of our flexible inflation target that could helpfully be looked at as part of the current Review. The first is whether 2 to 3 per cent is the appropriate nominal anchor and operating definition of ‘price stability’. Many other countries have chosen 2 per cent as their nominal anchor. As part of the Review, it is worth examining the arguments for and against a change to the nominal anchor. The second element is how to best think about the ‘flexible’ part of flexible inflation targeting. Flexibility means that the Board’s decisions are not determined by a rule – we have the flexibility to achieve the broad objective of price stability in a way that maximises welfare. A more rules-based, or highly parameterised approach, to monetary policy would provide less scope to respond in this way. Flexibility also means that the Board faces choices and trade-offs. For example, when supply shocks occur, there can be a short-term trade-off between inflation and growth. And in other circumstances, there can be a trade-off between achieving an inflation objective in the short term, via lower interest rates, and the build-up of macroeconomic and financial stability risks. Our legislation provides the scope to make these often difficult choices in the national interest. There is, though, a question here about accountability. Given the flexibility, the Bank’s performance is sometimes hard to judge at any single point in time. This can complicate the task of holding us to account. Given this, it is important that the Bank explains when trade-offs are being made, including how and why. I hope the Review will provide a further opportunity to examine how the RBA has managed these trade-offs in the past and how it might manage and explain them in the future. Recent monetary policy I would now like to turn to the Board’s monetary policy decisions over recent months. The Board is committed to doing what is necessary to ensure that inflation returns to target over time. High inflation is a scourge. It damages our standard of living, creates additional uncertainty for households and businesses, erodes the value of people’s savings and adds to inequality. And without price stability, it is not possible to achieve a sustained period of low unemployment. It is important, therefore, that this current surge in inflation is only temporary and that we once again return to the 2 to 3 per cent range. The Board is committed to the return of inflation to target. It is seeking to do this in a way that keeps the economy on an even keel; it is possible to achieve this, but the path here is a narrow one and it is clouded in uncertainty. I would like to highlight three sources of this uncertainty. The first is the global economic environment. In the United States, the Federal Reserve has indicated that a period of tight monetary policy and below-trend growth will be required to get inflation under control. In Europe, real incomes are suffering very big declines because of sharply higher energy costs, and this will weigh on spending and growth. And in China, the economy is being affected by the authorities’ approach to COVID, major stresses in its property industry and drought in parts of the country. Some slowing in the global economy will help bring inflation down, but a sharp slowing would make the job of delivering a soft landing here in Australia much harder. The second source of uncertainty is domestic in nature – and that is how inflation expectations and the inflation psychology in Australia adjust to the period of high inflation. If workers and businesses come to expect higher inflation, and wages growth and price-setting behaviour adjusts accordingly, the task of navigating that narrow path will be very difficult, if not impossible. A shift higher in inflation expectations will require higher interest rates. In time that would mean a sharper slowing of the economy. It is in our national interest that we avoid this. The third source of uncertainty is how households respond to higher interest rates. Interest rates are increasing for the first time in 12 years and they are rising quickly. The full effects of this are still to be felt. Household budgets are also under pressure from higher inflation, and housing prices are declining after large gains R E S E R V E B A N K O F AU S T R A L I A (Graph 8). On the other hand, many households have built up large financial buffers, including through offset accounts, and the household saving rate remains higher than it was before the pandemic. Many households are also benefiting from the strong labour market, with a higher share of Australians having a job than ever before. It is still difficult to know how all of these factors will balance out, but recent data continue to suggest resilience in consumer spending. Graph 8 Household Indicators index National housing prices % Saving ratio June 2022 = 100 $b Mortgage prepayments* Employment-to-population % * Stock of offset and redraw balances; seasonally adjusted and break-adjusted. Sources: ABS; APRA; CoreLogic; RBA We are paying close attention to these various uncertainties, but also recognise that there have been a number of developments that should prove helpful in navigating the narrow path. The first is that the supply side of the global economy is gradually improving and the demand for goods is stabilising – which means that a better balance of supply and demand is being established. Shipping costs are declining and delivery times have shortened (Graph 9). Many commodity prices have also reversed their rises following Russia’s invasion of Ukraine. Graph 9 Supply Indicators index Shipping costs* 2017–2019 average = 100 index Delivery times PMI Inverted scale 2022 2018 * Global index of container rates. Sources: IHS Markit; RBA; Refinitiv It is also noteworthy that inflation expectations in Australia remain consistent with the inflation target. In addition, wages growth has picked up, but not nearly to the same extent as in the United States (Graph 10). This is an important difference. While there are some areas where wages are rising very quickly in Australia, aggregate growth in wages has not responded materially to the higher inflation and is not inconsistent with inflation returning to target over time. It is important that this remains the case and that we avoid the cycle of higher inflation leading to higher wages growth and then higher inflation – a cycle like that would end in higher interest rates and a sharper slowing in the economy. Graph 10 Wages Growth* Year-ended % United States % Australia * Measured by the Employment Cost Index for the United States and the Wage Price Index for Australia. Sources: ABS; Refinitiv It is in this environment in which we have been increasing interest rates. Since May, the Board has raised the cash rate target by a cumulative 2¼ percentage points, including a ½ percentage point rise earlier this week (Graph 11). This increase in interest rates – from what was a historically low level – is to ensure that the current period of high inflation is only temporary and that a more sustainable balance between demand and supply is established. To repeat an earlier point, price stability is necessary for a strong economy and a sustained period of full employment. So, it is important that we achieve this. R E S E R V E B A N K O F AU S T R A L I A Graph 11 Australian Cash Rate Target % % Source: RBA The Board expects that further increases in interest rates will be required over the months ahead. The Board is not on a pre-set path, especially given the uncertainties that I have spoken about. We are conscious that there are lags in the operation of monetary policy and that interest rates have increased very quickly. And we recognise that, all else equal, the case for a slower pace of increase in interest rates becomes stronger as the level of the cash rate rises. But how high interest rates need to go and how quickly we get there will be guided by the incoming data and the evolving outlook for inflation and the labour market. Thank you very much for listening and for supporting the Anika Foundation. I look forward to answering your questions. Endnotes [*] I would like to thank David Jacobs and Tom Rosewall for assistance in preparing this speech. See Chahad M, A Hofmann-Drahonsky, B Meunier, A Page and M Tirpák (2022), ‘What Explains Recent Errors in the Inflation Projections of Eurosystem and ECB Staff?’, ECB Economic Bulletin, Issue 3/2022. See Bank of England (2022), Monetary Policy Report, August. A model in which sectoral factors influence aggregate inflation is explored in di Giovanni J, S Kalemli-Özcan, A Silva and M Yildirim (2022), ‘Global Supply Chain Pressures, International Trade, and Inflation’, ECB Forum on Central Banking, June. See Bank for International Settlements (2022), ‘Inflation: A look Under the Hood’, Annual Economic Report, June. See Federal Reserve (2020), ‘Statement on Longer-Run Goals and Monetary Policy Strategy’, 27 August (see also Powell JH (2020), ‘New Economic Challenges and the Fed’s Monetary Policy Review’, Speech, 27 August); European Central Bank (2021), ‘The ECB’s Monetary Policy Strategy Statement’; Bank of Canada (2021), ‘Joint Statement of the Government of Canada and the Bank of Canada on the Renewal of the Monetary Policy Framework’, Press Release, 13 December. | reserve bank of australia | 2,022 | 9 |
Opening statement by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Canberra, 16 September 2022. | Speech Opening Statement to the House of Representatives Standing Committee on Economics Philip Lowe Governor Canberra – 16 September 2022 Good morning chair and members of the Committee. Thank you for holding this hearing. At the Reserve Bank, we take these hearings very seriously. They are a critical part of the accountability process and my colleagues and I are committed to answering your questions openly and transparently. The previous hearing was held in early February. A lot has changed since then. I would like to highlight three of these changes: 1. The decline in unemployment. 2. The surge in inflation. 3. The earlier and sharper-than-expected increase in interest rates. Lower unemployment In February, the unemployment rate stood at 4.2 per cent. Today, it is 3½ per cent. This is the lowest unemploy ment rate in almost 50 years. Labour force participation has also increased, so that a higher share of the workingage population has a job than ever before. And underemployment is lower too, as people who work part-time are finding it easier to get the hours they want. I wanted to recount these facts because the improvement in the Australian labour market is a major achievement. Australians are finding it easier to get a job than they have for a long time. Young people and women are benefiting most from this and they have greater opportunities. Our economy and our society are stronger as a result. Higher inflation In contrast, the second change since February – the increase in inflation – is an unwelcome one. When the previous Committee met in February, underlying inflation in Australia had just reached the midpoint of the 2 to 3 per cent target range for the first time in many years. Seven months on, we are in a very different position. Inflation has very quickly gone from being too low, to being too high. Over the year to June, the headline inflation rate was 6.1 per cent. It is expected to increase further over the months ahead to peak at around 7¾ per cent later this year. Inflation is then expected to start declining, to be back around 3 per cent late in 2024. Global factors explain much of this increase in inflation. Russia’s invasion of Ukraine resulted in major disruptions to energy markets, increasing retail energy prices around the world. And COVID-related interruptions to global production are still rippling through global supply chains, pushing prices up. The demand for goods in global markets has also been very strong over the past few years as people switched their spending from services to goods. The result of impaired supply and strong demand has been higher prices around the world. Important as these global factors have been, they are not the full story for why inflation is high in Australia. Demand here has been very strong relative to the ability of our economy to meet that demand. This is clearly evident in the labour market, where the number of job vacancies is at a record high and firms are finding it hard to hire workers. There are also capacity constraints in many sectors, including the building of infrastructure and the housing industry. This strong demand is, in part, a result of the policy approach during the pandemic. During 2020 and 2021, both fiscal and monetary policy provided very considerable economic support to households and businesses. At the RBA, we did this to provide a financial bridge to the day when the virus was contained and to provide some insurance against the possibility of very bad economic outcomes. As we sit here in Canberra today, it can be easy to forget how dire the outlook was in 2020: there were credible projections that the unemployment rate would reach 15 per cent, spending was collapsing, our hospitals were expected to be overflowing and a vaccine seemed years away. It was a scary time. In that environment, the Reserve Bank Board wanted to do what it could to help and to shore up confidence. We also were also seeking to provide some economic insurance against the worst possible outcomes. In the event, vaccines were developed in record time and our economy – with the support of monetary and fiscal policies – proved to be very resilient. We avoided the dire outcomes that many thought likely. And today, many people are returning back towards their pre-pandemic way of life and are spending again, including on travel and services. We saw further evidence of this last week in the National Accounts, with the Australian economy growing by 0.9 per cent in the June quarter, and by 3.6 per cent over the year. These are good outcomes, and they are better than those being recorded in most other countries. Given the resilience of our economy and the surge in inflation, it is understandable that some people are questioning whether or not too much support was provided by the RBA over the past two years. Judgements on this will differ. But in those dark days of the pandemic, the Reserve Bank Board judged that the bigger policy mistake would have been to do too little, rather than too much. If we had done too little and the worst had occurred, Australians could have paid a heavy price. As things turned out, thankfully, the worst was avoided. So it has been appropriate to unwind the very easy monetary conditions of the pandemic years and address the higher inflation that has emerged so quickly. Higher interest rates This brings me to the third change since February – that is the increase in interest rates from the extraordinarily low levels during the pandemic. Since May, the cash rate has been increased by a cumulative 2¼ percentage points and now stands at 2.35 per cent. Like the rise in inflation, this increase has come sooner, and has been larger and faster, than was earlier expected. Previously the RBA had forecast that the damaging effects of the pandemic on our economy would be long lasting and that inflation would remain low. On that basis, we had expected that interest rates would remain low for some years. I am frequently reminded that many people interpreted our previous communication as a promise, or a commitment, that interest rates wouldn’t rise until 2024. This was despite our statements on interest rates always R E S E R V E B A N K O F AU S T R A L I A being conditional on the state of the economy. This conditionality often got lost in the messaging. We are currently working through the implications of this for our future approach to forward guidance and communication more generally. Now that inflation is as high as it is, we need to make sure that inflation returns to target in reasonable time. A powerful lesson from history is that low and stable inflation is a prerequisite for a strong economy and a sustained period of full employment. High inflation damages our economy, worsens inequality and devalues people’s savings. High inflation also makes it very difficult to sustain, or increase, real wages. It is a scourge. It is for these reasons that the RBA is committed to returning inflation to the 2 to 3 per cent target range over time. I know that higher interest rates are unwelcome for many people, especially those who have borrowed large sums over recent times. Higher interest rates are putting pressure on households, just at the time that higher petrol prices and grocery bills are squeezing budgets. So it is a difficult and a concerning time for some people. The alternative, though, of allowing higher inflation to become entrenched would be even more difficult and it would damage our economic prospects. The RBA will do what is necessary to make sure that higher inflation does not become entrenched and we are committed to returning inflation to the 2 to 3 per cent target range. We are seeking to do this in a way that keeps the economy on an even keel. It is possible to achieve this, but the path here is a narrow one and it is clouded in uncertainty. One important source of uncertainty is the global economy, where the outlook has deteriorated. The situation in Europe is very troubling, not least because of the extraordinary increases in energy prices. And in the United States, the Federal Reserve has indicated that monetary policy will need to become restrictive to lower inflation. The Chinese economy is also facing major challenges due to the combination of COVID, a severe drought and very weak conditions in the property sector. It will be difficult for Australia to stay on that narrow path to a soft landing if there is further material bad news on the global economy. Another factor that will determine how successfully we navigate that narrow path is how inflation expectations and the general inflation psychology evolve in Australia. To date, medium-term inflation expectations have remained well anchored, which is good news. But the general inflation psychology appears to be shifting; it is easier for firms to put their prices up and the public is more accepting of this. Wages growth has also picked from the very low rates of recent years and a further increase is expected due to the very tight labour market. Stronger wages growth is something that the RBA had been seeking for a number of years and some pick-up is welcome. It is also important to note that, to date, the stronger growth in wages has not been a major factor driving inflation higher and, at the aggregate level, growth in labour costs remains consistent with inflation returning to target. Looking forward now, it is important that we avoid a cycle where higher inflation leads to higher wages and inflation remaining high. This type of cycle would lead to higher interest rates, a weaker economy, and higher unemployment. Businesses, too, have a role in avoiding these damaging outcomes, by not using the higher inflation as cover for an increase in profit margins. A third issue we are watching carefully is household spending. Consumer sentiment has fallen, household disposable income is under pressure from higher interest rates and higher inflation, and housing prices are declining after large gains. On the other hand, many households are benefiting from the strong labour market, including by finding jobs and getting more hours of work. Some households are also continuing to save at a higher rate than before the pandemic. Quite a few have also built up large financial buffers, although many other households have only very limited buffers. In the face of these competing factors, the recent data suggest that spending has remained resilient so far. There is, though, considerable uncertainty as to how these factors will balance out over the months ahead and we are watching the situation carefully. In terms of the outlook for interest rates, the Reserve Bank Board expects that further increases will be required to bring inflation back to target. We are not on a pre-set path, though, especially given the uncertainties I have just spoken about. The increase in interest rates has been rapid and global and we know monetary policy operates with a lag. At some point, it will be appropriate to slow the rate of increase in interest rates and the case for doing that becomes stronger as the level of interest rates increases. As I have said previously, the size and timing of future interest rate increases will be guided by the incoming data and the Board’s assessment of the outlook for inflation and the labour market. On a different matter, as you would know, the Government has commissioned a review into Australia’s monetary policy arrangements and the RBA. Both the Board and the Bank’s staff welcome this review and we have already had constructive discussions with the Review Panel. We look forward to discussing with this Committee the topics raised by the Review at this and future hearings. To complement the external review, the RBA is undertaking internal reviews into the three-year yield target, the bond purchase program and our approach to forward guidance. The yield target review was published in June and the review of the bond purchase program will be published next week. The forward guidance review will be published later this year. Other responsibilities of the RBA Finally, since this is the first hearing of this Committee under the 47th Parliament, I would like to draw your attention to some of the RBA’s other responsibilities. We are the banker to the Commonwealth Government. We operate the Official Public Account and are the Government’s main transactional banker, providing banking services to the ATO, Services Australia and many government departments. Over the past couple of years we played an important role in making the COVIDrelated and flood disaster payments in real time. We made sure that people received their money quickly, often on weekends and outside of business hours. We are also responsible for the core of Australia’s payment system, which allows money to move from one bank to another. As part of this work, we operate the centre of Australia’s real-time fast payments system, which makes it possible for money to move between bank accounts in a matter of seconds at any time of the day or week. We also print the nation’s banknotes. While cash is being used less and less frequently for transactions, there is still strong demand for our banknotes. On average, there are 18 $100 notes and 38 $50 notes on issue for every person in Australia. The total value of notes on issue is $102 billion, which averages around $4,000 per person. That is a high number. The RBA has important regulatory responsibilities in the payments system, which are overseen by the Payments System Board. We supervise the central counterparties that are operated by the ASX and that are at the heart of Australia’s financial market infrastructure. We also have regulatory responsibilities for efficiency, competition and stability in Australia’s retail payments system. One issue that we are currently examining closely is the public interest case for the RBA to issue a digital form of the Australian dollar, which could complement the physical banknotes that we currently issue. We have an open mind as to whether it will be in the public interest to do this. We are currently working with the Digital Finance Cooperative Research Centre on potential use cases and also working with other central banks on this important issue. Thank you. My colleagues and I are here to answer your questions. R E S E R V E B A N K O F AU S T R A L I A | reserve bank of australia | 2,022 | 9 |
Speech by Ms Michele Bullock, Deputy Governor of the Reserve Bank of Australia, at Bloomberg, Sydney, 21 September 2022. | Speech Review of the Bond Purchase Program Michele Bullock[*] Deputy Governor Bloomberg Sydney – 21 September 2022 Thank you for the opportunity to talk with you today. I am going to use my time to talk about two issues: the review of our bond purchase program (BPP) during the pandemic; and the Bank’s financial statements for 2021/22. The two issues are related because, while the bond purchase program was a policy response to extraordinary economic circumstances, it has had big implications for the Bank’s balance sheet, profits and capital. I will give you the punch lines up front. In terms of the BPP, the review concludes that it broadly achieved its aims. But one result of the change in the Bank’s balance sheet is that the Bank will report a substantial accounting loss in its 2021/22 annual accounts and, as a consequence, negative equity. This will not, however, affect the Bank’s ability to operate effectively or perform its policy functions. And over the next few years the Bank will return to positive earnings and to positive equity. The bond purchase program The BPP was introduced in November 2020 as part of the Bank’s second package of monetary policy measures in response to the pandemic. It was a complement to the yield target, the Term Funding Facility (TFF), forward guidance and the very low overnight cash rate. Under the program, the Bank purchased Australian Government Securities (AGS) and semi-government securities (semis) in the secondary market to lower the structure of interest rates at maturities between five and 10 years. Unlike the yield target for three-year bonds, the BPP did not target a particular level of yields. Instead, it set a quantity of bonds to be purchased over a set time period. The initial program involved the purchase of $100 billion of bonds (split 80/20 between AGS and semis) over six months, at a rate of $5 billion a week. The program was extended several times: first, a further $100 billion from April to September 2021 at a rate of $5 billion a week; then, from September to November 2021 at a rate of $4 billion a week; and finally, purchases of $4 billion a week until mid-February 2022, at which point the program ceased. All up, the BPP resulted in the purchase of $281 billion of Australian, state and territory government bonds. Today, the Bank released its internal review of the BPP that was discussed by the Reserve Bank Board at its September meeting.[1] It is a fairly long document so I won’t go through it in detail – I highly recommend you read it though. It discusses the deliberations of the Bank and the Board in establishing and maintaining the program, the effects on the financial markets and economy, and the financial implications for the Bank. It concludes with an assessment of the program. I will first draw out a few of the key conclusions from the review. I will then discuss the financial impact on the Bank’s balance sheet in more detail. Review of the BPP In assessing the BPP, the review looked at its impact in four key areas: 1. its success in lowering bond yields, funding costs more broadly and the exchange rate 2. its support for economic growth and jobs 3. its implications for market functioning 4. its effect on the public sector balance sheet. The first conclusion reached was that the program was successful in lowering bond yields. We estimate that it lowered Australian Government bond yields by around 30 basis points and yields on semis by a bit more than this. This in turn helped to lower borrowing costs to historical lows and contributed to a lower exchange rate than otherwise. This is an important conclusion because the program was intended to have these effects. Second, the evidence suggests that the BPP supported economic growth and jobs. Given this was a novel tool implemented as part of a package of reinforcing measures, it is very difficult to isolate the specific effect of the BPP on the economy. But it is clear that the BPP, along with other policy measures, contributed to a strong recovery in economic activity and a sharp drop in unemployment. Further, a key benefit of the package of policy measures was to provide insurance against the serious downside risks the economy was facing during the pandemic. Third, we concluded that purchases of bonds by the Bank helped market functioning in times of stress. Even as the Bank held a larger share of bonds on issue, there was no negative impact on functioning more generally. This outcome was assisted by the features of the BPP – the fairly short announced purchase horizons and the flexibility to adjust the size, composition and timings of auctions in response to market conditions. Finally, the review highlighted that the program had an impact on the public sector balance sheet in several ways. It will result in a financial cost to the Bank because, as the economy has recovered, interest rates have had to rise. As I will discuss later, this will mean that the interest paid on some of our liabilities will for a time be higher than the return we receive on our assets, and as a result the Bank will be making losses. But the economic stimulus from the BPP contributed to higher revenues for the government, helping to reduce the budget deficit relative to earlier expectations. It also resulted in government debt being issued at a lower fixed cost than otherwise. Although the review concluded that the BPP achieved its aims, it did highlight a number of lessons. On the positive side, as I mentioned, the BPP was quite flexible. It was implemented with relatively short purchase horizons so it could be adjusted dependent upon market conditions and the economic outlook. Indeed this flexibility, along with the communication of developments in the program ahead of time, allowed for a relatively smooth exit from the program, particularly as compared with the exit from the yield target. On the other hand, just as we concluded in the review of the yield target, if more weight had been given to possible upside scenarios on the economy, the assessment of the relative costs and benefits of the BPP might have been different and led to alternative decisions. The review concluded that it would only be appropriate to consider the use of a BPP in the future in extreme circumstances – that is, when the cash rate target has been lowered as far as possible. This brings me to the Bank’s balance sheet and its 2021/22 financial results. R E S E R V E B A N K O F AU S T R A L I A The Bank’s balance sheet The review of the BPP discusses the losses that the Bank is expected to incur over coming years because the return on its assets will be less than the interest paid on its liabilities – primarily balances in Exchange Settlement accounts. But, in about a month’s time, the Bank will release its annual accounts in which it will report a large accounting loss and negative equity. What I want to do now is to step through the main features of the Bank’s balance sheet and the 2021/22 outcomes. The Bank’s balance sheet is relatively simple. On the asset side, the Bank essentially holds domestic bonds (either outright or under repurchase agreements) and foreign exchange reserves.[2] Prior to 2020, the Bank’s balance sheet was between $150 billion and $200 billion. Most of the assets were either foreign exchange reserves or domestic securities held under repurchase agreements (repos) as part of the Bank’s liquidity management; it held very few domestic bonds outright. This changed dramatically during the pandemic when, as discussed earlier, the Bank undertook novel measures to lower interest rates. This resulted in the Bank’s balance sheet expanding significantly. The BPP, combined with other policy responses to the pandemic, resulted in the Bank holding around $356 billion in AGS and semis at the end of June 2022 (Graph 1). It also held a further $188 billion in assets associated with the TFF. Graph 1 RBA Assets Monthly $b $b M J S D M J S D M Bond purchase program bonds Yield target and market function bonds Term Funding Facility J S D M J S Domestic reverse repos Other domestic bonds Gold and foreign exchange Source: RBA The Bank’s main liabilities are deposits by financial institutions (ES balances), government deposits and banknotes. Prior to the pandemic, banknotes accounted for most of the Bank’s liabilities with deposits making up most of the rest (Graph 2). Graph 2 RBA Liabilities Monthly $b $b M J S D M J S D M ES balances Government and other deposits J S D M J S Banknotes on issue Other liabilities Source: RBA The BPP and the TFF resulted in a significant change in the Bank’s liabilities, with ES balances increasing to over $450 billion, easily becoming the biggest component of liabilities. The Bank also holds a number of equity reserves on its balance sheet, which I will come back to in a minute. The Reserve Bank’s earnings come from two sources: underlying earnings (the most important of which is net interest income) less operating costs; and valuation gains or losses on holdings of government bonds and foreign exchange. The Bank’s net interest income is the difference between the interest it receives on its assets and the rate it pays on its liabilities. The Bank earns a market rate of interest on almost all of its assets. On the liability side, the Bank ordinarily pays interest on most deposits but importantly it does not pay interest on banknotes outstanding. So prior to the expansion in the Bank’s balance sheet in 2020, it paid no interest on over half of its liabilities. If the average rate earned on its assets is greater than the rate paid on its liabilities, the Bank will have positive net earnings. And indeed historically this has been the case. Underlying earnings (which subtracts operating costs) has been positive since the Bank was established in 1959 (Graph 3). R E S E R V E B A N K O F AU S T R A L I A Graph 3 RBA Underlying Earnings* Year ending 30 June $b $b -2 Underlying earnings * Net Interest income -2 Net other expenditure 2013/14 excludes the Commonwealth grant of $8,800 million. Source: RBA Over the past couple of years, underlying earnings have been particularly strong. In 2021/22, underlying earnings were $8.2 billion. This reflects interest earnings through the year on the larger portfolio of Australian Government bonds purchased under the various pandemic programs while paying no interest on almost all liabilities (banknotes and, until May 2022, ES balances). The other component of the Bank’s earnings is valuation gains and losses arising from fluctuations in the value of its assets due to movements in exchange rates or changes in the market yields on securities held outright. As the Bank applies fair value accounting in its financial statements, such movements have an immediate impact on earnings. Over the past year, valuation losses on the Bank’s holdings of domestic bonds due to the rise in bond yields were around $40 billion. In addition, because we purchased many of these bonds at a price higher than their face value, the amount of this ‘premium’ will also be recorded as a loss over the life of the bond.[5] Over the past year, this accounts for a further $5 billion valuation loss. These valuation losses were partially offset by a net $1 billion valuation gain on the Bank’s foreign assets from the depreciation of the Australian dollar over the year (Graph 4). Graph 4 RBA Valuation Gains and Losses Year ending 30 June A$ net value $b $b -20 -40 -20 Foreign investments Foreign currency Australian dollar securities % -40 % Per cent of RBA total assets -5 -5 -10 -10 Source: RBA The net impact of these two forces is that the Reserve Bank will announce a significant accounting loss when it releases its financial statements in October (Table 1). Table 1: Reserve Bank Earnings $ billion 2021/22 2020/21 2019/20 8.2 4.2 1.4 Valuation gains/losses (-) −44.9 −8.5 1.1 Accounting profit/loss (-) −36.7 −4.3 2.5 Underlying earnings Capital and reserves This leads to the question of how such a significant loss is treated. But first, a bit of background on the Bank’s capital and reserves. The Reserve Bank holds a number of reserves, the most important ones for the current discussion being the unrealised profits reserve (UPR) and the Reserve Bank Reserve Fund (RBRF). Both of these reserves are set out in the Reserve Bank Act 1959. There are also a number of accounting reserves but I won’t discuss them further because they don’t really impact the results (Graph 5). R E S E R V E B A N K O F AU S T R A L I A Graph 5 RBA Equity Monthly $b $b -20 -20 -40 M J S D M J S Net equity Unrealised profits reserve Accounting reserves D M J S D M J S -40 Capital and Reserve Bank Reserve Fund Accumulated losses Source: RBA The UPR functions as the name suggests. While unrealised valuation gains are reflected in profits, they are not available for distribution. Instead, they are placed in a reserve to either absorb any unrealised losses in future or become distributable when profits are realised from a sale or maturity of the underlying asset. The RBRF is the Bank’s main reserve and historically constituted the bulk of the Bank’s capital. The framework used by the Reserve Bank Board to determine the target balance of the RBRF had been in place for a number of years.[6] Under that framework, capital was assigned to cover market risk arising from the Bank’s portfolio of foreign and domestic asset holdings. A small amount of capital was also assigned to cover credit risk arising from the very small exposures to commercial banks that are not collateralised. The target balance in the RBRF is not a minimum level of capital that needs to be maintained at all times but rather a benchmark for the Board to consider when providing advice to the Treasurer regarding the Bank’s capital and dividends. The Reserve Bank Act sets out how these reserves are utilised when the Bank makes a profit or a loss: • Unrealised gains are not available for distribution and are transferred to the UPR. • Unrealised losses are first absorbed by the UPR. In the event unrealised losses exceed the balance of the UPR, they are offset against other sources of income. • If after this distributable earnings are positive, the Treasurer determines, after consulting the Reserve Bank Board, any amounts to be transferred from distributable earnings to the RBRF. The remainder of distributable earnings is payable as a dividend to the Commonwealth. • If, however, the unrealised losses are so severe that they totally deplete all other income, the RBRF is used to absorb the losses. The Act is, however, silent on what happens if the RBRF isn’t large enough to absorb the remaining losses. So, how has this played out in 2021/22? In 2021/22 the Reserve Bank recorded an accounting loss of $36.7 billion. While underlying earnings were $8.2 billion, valuation losses were $44.9 billion. Only $0.5 billion could be absorbed by the UPR so there still remained $36.2 billion in losses to distribute. The RBRF absorbed $15.4 billion of this before it was exhausted, leaving around $21 billion in losses. This will be recorded as accumulated losses on the Bank’s balance sheet (Table 2). This means that the Bank has negative equity. Table 2: Distribution of RBA Accounting Loss in 2021/22 $ billion – Accounting loss −36.7 – Absorbed by: – Unrealised profits reserve −0.5 – Reserve Bank Reserve Fund −15.4 – Transferred to accumulated losses −20.8 – Other reserves – Net equity 8.4 −12.4 If any commercial entity had negative equity, assets would be insufficient to meet liabilities and therefore the company would not be a going concern. But central banks are not like commercial entities. Unlike a normal business, there are no going concern issues with a central bank in a country like Australia. Under the Reserve Bank Act, the government provides a guarantee against the liabilities of the Reserve Bank. Furthermore, since it has the ability to create money, the Bank can continue to meet its obligations as they become due and so it is not insolvent. The negative equity position will, therefore, not affect the ability of the Reserve Bank to do its job. Indeed, a number of central banks in other countries have a similar issue – large bond portfolios that, if markedto-market, will result in substantial accounting losses and, potentially, negative equity. But the Reserve Bank of Australia is unusual in using market value accounting without an indemnity from the Government. For example, both the Bank of England and the Reserve Bank of New Zealand use market value accounting for securities purchased under their equivalent bond purchase programs but their profits are unaffected by mark-to-market gains or losses because they are offset by a matching entry that reflects the value of their indemnity. What about future profits? Despite the fact that the Bank can continue to operate with negative equity, the Board’s view is that it is important that the Bank return to positive equity over time. The Board has communicated this to the govern ment. While it has not sought a capital injection, the Board has indicated to the government that it expects that future profits will be retained by the Bank until the Bank’s capital is restored. The Treasurer has endorsed this general approach, noting that under the Reserve Bank Act the issue of distributions to the government is considered each year. One reason why we expect profits in the future is that the majority of the Bank’s domestic bonds are now carried on the balance sheet at a value less than these bonds will be redeemed at on maturity, so that capital gains are expected to be realised as these bonds mature. This will add to the Bank’s earnings in future periods. Furthermore, the Bank is continuing to earn seigniorage on the banknotes it issues. Offsetting this, however, is the fact that over the next few years the interest the Bank earns on its domestic bond holdings is likely to be less than the interest it is paying on ES balances. Indeed, as monetary policy has been tightened over the past five months, the interest rate paid on ES balances has been rising and we are now in the position where, on average, the interest being earnt on our assets is less than the interest being paid on our liabilities. In other words, underlying earnings are negative. It is difficult to be precise about how long this situation will last or how big these negative earnings will be. The Review of the BPP set out four scenarios to illustrate how the Bank’s future earnings may vary with different assumed paths for policy rates. We can use these scenarios to get some idea of the potential future path of the R E S E R V E B A N K O F AU S T R A L I A Bank’s earnings and net equity position. The Bank would incur losses for the next few years, as the interest rate on ES balances would be higher than income on the Bank’s assets (especially funds lent under the TFF). But valuation gains on the Bank’s domestic bonds will also boost earnings and within a few years it is expected they will more than offset negative underlying earnings. At this point, net equity will begin to improve. The other factor that will lead to an improvement in profit and net equity is the reduction in the size of the balance sheet. As noted earlier, prior to the pandemic, the more usual situation for the Bank was a much smaller balance sheet in which banknotes (paying no interest) accounted for most liabilities. As the Bank’s bond portfolio matures, ES balances will run down and we will move back towards a situation with positive income and much less exposure to interest rate risk. It is worth noting, however, that the AGS that the Bank holds are actually liabilities issued by the government. So, while the Bank will report a large valuation loss in 2021/22, the government’s debt issuer – the Australian Office of Financial Management (AOFM) – will report a significant valuation gain. For the whole of government, therefore, the Bank’s loss on this part of its portfolio will net off against the AOFM’s gain. Conclusion The Bond Purchase Program was implemented by the Bank as part of a package of measures designed to provide insurance against very bad economic outcomes as a result of the pandemic. The Bank’s internal review of the program suggests that it broadly achieved its aims. But one outcome of the bond purchases and other policy measures has been that the Bank will report a substantial accounting loss in its 2021/22 annual accounts, resulting in the Bank being in a position of negative equity. This will not, however, affect the Bank’s ability to operate. As the bonds mature and the Bank’s balance sheet declines, the Bank will once again return to positive earnings. These earnings will result in the Bank returning to positive equity over time. Thank you for your attention. Endnotes [*] I am grateful to Paul Kandelas, Max Prakoso and Sam Tomaras for excellent assistance in preparing this speech. See RBA (2022), ‘Review of the Bond Purchase Program’, September. A reverse repurchase agreement involves the purchase of securities with an undertaking to reverse this transaction at an agreed price on an agreed future date. As a reverse repurchase agreement provides the Bank’s counterparties with cash for the term of the agreement, the Bank treats it as an asset by recording a cash receivable. The financial benefit that the Bank receives from issuing liabilities on which it pays no interest (banknotes) and investing the proceeds in interest-bearing assets (either outright, under repurchase agreement, or via a foreign exchange swap) is known as seigniorage. For a discussion on the concept, see Box A in Wakefield M, L Delaney and R Finlay (2019), ‘A Cost-benefit Analysis of Polymer Banknotes’, RBA Bulletin, December. The remuneration rate for ES balances was reduced to 10 basis points below the cash rate target at the November 2020 Board meeting. With the cash rate target remaining at 10 basis points until May 2022, interest rate on ES balances was zero for the first 10 months of the 2021/22 financial year. These premiums are unwound on a straight-line basis and recorded as unrealised valuation losses each day, and realised upon sale or maturity of the bond For a discussion of the Bank’s capital framework, see RBA (2021), ‘Earnings, Distribution and Capital’, RBA Annual Report. For more information on the approach taken by other central banks, see RBA, n 1. | reserve bank of australia | 2,022 | 9 |
Keynote address by Ms Luci Ellis, Assistant Governor (Economic) of the Reserve Bank of Australia, to the Citi Australia & New Zealand Investment Conference, Sydney, 12 October 2022. | Speech The Neutral Rate: The Pole-star Casts Faint Light Luci Ellis [ * ] Assistant Governor (Economic) Keynote Address to Citi Australia & New Zealand Investment Conference Sydney – 12 October 2022 Thanks to Citi for the opportunity to speak today. My topic is the so-called ‘neutral interest rate’. The concept has attracted a lot of attention in recent months. It’s no surprise why. Until earlier this year, policy interest rates – in Australia, the cash rate target – had been held at very low levels to support economies through the COVID-19 pandemic and into recovery. Such low levels are understood to be unusual – they are an emergency setting for extraordinary times. But now, with unemployment close to a 50-year low and inflation currently very high, policy stimulus is no longer needed. It’s natural in these circumstances to think of policy getting back to a ‘more normal’ setting – although one could argue that times are still far from normal, just in a different way to the previous two years. Regardless, it’s understandable that in recent months people have been wondering what ‘normal’ policy might be. To the extent it means ‘no longer providing stimulus’, this then becomes a question of what ‘neutral’ policy might mean. Economic theory contemplates a riskfree or policy rate that can be considered ‘neutral’. This rate – whatever it is – is usually labelled ‘r *’. Today I’m going to talk about how a neutral rate might be defined and measured, what might determine its level, and how we might respond, knowing that it could change. In doing so, I want to emphasise that the neutral interest rate is a long-run concept. There are other ways of thinking about this; some people make a distinction between ‘long-run r *’ and ‘short-run r*’. [ 1] What is it? When the policy interest rate is low enough, it stimulates demand. And when it is high enough, it restrains demand. Somewhere in the middle, there must be a rate that is neither contractionary nor expansionary. That’s one way to frame the neutral rate. Certainly that’s how we have defined it publicly in the past. Dig a little deeper, though, and there are some subtleties in this definition that are worth unpacking. Consider what it means for policy to be stimulatory: growth would tend to increase, unemployment decline and inflation accelerate. But what if some negative shock hits the economy that offsets the effect of monetary policy? Then we wouldn’t see those tendencies be borne out in the data. This means that, when we think about policy being expansionary or contractionary, underneath those concepts is always the question: ‘compared with what?’. Well, compared with the situation if we had held interest rates at a different level. Rather than seeing the economy expand or slow in response to the stance of policy, at times policy will only be cushioning the effects of forces working in the other direction. The neutral rate is therefore best thought of as a long-run concept. It is the interest rate that keeps growth at trend and inflation constant at target, when no other shocks are hitting the economy. Put another way, it is where the policy rate settles once all shocks have played out. Still another definition stems from the first – for growth to be constant at its trend rate and inflation to be constant at target, the levels of desired saving and desired investment must balance each other. So the neutral rate can also be described as the level of the policy rate that balances desired saving and investment. This framing can be useful when thinking about the determinants of the level of the neutral rate, and therefore what might cause the neutral rate to change. Before turning to the question of how to measure the neutral rate, we should note some important features that are implied by these definitions: 1. The neutral rate is not directly observable. Like all the other so-called ‘star’ variables, such as the NAIRU or the rate of growth in potential output, it has to be inferred from data. 2. It is mostly a global concept. Capital can flow across borders. This means that the desired saving and desired investment that must be balanced are global desired saving and global desired investment. Shifts in desired saving and investment globally therefore influence the neutral rate across economies. [ 2] That said, country-specific factors also matter. For example, economies with aboveaverage trend growth may attract more investment, leading to a higher neutral rate. Neutral real interest rates can therefore differ across economies even if capital is fully mobile across borders. Neutral rates expressed in nominal terms can also differ if trend inflation differs across countries. So different inflation targets imply different nominal neutral rates, even though the neutral real rate won’t necessarily be different. 3. It is an emergent property of the economic system. The neutral rate arises from the combined behaviour of many actors in the economy. It is not an ‘exogenous’ variable from outside the system and shouldn’t be treated as such. Rather, causation runs both ways – economic outcomes can influence the level of the neutral rate, and vice versa. So we should expect that it can change over time, and that these changes have underlying economic explanations. Changes in the neutral rate are not random or external shocks. Like the other ‘star variables’, the neutral rate is an economic fundamental, but fundamental does not mean fixed. 4. The neutral rate is a real interest rate. Economic theory holds that it is real, inflationadjusted interest rates that matter for people’s saving and investment decisions. People look though the expected inflation component of nominal rates; lenders expect to be compensated for it, and borrowers expect to have to provide that compensation. From real back to nominal Real interest rates are not readily observed, however, and monetary policy is conducted in nominal terms. This means that once you have inferred the level of the neutral real rate, you have to translate that back to the nominal rate by reflating using some measure of inflation. The choice of which inflation rate to use is not clear cut. If you are focusing on these longer run conceptions of the neutral rate, a longer run or trend rate of inflation makes most sense. But there are other choices. The saving and investment decisions that inform the level of the neutral rate depend on expectations of the future. As such, it makes sense to use some measure of inflation expectations, ideally over a multi-year horizon. This adds another layer of uncertainty to the calculation. Inflation expectations are imperfectly measured at every horizon, and it is not obvious which horizon should be used. A one-year horizon is a common choice (and can be seen in some graphs in this speech) – but it is a choice driven largely by data availability, rather than being well grounded in theory or empirical evidence. Another approach is to use the inflation target – in our case, the midpoint of the target band. This can be justified by the definition of the neutral rate as the rate that keeps inflation at target and growth at trend. Given the difficulties and judgements involved in choosing a forward-looking inflation rate, people sometimes resort to using recent observed inflation instead. That’s understandable. Most of the time, when inflation is stable, it won’t put you too far wrong. Conceptually it isn’t quite right, though. People’s decisions depend on their beliefs about the future, not solely on the recent past. And there are times when using past inflation produces very different estimates of current real rates than a trend or forward-looking measure. We are definitely in one of those times. Current inflation is very high, and expected to stay high in the short term. But beyond the next year, inflation expectations remain well anchored inside the target range, both here and overseas (Graph 1). Using the current or near-term inflation rate would imply that real interest rates were very negative at the moment. That doesn’t seem like the right conclusion to draw; if it were true, borrowing behaviour would be a lot more exuberant than it currently is. So while we can learn something from that calculation – and I show it later – it isn’t a preferred measure. Graph 1 Inflation Expectations Australia, inflation swaps measure % Next year 1–5 years ahead 5–10 years ahead % -2 -2 Sources: Bloomberg; RBA Measuring the real rate could also be subject to perception biases. It’s possible that saving and investment decisions depend more on people’s and firms’ expectations about growth in their own prices or wages, than on their expectations about inflation in the whole economy. If these own-price expectations are systematically biased, they will not aggregate to the expected rate of inflation in the whole economy. That is, when you ask people what they expect inflation across the whole economy to be, you will get a different answer than if you could aggregate all these own-price expectations that actually drive people’s behaviour. If these biases are large enough, the real rate you infer by subtracting an economy-wide measure of inflation expectations won’t be the real rate that people actually perceive and act on. How is it measured? The definitions of the neutral rate just described relate to a long run when all the shocks have worked their way through. To infer it, you have to identify the confounding shocks and strip out their effects on the economy. That is no small task. Fortunately, we have data and econometric models, so the cause isn’t completely hopeless. Before we get into those more sophisticated approaches to measurement, it is worth mentioning one helpful rule of thumb: in the long run, the neutral real rate is highly likely to be positive. This is because of time preference. People would rather have a dollar now than a dollar tomorrow or next year. They demand some compensation for having to wait, even if the payoff next year is risk-free. Because the policy rate represents the risk-free short-term interest rate, it embeds people’s underlying time preference. So we should expect the neutral real rate also to be positive, though it could be small. And when you add in the condition that inflation should be at target, it implies a nominal neutral rate in Australia of at least 2½ per cent. Because the definition of the neutral rate can be framed in different ways, and because of the inherent difficulties in measurement, at the Bank we use nine different models to estimate it. These nine models are derived from three broad approaches. For each approach, we construct three models, each with minor variations. Approach 1: The neutral rate is inferred from financial market pricing. It estimates the neutral rate as the average of expected future short-term real interest rates derived from a model of the term structure of nominal and real interest rates, adjusting for term premia. [ 3] The underlying assumption is that the real interest rate should revert to its neutral rate over time as the effects of shocks fade. The three models estimated using this approach assume different horizons over which the interest rate settles at neutral – three, five and 10 years. Approach 2: A statistical model is used to infer the neutral rate at each point in time as the level of the real policy rate that would prevail if inflation is at target, output is at potential and the economy is at full employment. [ 4] The model updates its estimate of the neutral rate each quarter based on how much some variables deviate from the model’s predictions for the previous quarter. This method makes strong, but standard, assumptions about the structure of the economy, including the relationship between output and inflation and the gap between the cash rate and the neutral rate. The three specific models we use allow for varying emphasis on different drivers of inflation – for example, domestic versus global factors. Approach 3: A flexible statistical model is used to forecast the future value of the policy rate once all cyclical influences have dissipated, which is then used as an estimate of the neutral rate. The idea is that this forecast is the trend value to which the policy rate will converge based on structural influences. [ 5] In practice, this method makes fewer assumptions about economic structure than the second approach. However, its estimates will only be plausible if a forecast of the future actual policy rate is actually a good estimate of the neutral rate. We then take a simple average across the nine models to derive a central estimate of the neutral real rate. This is a standard approach to dealing with model uncertainty. Nonetheless, it is important to remember that each model is estimated with considerable uncertainty, and we are combining these highly uncertain estimates. You can see the wide range of the different model estimates in this graph; they span a range from −0.5 per cent to 2 per cent, with the model average just under 1 per cent (Graph 2). Graph 2 Real Neutral Interest Rate Average of the model estimates % % Model-average Range of available estimates* -2 -2 Real cash rate (ex ante)** -4 Real cash rate (ex post)*** -6 -4 -6 * ** Range of central estimates corresponding to available models. The ex-ante real cash rate is deflated using expected inflation; December quarter 2022 value is a preliminary estimate. *** The ex-post real cash rate is deflated using year-ended trimmed mean inflation; December quarter 2022 value is a preliminary estimate. Source: RBA How has it changed? The other point to note about the estimates in the graph are that they have declined over the course of several decades, and noticeably so in the wake of the global financial crisis (GFC). This decline is common globally (Graph 3), which is to be expected as the neutral rate largely rests on global factors. The causes of this common downward trend are less clear-cut, however. Many possible explanations have been proposed in the literature. Some are more plausible than others, and of course there could be more than one thing going on. Graph 3 Real Neutral Interest Rates* % % United States Australia United Kingdom Canada Euro area New Zealand -1 -1 * Last data point for United States, United Kingdom, euro area and Canada is June 2020. Sources: Holston, Laubach and Williams (2017); RBA; RBNZ One possible cause is the apparent decline in potential output growth, which has been a multidecade trend common across advanced economies (Graph 4). Lower potential growth reduces expected future demand. In turn, it reduces firms’ incentive to invest and so decreases the interest rate that balances investment with desired saving. Graph 4 Neutral Interest Rates and Potential GDP Growth* Select advanced economies % % Potential GDP Neutral rates * United States, euro area, United Kingdom and Canada; PPP-weighted; last available data point December 2019. Sources: Holston, Laubach and Williams (2017); OECD; RBA Slower growth in potential output can stem from lower productivity growth or population ageing, or a combination of the two. Productivity growth has slowed over the past few decades, in Australia and elsewhere (Graph 5). [ 6] Candidate explanations for this include reduced innovation, increased regulation, slower adoption of innovation, reduced business dynamism and reduced competition. [ 7] The trend has been obscured lately by the effects of the pandemic. As best as we can tell, though, this slow productivity performance has continued below the surface. Graph 5 Labour Productivity* March 1993 = 100, log scale, quarterly index 1993–2002 2003–2014 2015–2022 0.9% 1.2% index 2.4% * GDP per hour worked; black lines denote linear trend; labels show average annual growth. Sources: ABS; RBA The effect of slower population growth and population ageing is a bit more nuanced. In principle, population ageing should lower saving because more people are retired and drawing down on their savings. But this effect seems to be overshadowed by the need to increase saving as longevity increases – that is, people need to save more to fund a longer period in retirement. Other factors beyond potential growth could also help to explain the decline in neutral rates. One of these is reduced risk appetite. [ 8] The uncertainty that prevailed following the GFC dampened firms’ appetite to invest; instead, the focus turned to cost-cutting. It also encouraged households to increase precautionary saving and reduce debt. In Australia, this was evidenced in the broadly stable ratio of debt to income, even though lower interest rates would ordinarily encourage leverage. Risk aversion also showed up as increased demand for safe assets – such as liquid and highly rated bonds – by global investors, especially central banks in emerging economies and pension funds in advanced economies. A related explanation of the decline in the neutral rate is the ‘global savings glut’ hypothesis. Recall the earlier discussion of how the neutral rate balances global desired saving and global desired investment. If some factor drives up desired saving without also expanding investment opportunities, the neutral rate necessarily falls. According to this explanation, following the Asian financial crisis, governments in emerging Asia built up foreign exchange reserves to prevent something similar happening to them again. The counterpart to that reaction was that these countries ran large current account surpluses – they switched from being net importers of capital to net exporters. The resulting increased global saving flowed into advanced economies and put downward pressure on interest rates there. An alternative explanation of a higher desired saving rate focuses more on the advanced economies than emerging Asia. According to this view, deregulation, lower inflation and other factors resulted in debt expanding relative to incomes. This lifted servicing burdens relative to incomes at any given (nominal) interest rate, thereby raising the saving represented by repayments of principal. Another explanation for lower neutral rates is that they have been driven by increased inequality. [ 9] This relies on the observation that saving rates tend to be higher for high-income households, and high-income households’ share of overall income has increased since the 1980s. This is the same period over which neutral interest rates have fallen. Because global saving and investment influence the domestic neutral rate, increased inequality globally can reduce the neutral rate in Australia even though income inequality has not increased by as much here. [ 10] These explanations for lower neutral rates are largely based on structural factors. Another possibility is that cyclical influences might be persistent enough that standard models read them as affecting the neutral rate. One such influence might be the global stance of fiscal policy. Its effects are hard to disentangle: expansionary fiscal policy boosts demand in the short run, but might reduce expected future growth in the long run if people focus on the need to fund current fiscal spending. That said, if fiscal policy is persistently tight, it is likely that monetary policy will have to be persistently accommodative to offset the contractionary influence on the economy. And if your model of the neutral rate does not explicitly include the global stance of fiscal policy, it will interpret this as the neutral rate having fallen. This omission might go some way to explaining a puzzle surrounding standard estimates of the neutral rate. It has fallen, but policy rates fell even more and were consistently below estimates of the neutral rate for a decade (Graph 6). Despite this, inflation stayed low, both in Australia and in other advanced economies. Something must have been offsetting this apparently expansionary policy; fiscal consolidation in the wake of the GFC, especially in Europe, could have been part of that. Graph 6 Nominal Neutral Interest Rate Range using different inflation measures % % Model-average* Range** Cash rate target * ** Inflated using expected inflation. Inflated using the inflation target or trimmed mean inflation. Source: RBA What are the consequences of a low neutral rate? It is not necessarily good or bad for the neutral rate to be at a particular level – it just is what it is. Given the possible role of demography and inequality in bringing the neutral rate to low levels, it is plausible that low neutral rates persist for the foreseeable future. If so, there are some implications to consider. A low neutral rate in a low-inflation world means that the economy could be more frequently constrained by the effective lower bound on nominal interest rates. It becomes harder to stimulate the economy when needed. The central bank must resort to other measures beyond reducing the cash rate to support the economy. This is one reason why central banks have inflation targets that are above zero. Another implication is that it can make it harder to achieve a desired rate of return. So investors with a mandate to achieve an absolute return could end up taking on risk that they would otherwise not take. Alternatively, the neutral rate could increase at some point. This is also plausible: the factors holding back productivity growth could dissipate; Asian governments will not necessarily continue to accumulate foreign reserves at the rate they did in the early 2000s; and fiscal consolidation might not be as much of a priority as it was in Europe in the early 2010s. An increase in the neutral rate has important implications, which will depend crucially on the cause of the increase. For example, those who look forward to a future of faster productivity growth must recognise that this will likely imply higher real rates as well as higher trend growth. This matters for investors, borrowers and fiscal authorities alike. These implications are mostly benign, but not if global productivity growth picks up and Australia does not keep pace. A future increase in the neutral rate would also have implications for balance sheets. Lower average nominal interest rates mean that you can service more debt for the same repayment. If the reason average nominal rates are lower is a permanent disinflation – as occurred after Australia adopted inflation targeting in the 1990s – the resulting expansion in balance sheets is sustainable. But if average (real) rates increase again, some deleveraging would be needed. That process is unlikely to be painless. If that were to occur, interest rate buffers become particularly valuable. In Australia and some other countries, banks determine allowable loan sizes by assessing a borrower’s capacity to pay based on an interest rate that is higher than the currently prevailing rate. These measures are designed to ensure that borrowers don’t overstretch and end up in distress from normal cyclical moves in interest rates. But it is easy to see that these buffers also provide some margin to cushion the adjustment if average real rates were to increase in the future. In this way, short-term prudence also supports long-term prudence. What does it all mean for policy? Having considered all the possible drivers of the neutral real rate and the measurement difficulties, I’d like to briefly conclude by considering the question of how that translates into our policy practice. The Reserve Bank is responsible for meeting a flexible inflation target. As set out in our various communications over recent months, the Board’s objective is to get inflation back to target. What that implies for the policy rate depends on what else is going on. Some factors could be dragging on growth and inflation; others could be boosting them. We make a holistic assessment of the forces that are affecting the economy and whether they might be reinforcing or offsetting the impact of monetary policy; it isn’t a simple mapping from inflation forecast to desired policy stance. The framework that brings that assessment together is our forecasting process, including the risks around our central projections. While far from perfect, a fullblown whole-economy forecast reduces the chance that we would miss something important. As I mentioned at the beginning of this talk, and has been clear for some time, the strong recovery of the economy and high rate of inflation mean that the previous setting of a cash rate near zero per cent is definitely no longer appropriate. But don’t think of this as a mechanistic approach of ‘we have to get back to neutral’, or above neutral. The neutral rate is an important guide rail for thinking about the effect policy might be having. It is not necessarily a prescription for what policy should do. ‘Neutral’, then, is not a destination we necessarily reach, but more a pole-star to guide us. And even then, its location is sufficiently uncertain that we are perhaps better served by paying more attention to the ground as it shifts beneath our feet than to that faraway pole-star. We need to be mindful of the limitations of our instruments, and of the prospect that the stars themselves can realign. But as we navigate the narrow path to our intended goal, we welcome any faint light that those stars may cast. Thank you for your time. Endnotes [*] Much of the material in this speech is drawn from work done by the Structural Analysis and Macro Modelling section in Economic Group for a briefing to the Board in July. Particular thanks are due to Ivan Roberts and Ivailo Arsov for leading this work, and to Matt Read for thought-provoking comments on this talk. See, for example, Bailey A (2022), ‘The Economic Landscape: Structural Change, Global R * and the Missinginvestment Puzzle’, Speech given at the Official Monetary and Financial Institutions Forum, London, 12 July. See Rachel L and LH Summers (2019), ‘On Secular Stagnation in the Industrialised World’, Brookings Papers on Economic Activity, Spring. See Hambur J and R Finlay (2018), ‘Affine Endeavour: Estimating a Joint Model of Nominal and Real Term Structures of Interest Rates in Australia’, RBA Research Discussion Paper No 2018-02. The statistical method used to infer the neutral rate is the Kalman filter. See McCririck R and D Rees (2017), ‘The Neutral Interest Rate’, RBA Bulletin, September, pp 9–18. See also Holston K, T Laubach and JC Williams (2016), ‘Measuring the Natural Rate of Interest: International Trends and Determinants’, FEDS, No 2016-073. This method uses a time-varying parameter vector autoregression with stochastic volatility. See Lubik TA and C Matthes (2015), ‘Calculating the Natural Rate of Interest: A Comparison of Two Alternative Approaches’, Richmond Federal Reserve Economic Brief No EB15-10. Goldin I, P Koutroupmpis, F Lafond and J Winkler (2022), ‘Why Is Productivity Slowing Down?’, Oxford Martin Working Paper Series on Technological and Economic Change No 2022-08. Andrews D and D Hansell (2019), ‘Productivity Enhancing Labour Reallocation in Australia’, Australian Treasury Working Paper No 2019-06; Hambur J (2021), ‘Product Market Power and Its Implications for the Australian Economy’, Australian Treasury Working Paper No 2021-03. See Jones, B (2021), ‘Uncertainty and Risk Aversion – Before and After the Pandemic’, Keynote Address at the Minerals Week Australia-Asia Investment Outlook, Canberra, 2 June 2021. See Mian A, L Straub and A Sufi (2021), ‘What Explains the Decline in r*? Rising Income Inequality Versus Demographic Shifts’, Becker Friedman Institute for Economics Working Paper No. 2021-104; Rachel L and D Smith (2017), ‘Are Low Real Interest Rates Here to Stay?’, International Journal of Central Banking, 13(3), pp 1–42. See Productivity Commission (2018), ‘Rising Inequality? A Stocktake of the Evidence’, Commission Research Paper, August. | reserve bank of australia | 2,022 | 10 |
Speech by Ms Michele Bullock, Deputy Governor of the Reserve Bank of Australia, at the Australian Finance Industry Association (AFIA) Annual Conference, Sydney, 18 October 2022. | null | reserve bank of australia | 2,022 | 10 |
Speech by Mr Christopher Kent, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, at the Commonwealth Bank Global Markets Conference, Sydney, 24 October 2022. | Speech Exchange Rates and Inflationary Pressures Christopher Kent[*] Assistant Governor (Financial Markets) Commonwealth Bank Global Markets Conference Sydney – 24 October 2022 Introduction I’d like to thank CBA for the opportunity to be here today. Inflation is too high in most economies. This reflects disruptions to supply coupled with strong demand. There has been an unprecedented monetary response in terms of the size of policy rate increases, across a wide range of central banks in a short span of time. Graph 1 shows the average of policy rates across a selection of central banks covering about 70 per cent of the global economy. If market expectations for policy rates pan out, then by the first part of next year the average policy rate will have increased by an amount comparable to the rise seen through the mid-2000s – but while that increase occurred over four years, this increase will have taken just four quarters. Graph 1 International Policy Rates* % ppts Average level % Quarterly change ppts -1 -1 -2 -2 * Central bank policy rates, quarterly data, weighted by June 2021 USD GDP: Fed, ECB, BoJ, BoC, BoE, RBA, PBoC. From November 2012 onwards the PBoC 7-day reverse repo rate is used; the official 1-year lending rate is used prior to this. Projections (dashed lines) are based on OIS-implied policy rate expectations, except for the PBoC where the policy rate is assumed to remain constant. Sources: Bloomberg; Central banks; RBA; Refinitiv The increase in the Reserve Bank’s cash rate target has also been sizeable and rapid. After raising rates by 25 basis point in May, the Board then raised rates by 50 basis points in each of the four meetings between June and September. At its October meeting, the Board raised rates by 25 basis points. The Board expects to increase interest rates further in the period ahead, given the need to establish a more sustainable balance of demand and supply and in the face of a very tight labour market. While wages growth has picked up in Australia from the low levels of recent years, it remains lower than in many other advanced economies. Indeed, wages growth is well above levels consistent with inflation targets in a number of these economies. The size and timing of rate increases in Australia will depend on incoming data – including the response of household spending to the tightening in financial conditions that is still working its way through the system. Rate increases will also depend on the outlook for inflation and the labour market. In my presentation today I will consider some issues related to inflationary pressures with a focus on the behaviour of exchange rates, both real and nominal. The real exchange rate and wages Wages growth and inflation in Australia had been low over a number of years prior to the COVID-19 pandemic. Looking at the growth of one measure – the Wage Price Index (WPI) – annual wages growth of around 2 per cent had become normal, while 3–4 per cent growth was the norm in the 15 years or so prior to the end of the mining investment boom (Graph 2). R E S E R V E B A N K O F AU S T R A L I A Graph 2 Wage Price Index Growth* Year-ended % % Mining investment boom average** Post-boom average** Pre-boom average** * ** Total pay excluding bonuses. Average annual growth, pre-boom average is 1992:Q3–2003:Q2; mining investment boom average is 2003:Q3–2012:Q2; post-boom average is 2012:Q3–2019:Q2. Source: ABS For many years over the past decade or so, actual wages growth was much weaker than the Bank had forecast. The Bank has discussed a range of reasons for that unexpected weakness,[2] including rising participation rates, heightened global competition, changes in bargaining arrangements and technology advancements. Another factor that contributed to the spare capacity in the labour market and affected wages growth was the long shadow cast by the end of the mining investment boom. On the back of a boom in commodity prices, mining and mining-related investment rose from around 2 per cent of GDP prior to the boom to a peak of around 9 per cent in 2012. This massive expansion in productive capacity underpinned a sizeable and prolonged increase in the demand for Australian labour. But once the new infrastructure was in place, and coincidentally the terms of trade began to decline, the demand for labour eased noticeably. The surge in demand for labour in the boom years and the decline thereafter had significant effects on wages growth and the Australian dollar, which persisted for many years after the peak in mining investment. To understand these effects, it’s helpful to consider two margins of adjustment that enabled the resources sector to attract labour in the boom years. First, and most obvious, companies in the resources sector offered much higher wages in Australian dollar terms than those being offered elsewhere. This encouraged workers across the country to shift away from other endeavours and move into the sector. The nominal exchange rate provided a second margin of adjustment, and helped to contain broader inflationary pressures in the face of strong growth in domestic demand. The appreciation of the Australian dollar over the years leading up to the peak of the mining investment boom pushed up the value of Australian wages in foreign currency terms. This made conditions in non-resource firms in the traded sector more difficult, and growth in investment, output, employment and wages was weak in those parts of the economy. Meanwhile, resource firms were benefitting from sharp rises in the prices of their outputs and had high expectations of future profits from the new infrastructure they were building. As such, they were willing to pay higher wages and absorb the freed up labour from the weaker sectors. The key point was that the adjustment in the boom years was achieved with a balance of a rise in wages in Australian dollar terms and a nominal exchange rate appreciation that pushed up wages in foreign currency terms. We can summarise the magnitude of these two margins of adjustment by comparing the nominal tradeweighted index of the exchange rate (or TWI) with the real TWI rate based on unit labour costs (Graph 3).[4] The nominal TWI appreciated by 25 per cent over this period (from around 2003/04–2011/12). The real TWI appreciated by 45 per cent. The difference between the two is the extra growth in Australian dollar wages relative to the growth of wages for our trading partners (expressed in their domestic currencies and adjusted for differences in productivity growth). Indeed, growth in Australian unit labour costs was about 2 percentage points higher on average per annum during the boom years than prior to the boom (Table 1). The average growth of unit labour costs across our major trading partners was little changed by comparison over these periods. Australian inflation was also higher during the boom years than prior to the boom; the average over this period was towards the upper end of the inflation target range of 2–3 per cent and at times inflation was noticeably above 3 per cent. So although the exchange rate dampened the effect of the terms of trade shock – by lessening the need for higher wages in Australian dollar terms – the economy still felt some inflationary bumps along the road. Graph 3 Australian Dollar June 2004 = 100 index Boom Pre-boom index Postboom Real TWI* Nominal TWI * Nominal TWI adjusted for ratio of nominal unit labour costs weighted by trade share; series exclude India and several other Asian trading partners as unit labour costs data are unavailable. Sources: OECD; RBA; Refinitiv R E S E R V E B A N K O F AU S T R A L I A Table 1: Key Prices and Activity Average annual growth (per cent) Pre terms of trade boom (1992/93 – 2002/03) Terms of trade boom (2003/04 – 2011/12) Post terms of trade boom (2012/13 – 2018/19) Exchange rate determinants Terms of trade 0.9 7.0 −0.8 RBA Index of Commodity Prices 0.1 16.1 −3.2 3-year yield differential (ppt change)* −0.5 −0.3 −2.2 Nominal TWI 0.2 2.7 −3.7 Real TWI CPI 0.2 3.8 −3.4 Real TWI ULC −0.1 4.6 −4.8 −0.9 −0.7 −1.7 Consumer Price Index 2.3 2.8 1.9 Trimmed mean Consumer Price Index 2.5 3.0 2.0 Wage Price Index 3.3 3.8 2.2 Australia 1.9 4.1 1.1 Trading partners**** 0.7 1.4 2.0 Exchange rate measures Domestic policy Cash rate target (ppt change)** Wages and prices*** Unit labour costs * Australian sovereign yield less yields of the United States, Japan and Germany, weighted by GDP; absolute percentage point change in average differential between start and end of period. ** Absolute percentage point change in average rates between start and end of period. *** Consumer price indices are adjusted for the tax changes of 1999–2000. Trimmed mean inflation excludes interest charges prior to September of 1998. **** In local currency terms, weighted by trade share. Series exclude India and several other Asian trading partners as unit labour costs data are unavailable. Note: Data not available for full 1992/93 – 2002/03 period for 3-year yield differential and Wage Price Index. Sources: ABS; Bloomberg; OECD; RBA; Yieldbroker Once the terms of trade and mining investment declined, and the associated labour was freed up from the resources sector, this process of adjustment worked in reverse. The nominal exchange rate depreciation that followed reduced the cost of Australian labour in foreign currency terms, helping to guide labour that was now in surplus in the resources sector back into other traded sectors. The nominal TWI depreciated by 20 per cent from the end of the boom to 2019. By itself, however, this depreciation wasn’t sufficient to restore the level of competitiveness of Australian labour to its pre-boom levels and absorb all of the economy’s spare capacity. That was achieved by slower growth in the cost of Australian labour in Australian dollar terms relative to our trading partners. Indeed, there followed a long period of low wages growth in Australia. For example, annual WPI growth dropped to rates that were 1 percentage point below pre-mining boom norms. More importantly though for competitiveness, growth of unit labour costs dropped by a similar amount. Meanwhile, inflation averaged 1.9 per cent, just under the inflation target range, from the end of the mining investment boom up to the pandemic. It took quite a few years after mining investment had peaked for the real Australian TWI to return to be close to its pre-mining boom level. While slower wages growth contributes only gradually to adjustments in the real exchange rate, this is not true of the nominal exchange rate given it can be much more flexible. This raises the question: why didn’t the flexible nominal exchange rate adjust in a way to facilitate a more rapid adjustment of the real exchange rate? One notable feature of this episode was that the depreciation in the nominal TWI didn’t start in earnest until around 18 months after the peak in the terms of trade. This may have in part reflected expectations for the terms of trade, which for a time remained at elevated levels even when the actual terms of trade had declined.[5] It is also likely to have reflected the effect of very low interest rates globally and unconventional monetary policies adopted by the major advanced economies in response to the global financial crisis. Meanwhile, the Reserve Bank eased monetary policy from late 2011 in response to the prevailing weaker economic conditions in Australia. However, from around 2016, the Bank was balancing the case for a faster return of inflation to the target range by lowering the cash rate further, against the medium-term risks associated with an increase in what were already high levels of household debt.[6] The Board’s decisions sought to limit the buildup of financial imbalances that can be a source of instability down the track. Over time, however, the evidence shifted. It became clearer that, even with the easing in monetary policy that had occurred, there was still spare capacity in the economy, which was weighing on wages growth and inflation. A further easing in policy would be needed to absorb that capacity and for inflation to rise. Also, there had been a tightening in lending standards in response to the Australian Prudential Regulation Authority’s earlier tightening of macro-prudential policies, lessening somewhat the concerns related to household debt. Accordingly, the cash rate was lowered further through 2019 and the Australian dollar depreciated to its lowest level in over a decade. Hence, by about the time of the pandemic, Australia’s pre-mining boom level of international competitiveness had been restored. The US dollar, the Australian dollar and inflation Over the course of this year, the US dollar has appreciated significantly against the currencies of both advanced and emerging economies (Graph 4). The 12 per cent appreciation of the US dollar in trade-weighted terms, is consistent with the rapid rise in US interest rates relative to those of many other economies, including Australia. R E S E R V E B A N K O F AU S T R A L I A Graph 4 US Dollar Against currency; change since the start of 2022 Mexico Canada Switzerland US TWI China Australia Euro New Zealand South Korea UK Norway Sweden Japan -10 % Sources: Bloomberg; Board of Governers of the Federal Reserve System The depreciation of currencies against the US dollar will add some pressure to already high rates of inflation in a wide range of advanced and emerging economies via a rise in the prices of imported goods and services. This is because much of global trade is invoiced in US dollar terms.[7] However, leaving it at that is an incomplete assessment of the effect of the Fed’s tightening of monetary policy. Two other points should also be made. First, higher interest rates in the United States will, in time, help to stem the growth of US demand for goods and services. The US economy accounts for about 25 per cent of the global economy (based on 2021 nominal GDP in US dollar terms). So an easing in demand pressures in the United States will help to ease a noticeable portion of global demand. Second, when most of the world’s currencies depreciate against the US dollar, households and firms in those economies will not be as willing nor able to pay the same US dollar denominated prices for their imports. Hence, we could expect those prices to decline, or at least rise less rapidly, over time. We can actually see that effect quite clearly and in very quick time with homogeneous goods like commodities that are traded on global spot markets. Take gold and oil as examples. The daily changes in the US dollar prices of those commodities typically have a strong negative correlation with the change in the value of the US dollar (Graph 5). That is, when the US dollar goes up, prices of those commodities come down somewhat on average. Graph 5 ρ US Dollar Commodity Price Correlations* ρ Oil 0.0 0.0 -0.2 -0.2 -0.4 -0.4 Gold -0.6 -0.8 -0.6 -0.8 * 1-year rolling correlations of daily changes in the US dollar trade-weighted index and commodity prices. Sources: Bloomberg; Board of Governors of the Federal Reserve System; RBA While this response may take more time to play out in markets for goods and services that are not as homogenous and not traded on global spot markets, the same sort of adjustment is likely to occur for a broad range of traded items. Even so, for many emerging market economies, there is likely to be a sizeable pass-through of the depreciation of their currencies against the US dollar to domestic inflationary pressures. This reflects the tendency of emerging market economies to have a larger share of tradable goods in their consumption baskets compared with advanced economies.[8] Also, inflation tends to be less well anchored in these economies. A number of economies – both advanced and emerging – have experienced broad-based exchange rate depreciations. So those economies will tend to experience more notable increases in their import prices as a result. This is in contrast to economies whose currency depreciations have been more narrowly based. The Australian dollar is in that latter camp. While it has depreciated significantly against the US dollar – falling by 14 per cent this year – in trade-weighted terms, the Australian dollar has depreciated by only 2 per cent over the same period (Graph 6). In trade-weighted terms, the Australian dollar has moved broadly in line with its fundamental determinants. In particular, it has been underpinned in part by the elevated prices of some of our key commodity exports. Commodity prices overall have declined over the past few months, but they remain around the levels seen at the turn of the year. The decline in the Australian dollar over recent months also accords with the fall in the differential between interest rates in Australia and those of major economies. Again, much of this reflects the rapid and prospective rise in the policy rate in the United States, which is larger than for the cash rate in Australia based on market expectations. R E S E R V E B A N K O F AU S T R A L I A Graph 6 Australian Dollar index US$ TWI* (LHS) 0.75 0.70 USD per AUD (RHS) 0.65 0.60 index ppt 0.8 3-year yield differential*** (RHS) 0.4 0.0 RBA ICP** (LHS) -0.4 * Trade-weighted index, 1 January 2019 = 100. ** Index of commodity prices (USD terms), 1 January 2019 = 100. *** Australian sovereign yield less yields of the United States, Japan and Germany, weighted by GDP. Sources: Bloomberg; RBA; Yieldbroker The smaller depreciation of the Australian dollar in trade-weighted terms than against the US dollar is important because the TWI typically has a greater bearing on our imported inflation than any one bilateral rate.[9] The Bank’s models suggest the depreciation will contribute to a higher level of consumer prices in Australia. But the effect from the depreciation in the TWI that we have seen over the year to date of around 2 per cent is estimated to be relatively modest. A rough rule of thumb from our models suggests that the level of the Consumer Price Index (CPI) will be higher by only around 0.2 per cent in total over the course of a few years. One final point on the rapid rise in US interest rates and the appreciation of the US dollar is the potential financial effects of this on other economies. Of most concern are some emerging market economies that have elevated levels of foreign debt, denominated in foreign currency terms, and unhedged. Australia’s offshore debt is well hedged.[10] Moreover, because Australian banks issuing debt offshore swap most of that back into Australian dollars, in effect they end up paying Australian interest rates on that funding, not higher US rates.[11] In other words, the rise in US interest rates is not likely to have a significant effect on Australian banks’ funding costs. Conclusion The long shadow cast by the end of the mining investment boom contributed to many years of lower wages growth in Australia. But, with Australia’s real exchange rate based on unit labour costs having returned to levels around its pre-mining boom days, that adjustment appears to have run its course. This year, the US dollar has appreciated noticeably as US interest rates have risen more rapidly than those in many other economies. Because much of global trade is invoiced in US dollars, this will add to the cost of imports for a time. But the rise in US interest rates will also contribute to a decline in global inflationary pressures. While the exchange rate can play an important role in inflation outcomes, the depreciation of Australia’s nominal tradeweighted exchange rate over the year to date will contribute only a very modest uplift in the level of consumer prices over the period ahead. Endnotes [*] I thank Tim Atkin and Jacob Harris for their excellent assistance in preparing this speech. See, for example, Bishop J and N Cassidy (2017), ‘Insights into Low Wage Growth in Australia’, RBA Bulletin, March. See Bishop and Cassidy, n 1; Lowe P (2019), ‘The Labour Market and Spare Capacity’, Address to a Committee for Economic Development of Australia (CEDA) Event, Adelaide, 20 June; Lowe P (2018), ‘Productivity, Wages and Prosperity’, Address to Australian Industry Group, Melbourne, 13 June; Debelle G (2019), ‘Employment and Wages’, Australian Council of Social Service (ACOSS) National Conference 2019, Canberra, 26 November; Jacobs D and A Rush (2015), ‘Why Is Wage Growth So Low?’, RBA Bulletin, June. See Kent C (2012), ‘Implications for the Australian Economy of Strong Growth in Asia’, Speech to the Structural Change the Rise of Asia Conference, Canberra, 19 September; Plumb M, C Kent and J Bishop (2013), ‘Implications for the Australian Economy of Strong Growth in Asia’, RBA Research Discussion Paper No 2013-03; Kent C (2016), ‘After the Boom’, Bloomberg Breakfast, Sydney, 13 September. This measure of the real exchange rate gives a sense of international competitiveness from the perspective of labour costs, and so is most useful when comparing the growth of wages across countries. However, it is not a comprehensive measure of competitiveness – for example, it does not capture the effect of margins and non-labour costs on international competitiveness, and it is subject to various data limitations. Another commonly cited measure of the real exchange rate is based on consumer prices. See Chapman B, J Jääskelä and E Smith (2018), ‘A Forward Looking Model of the Australian Dollar’, RBA Bulletin, December; Hambur J, L Cockerell, C Potter, P Smith and M Wright (2015), ‘Modelling the Australian Dollar’, RBA Research Discussion Paper No 2015-12. See Lowe P (2019), ‘Inflation Targeting and Economic Welfare’, Address to the Anika Foundation Luncheon Supported by NAB and ABE, Sydney, 25 July; Lowe P (2019), ‘Some Echoes of Melville’, Sir Leslie Melville Lecture, Canberra, 29 October. See Gopinath G, E Boz, C Casas, F Díez, P Gourinchas and M Plagborg-Møller (2020), ‘Dominant Currency Paradigm’, American Economic Review, 110(3), pp 677–719. For a broader discussion of exchange rate pass-through in emerging market economies, see BIS (2019), Annual Report, June, ‘Ch II – Monetary Policy Frameworks in EMEs: Inflation Targeting, the Exchange Rate and Financial Stability’. This is captured in the Bank’s macroeconomic modelling work: see Ballantyne A, T Cusbert, R Evans, R Guttmann, J Hambur, A Hamilton, E Kendall, R McCririck, G Nodari and D Rees (2019), ‘MARTIN Has Its Place: A Macroeconometric Model of the Australian Economy’, RBA Research Discussion Paper No 2019-07. [10] See Berger-Thomson L and B Chapman (2017), ‘Foreign Currency Exposure and Hedging in Australia’, RBA Bulletin, December. [11] See Kent C (2018), ‘US Monetary Policy and Australian Financial Conditions’, Speech at the Bloomberg Address, Sydney, 10 December. R E S E R V E B A N K O F AU S T R A L I A | reserve bank of australia | 2,022 | 10 |
Remarks by Mr Philip Lowe, Governor of the Reserve Bank of Australia, at the Reserve Bank Board Dinner, Hobart, 1 November 2022. | Philip Lowe: Remarks at the Reserve Bank Board Dinner Remarks by Mr Philip Lowe, Governor of the Reserve Bank of Australia, at the Reserve Bank Board Dinner, Hobart, 1 November 2022. *** Good evening. On behalf of the Reserve Bank Board, I would like to warmly welcome you to this community dinner. This is the first time the Board has met outside Sydney since October 2019. We are delighted that we are able to do so in this beautiful and historic city of Hobart. It's a great pleasure to be back here. Thank you very much for joining us this evening. Earlier today, the Board held its meeting in the Cabinet Meeting Room here in Hobart. I would like to thank the Premier very much for his hospitality. Your Cabinet Room was an ideal place for the Board to discuss the state of the Australian and global economies and decide upon the level of interest rates in Australia. As you are probably aware by now, the Board decided to increase the cash rate by a further one-quarter of a percentage point to 2.85 per cent. I will talk about the reasons for this in a moment. The previous time that the Reserve Bank Board met in Hobart was back in April 2016. The economy was in a very different position then from where it is today. Inflation was below target and surprising on the downside, wages growth was very slow, the unemployment rate was close to 6 per cent and interest rates were trending lower, with the cash rate then at 2 per cent. The global economy was growing a bit slowly, but it was broadly okay. How much things can change in just a few short years. A couple of weeks ago, I was in Washington DC with the Australian Treasurer at the G20 and IMF meetings. It was a sobering experience. We heard that: inflation globally is way too high; the rising cost of living is hurting many households; the world is falling behind on the agreed carbon reduction targets; war is once again tragically occurring in Europe; and the global economy is becoming more fragmented. As you can imagine, there was not much cheer around, even for somebody like myself who sees the glass as half full. I recount this, though, for a couple of reasons. The first is as a reminder of how difficult the global backdrop is at present. There is no escaping the fact that we are living through a challenging period. It's true that the choices that we make here in Australia during this period will help shape our own destiny, but we can't ignore the global environment. The second reason is that as I listened to my colleagues from around the world, my thoughts kept returning to the idea of how fortunate we are to live in Australia. We live in peace and we enjoy a level of material prosperity that few other people in the world 1/4 BIS - Central bankers' speeches experience. Our economy has bounced back better than most from the COVID-19 disruptions and we are benefiting from a surge in the prices of our key exports. And for the first time in almost 50 years, it is possible to say that almost all Australians who want a job can find one. Our public services are of a generally high quality and our public finances are in better shape than those of many other countries. And our natural assets mean that Australia is well positioned for the clean energy transition. We have a lot to be thankful for. None of this is to deny that we face some pretty serious challenges, but as I listened to the finance ministers and central bank governors in Washington DC, I kept thinking I wouldn't want to trade our place for anybody else's. Today, the Board heard how the Tasmanian economy too has bounced back well from the COVID disruptions. Gross state product per capita has grown a bit more quickly here than in the other states and the unemployment rate is the lowest in many years. Visitor numbers are recovering and investment is in an upswing, with Tasmania set to play an important role in Australia's energy transition. On the other side of the ledger, though, household budgets are under strain from cost-of-living pressures, the rental market is very tight and many firms are finding it hard to find workers. Even so, it is important to remember that we are in a better position than many others around the world. One challenge that is facing all Australians is high inflation. Over the year to September, the inflation rate was 7.3 per cent. This is the highest rate in more than three decades and we are expecting inflation to increase further to reach around 8 per cent later this year. After that, inflation is expected to moderate. This is due to the ongoing resolution of supply-side problems, a decline in commodity prices and higher interest rates which will establish a better balance between supply and demand in the economy. I would like to take the opportunity to assure you that the Board is resolute in its determination to return inflation to the 2 to 3 per cent target range. We will do what is necessary to achieve that. At our meeting today we discussed the damage that high inflation does to people; it is a scourge. High inflation devalues your savings. It worsens inequality in our society and it undermines our living standards. It hurts us all by impairing the functioning of our economy. It is for these reasons that the Reserve Bank Board will make sure that this episode of high inflation is only temporary. I understand that the higher interest rates that are needed to bring inflation under control are unwelcome by many people, especially those who have borrowed large amounts over recent times. At our meeting, we discussed how the higher interest rates are putting pressure on family budgets, just at the time that high petrol prices and grocery bills are also squeezing budgets. We are conscious of this and are certainly taking it into account. This morning, we also discussed the consequences of not raising interest rates, and allowing high inflation to persist and become entrenched in expectations. If this were to happen, the evil of inflation would be with us for longer and the eventual increase in 2/4 BIS - Central bankers' speeches interest rates needed to bring it down would be greater. This would increase the risk of a severe recession and a sharp rise in unemployment. It would be much better to avoid such a costly outcome and so we have acted strongly to avoid it. I want to acknowledge, though, that we are travelling along a narrow path here. The Board is seeking to return inflation to the 2 to 3 per cent range while at the same time keeping the economy on an even keel. It is still possible to do this, but there is a lot of uncertainty and we could be knocked off that narrow path, not least because of developments elsewhere in the world. At our meeting we also discussed an updated set of economic forecasts. Our central case is that we do stay on that narrow path. Economic growth, though, is expected to slow next year because of the deterioration in the global economy and the squeeze on household finances. Our central forecast is that the unemployment rate holds steady for a while at what is a historically very low level, but then increases a bit as the economy slows. Inflation is expected to start declining early next year and then take a couple of years to return to the 2 to 3 per cent range. In the short term, the east coast floods are adding to the upwards pressure on food prices, and next year there are likely to be very large increases in the prices that households pay for gas and electricity. To control inflation, the Board has already increased interest rates substantially. We moved in large half percentage point increments for four months, but at this and the previous meeting, we returned to more standard quarter percentage point increases. The earlier large increases were required to move interest rates quickly away from their pandemic levels to address the rapidly emerging inflation problem. But as interest rates moved back to more normal levels, the Board judged that it is appropriate to move at a slower pace while we assessed the data, the economic outlook and the impact of the rate rises to date. We are conscious that interest rates have been increased by a large amount in a very short period of time and that higher interest rates affect the economy with a lag. If we are to stay on that narrow path, we need to strike the right balance between doing too much and too little. The Board's base case remains that interest rates will need to go higher still to bring inflation back to target and our forecasts have been prepared on that basis. We are not on a pre-set path, though. If we need to step up to larger increases again to secure the return of inflation to target, we will do that. Similarly, if the situation requires us to hold steady for a while, we will do that. Given the uncertainties regarding the outlook, we will be watching very carefully how the economy and the inflation pressures evolve over the summer. Finally, while it is interest rates that keep the Reserve Bank in the news, I hope that you know that we do a lot more than just set interest rates. We are the banker to the Australian Government, so we process all social security payments, tax payments and Medicare refunds. We also operate the core of Australia's payments system. When you send money from your bank to another bank it goes through the Reserve Bank. We also operate a central part of Australia's 24/7 real-time payments system. I hope that you all have a PayID, so that you can take best advantage of this technology. If you don't have one, I encourage you to go get one. 3/4 BIS - Central bankers' speeches We also print Australia's banknotes. It comes as a surprise to many people just how many banknotes are in circulation. The total value of notes on issue is over $100 billion – that's around $4,000 per person in Australia. This is despite cash being used less and less for transactions. Our analysis is that most of these banknotes are being held as a store of value. On average, there are 18 $100 notes and 38 $50 notes on issue for every person in Australia. I don't have my share of these or know many people who do. As interest rates have risen recently, I thought that the attractiveness of holding banknotes as a store of value might decline, but there is little sign of that yet. Time will tell, though. The Reserve Bank is also responsible for the design of Australia's banknotes. Given this, we are currently considering the design of the $5 banknote following the passing of Queen Elizabeth II. We recognise that this is an issue that is of national interest and there is a long tradition of the monarch being on Australia's banknotes. Indeed, the monarch has been on at least one of Australia's banknotes since 1923 and was on all our notes until 1953. Given this tradition and the national significance of the issue, the Bank is consulting with the Australian Government regarding whether or not the new $5 banknote should include a portrait of King Charles III. We will make a decision after this consultation with the government is complete. Again, thank you very much for joining us this evening. We are looking forward to learning more from you over dinner about how things are going here in Tasmania. 4/4 BIS - Central bankers' speeches | reserve bank of australia | 2,022 | 11 |
Speech by Ms Michele Bullock, Deputy Governor of the Reserve Bank of Australia, to Australian business economists, Sydney, 9 November 2022. | Speech The Economic Outlook Michele Bullock[*] Deputy Governor Australian Business Economists Sydney – 9 November 2022 Thank you for the opportunity to speak with you this evening. As our Statement on Monetary Policy was published last Friday, I would like to talk about our current outlook for the Australian economy. As many of you would understand from first-hand experience, forecasting is always difficult, but especially so over the past couple of years. Nevertheless, as I noted in a speech last month, forecasting is an important part of our monetary policy process since the RBA Board needs to form a view on how its policy decisions might impact the economy and inflation in the future. I will start with a look back at where our forecasts stood in August and then highlight the areas in which subsequent developments have impacted the forecasts. I will then set out our current forecasts for inflation, growth and employment. Finally, I will talk about some of the ways we review our forecasts, and about the main uncertainties around the current forecasts and how they impact our thinking on monetary policy. It is worth emphasising up front that the Board’s priority is to return inflation to the 2–3 per cent band over time. Price stability is a prerequisite for a strong economy and a sustained period of full employment. This is what has driven our policy decisions to date and it is expected that further increases in interest rates will be required to meet this objective. The size and timing of future increases, however, will depend on the data. The August forecasts First off, I want to set the scene for where we were three months ago. Internationally, inflation was at multidecade highs in many countries. Although energy was a large part of this, there were also broad-based price pressures from strong demand meeting supply constraints for both labour and goods. As a result, central banks were increasing interest rates quickly. And while global demand was holding up, the twin pressures of declining real wages and interest rate rises were expected to put pressure on households and businesses. Forecasts for global growth were therefore being revised down. For China, the COVID-19 containment policy and issues in the real estate sector were viewed as being negative for growth. Given China’s importance as a trading partner, this would have implications for Australia. At the same time, Australian economic activity was holding up well. Consumption of services that had been curtailed during COVID-19 outbreaks early in 2022 had rebounded and goods consumption was holding up. The labour market was tight, supporting household incomes. At the same time, inflation was at multi-decade highs and interest rates were rising. While this was impacting consumer confidence, we were yet to see much of an impact on consumer spending and business confidence was high. Higher consumer prices, rising interest rates and falling housing prices were all expected to increasingly weigh on consumption. In this environment our forecasts were for growth to slow in 2023. In line with this we were forecasting the unemployment rate to gradually increase over the forecast period. Inflation was forecast to peak at 7¾ per cent at the end of 2022 before gradually moving back to the top of the target band by the end of 2024. Key developments since August There have been a number of developments that have led us to revise our forecasts since August, although the extent of revisions has been reasonably modest compared with the experience of recent years. On the international front, the prospects of a significant slowing in the global economy have intensified. This reflects a number of factors. Inflation has stayed persistently high, which has resulted in an upward revision of the outlook for policy rates in a number of advanced economies. There has already been a fast and simultaneous rise in policy rates, and many central banks have indicated that they will do what it takes to get inflation back down to their targets. The energy crisis in Europe has also led to a further downgrade of growth in the euro area and the United Kingdom. Expectations for growth in advanced economies are, therefore, a bit weaker than three months ago, and much weaker than was the case at this time last year (Graph 1). And finally the outlook for China has been downgraded. Overall growth in Australia’s trading partners is expected to be slightly below 3½ per cent in 2022 and 2023 – well below its pre-pandemic decade average of 4½ per cent. Graph 1 GDP Level Forecasts* December 2021 = 100 index G7 Major trading partner East Asia** Nov 2021 SMP Current index * ** Dashed lines represent forecasts. Major East Asian economies excluding Japan. Sources: ABS; CEIC Data; Consensus Economics; RBA; Refinitiv Turning to the domestic economy, the recent flooding in south eastern Australia has been disastrous for many households and businesses. The Murray-Darling Basin received a record volume of rain in October following wellabove-average rainfall earlier in the year (Graph 2). The full extent of crop and livestock losses is still being assessed and there is more and more damage as flooding progresses along river systems. The areas flooded in New South Wales, Tasmania and Victoria in October together account for a substantial proportion of agricultural output. Affected products include the winter cereal crops, fruits & vegetables and dairy. Encouragingly, contacts in the Bank’s liaison program have noted that not all crops in affected areas will have been destroyed. While there are substantial effects on flood-impacted communities, with significant disruption and damage, the effect of the R E S E R V E B A N K O F AU S T R A L I A floods is likely to be less evident in economy-wide activity data. However, prices for some food products are likely to be temporarily higher. Furthermore, with above-average rainfall expected over coming months consistent with the ongoing La Niña event, there is also an increased likelihood of further supply disruptions affecting costs and prices for a range of goods in late 2022 and early 2023. Graph 2 Murray–Darling Basin Rainfall Cumulative annual rainfall by year, 1900–2022 mm mm 90th percentile Median 10th percentile J F M A M J J A S O N D Source: Bureau of Meteorology A second material development for the domestic economy has been the revised outlook for energy prices. Retail prices of electricity and gas have increased by 10–15 per cent since the middle of the year, with much of this effect to come through in the December quarter CPI. This is consistent with our expectations a few months ago. Since then, however, we’ve learned that larger electricity and gas price increases than previously assumed are now likely in 2023. Finally, there are indicators suggesting that wages growth is a bit stronger than we had thought three months ago. In liaison, firms in most industries have reported higher-than-average wages growth (Graph 3). Since the middle of the year, close to half of firms reported realised wage increases of 3–5 per cent, with a further quarter of firms reporting increases above 5 per cent. New and timely data on wages outcomes for enterprise agreements from the Fair Work Commission shows that average wage increases in newly lodged enterprise agreements were a touch stronger in the September quarter, compared with approved agreements in the June quarter. Despite the stronger pick-up, aggregate wages growth remains moderate so far and wage growth expectations generally remain consistent with the inflation target. Graph 3 Timely Measures of Wages Growth Year-ended % % Wage Price Index CBA wage indicator* % Liaison** % % Private Wage Price Index % Xero small business indicator SEEK Advertised Salary Index -2 -2 * Changes in base wages based on a sample of CBA retail banking transactions. ** Private sector; trimmed mean; rescaled to have the same mean as the private Wage Price Index. Sources: ABS; CBA; RBA; SEEK; Xero Small Business Insights The current forecasts Given these developments, we now expect inflation to be a little higher than our August forecasts. At the same time though, we have also lowered our forecasts for growth and employment. Inflation We now expect headline inflation to peak around 8 per cent at the end of 2022 (Graph 4). Larger-than-expected increases in food prices are part of the story, but it is also the case that underlying inflationary pressures have been a little stronger than we previously thought. Faster rates of price inflation have spread beyond consumer durables and the prices of newly constructed homes to items such as groceries and market services in recent quarters. Grocery inflation has been elevated and this is expected to be sustained in the near term as a consequence of the floods and as rising costs of suppliers continue to be passed through to prices in supermarkets. The broad-based nature of the price pressures are evident in the share of CPI items that are rising at an annualised rate of more than 3 per cent (Graph 5). This share is the highest it has been in a number of decades and the last time it was close to this in 2008, inflation was well above target and the Bank was increasing the policy rate. R E S E R V E B A N K O F AU S T R A L I A Graph 4 Headline Inflation Forecasts Year-ended % Forecasts % Current Actual Previous -2 -2 Sources: ABS; RBA Graph 5 Share of CPI Items Rising by More than 3 Per Cent* % % * Proportion of CPI items by number with annualised quarterly growth more than 3 per cent; based on seasonally adjusted data; adjusted for the tax changes of 1999–2000. Sources: ABS; RBA While our inflation forecasts have been revised up a little, there are good reasons to think that we are approaching the peak of inflation this cycle. Much of the initial surge in grain prices in reaction to Russia’s invasion of Ukraine has reversed. The global imbalance between supply and demand for goods continues to be resolved. Higher interest rates globally are helping to moderate demand pressures. Supplier delivery times have shortened, backlogs of work have declined and inventories have mostly recovered to more normal levels (Graph 6). Along with lower oil prices, this has contributed to a decline in shipping costs and a moderation in input costs more generally. Graph 6 Supply Indicators index Delivery times PMI* Inverted scale index Shipping costs** 2017–2019 average = 100 * ** Purchasing Managers’ Index. Index of spot and contract container rates by route from China. Sources: IHS Markit; RBA; Refinitiv Domestic price pressures are also playing a role in the current period of high inflation. The outlook for domestic energy prices and rents are two areas we are monitoring closely. The large increases in retail gas and electricity prices that are predicted for next year will directly add over 1 percentage point to headline inflation over the year to September 2023. Because energy is an input to many of the goods and services we buy, there will also be second-round effects as businesses increase their prices in response. These effects are uncertain, but the secondround contribution of electricity prices to underlying inflation could be around ½ percentage point over 2024. Rental price inflation has also picked up and is expected to increase further over coming quarters (Graph 7). Rental vacancy rates have declined since the beginning of the year and are at historic lows in a number of cities. Growth in advertised rents for new leases has been very strong as a result. This will continue to flow through to the CPI measure of rent inflation, which measures rent increases for all leases, over coming quarters. Close to onethird of Australian households rent and many of these households have relatively low income and wealth. Higher rents could push some renters into financial stress, particularly when combined with broader cost-of-living pressures. R E S E R V E B A N K O F AU S T R A L I A Graph 7 Rental Market Indicators % % CPI rents inflation % % Rental vacancy rate Inverted scale Sources: ABS; RBA; REIA Growth and employment The Australian economy appears to have grown solidly over the second half of 2022, as household spending on services remains firm alongside a further pick-up in education and travel services exports (Graph 8). GDP growth is then expected to slow in early 2023, as the recovery in household spending from pandemic-related restrictions is expected to have mostly run its course. Consumer spending has been supported by past gains in incomes, asset prices and accumulated savings during the pandemic. However, these sources of support are being eroded to some extent by high inflation, rising interest rates and falling housing prices, and this is expected to contribute to a slowing in consumption growth from early next year. Graph 8 GDP Growth Year-ended % Forecasts Actual Previous Current -5 -10 % -5 -10 Sources: ABS; RBA Demand for labour remains strong but employment growth has been modest recently, suggesting that limited spare capacity remains in the labour market. The unemployment rate is forecast to remain around 3½ per cent until mid-2023 before rising to 4¼ per cent by the end of 2024 as economic growth slows (Graph 9). Broader measures of labour underutilisation that include workers who are underemployed are also expected to remain around their lowest levels in many years in the near term. Graph 9 Unemployment Rate % Forecasts % Actual Current Previous Sources: ABS; RBA It is worth emphasising the positives that strong labour market conditions will continue to deliver for Australians. Even with the modest increase in unemployment that we have forecast to occur as the economy slows, the unemployment rate will still be close to its lowest level in decades. A higher share of Australians have a job than ever before. Female labour force participation is near its record high and there are opportunities for young Australians to gain employment. Reviewing the forecasts Before I talk about some of the uncertainties around the outlook, I want to take a few minutes to talk about how we review our forecasts. Forecasting is difficult at the best of times. It is unlikely that GDP growth, unemployment or inflation will exactly match point forecasts. As the past few years demonstrates, however, it is more often a question of how wrong the forecasts will be. This could be because unforeseen shocks hit the economy or households and businesses behave differently to what we expected. So although we only publish updated forecasts once a quarter, we in fact keep a close eye on how our forecasts are going throughout the quarter by closely analysing the incoming data and information from our own business liaison to see if the economy is evolving as expected. We also review past forecast errors. Each year, a review of the accuracy of the Bank’s economic forecasts is presented to the Board to assess what we have learned about the economy and our forecasting approach over the previous year. The annual review draws on a wide range of inputs such as new econometric models and forecast techniques, forecast accuracy for specific variables and alternative sources of information. The November Statement on Monetary Policy summarises some of the findings from this year’s forecast review, focusing in particular on our inflation forecasts. Forecasts from other sources are another way in which we review our thinking. Comparisons between Bank forecasts and those of other economic forecasters are regularly conducted. This process includes regular discussions with government agencies, reviews of available forecasts and quarterly surveys of private sector economists. These comparisons provide alternative interpretations of the outlook, challenge our own thinking and provide a benchmark to assess accuracy. For example, the average forecast for GDP growth among private R E S E R V E B A N K O F AU S T R A L I A sector economists is similar to the Bank’s outlook for 2023, but inflation is anticipated by many to decline a little faster than we expect (Graph 10). These forecast comparisons are complemented by panel discussions with academics and these economists where specific issues can be examined more closely. Graph 10 RBA and Market Economist Forecasts Year-ended % GDP growth (LHS) Unemployment rate Headline inflation % (LHS) (RHS) Market economist survey median RBA 2022 2023 2024 2022 2023 2024 2022 2023 2024 Sources: ABS; RBA The uncertainties A key part of the forecasting process is thinking about the risks and uncertainties around the central forecast and the ways things could turn out differently. Each quarter when we publish our forecasts, we discuss a range of uncertainties that explore how the economy might respond under conditions that vary from the central case. This helps us to identify events that could have a meaningful effect on the economy and policy. The uncertainties around the central forecasts are particularly elevated at the moment. In the Statement we highlight four: • The international environment • Wage and price setting behaviour • Household consumption • Energy and supply shocks. I talked a little about the international situation earlier. While forecasts for global growth have been revised down, risks are still to the downside. A significant concern from our perspective is the downside risks in China. The authorities’ approach to supressing COVID-19 increases the risk of major lockdowns periodically impacting production and consumption. Stress in the property market, one of the engines of Chinese growth in the past, also carries the possibility of a significant downturn in activity. Residential property sales have declined sharply over the past year, and housing starts have also fallen to be lower than they have been for over a decade. Property developers are in stress and many are finding it difficult to finance the construction of apartments they have committed to. The government is encouraging banks to lend and is providing some direct support but, at the same time, it has been encouraging developers to reduce their indebtedness. This weakness in the property sector has implications for steel demand and hence demand for our iron ore. The second area of substantial uncertainty is what the current high inflation and cost-of-living pressures might do to price and wage expectations in Australia. Every day in the news we hear about how price rises are hurting households. First it was rises in the prices of goods during the pandemic as supply chains couldn’t cope with the surge in demand. But increasingly price rises in non-discretionary goods are impacting household budgets. Petrol, then groceries, now rent and electricity. The floods have resulted in volatility in fresh food prices. Furthermore, high fuel and shipping costs are finding their way into prices as businesses pass on increases in their input costs. How households and businesses respond to these pressures is going to be critical for the Australian economy and the path of monetary policy. Households recognise that their real wages are declining. And with the labour market as tight as it is, it is quite possible that workers will demand and may get wage rises. Businesses might well be willing to pay higher wages if they think they can easily pass on the cost increase in higher prices. How this inflation psychology plays out is critical for the inflation outlook and for monetary policy. If this mindset were to take hold inflation will remain high. A third uncertainty is the behaviour of households as interest rates and inflation rise. Although household debt hasn’t risen much over the past decade relative to income, it is still high so rising interest rates could make servicing debt much harder. On the other hand, one of the legacies of the pandemic was a large build-up in household savings buffers. With fiscal support for incomes during the pandemic, low interest rates increased the cash flow of households with mortgages and at times limited opportunities to spend and savings increased markedly over the past couple of years. We estimate that households overall accumulated more than $250 billion in additional savings during the pandemic. Most of this saving has been among households at the upper end of the income distribution reflecting, in part, the constraints on consumption of discretionary services. So while households on lower incomes with lower buffers are likely to cut back on consumption, some households could draw down their savings to support consumption in the face of rising interest rates and cost-of-living pressures. Furthermore, the response of household consumption to falling housing prices is uncertain. We know that consumption typically weakens as asset prices, and particularly housing prices, decline but the magnitude is difficult to forecast. And despite recent falls, housing prices still remain substantially above their level prior to the pandemic. The final uncertainty is around energy and other supply shocks that could boost inflation and lower growth. The situation in Europe remains very uncertain. While gas prices have declined lately, they are expected to rise again, particularly if there is an unusually cold winter or Russia’s war on Ukraine escalates further. Higher global energy prices can help our export earnings, but they could also put upward pressure on electricity prices in Australia, adding to inflationary pressures. We have built a large increase in electricity prices into our central scenario but there is a risk we haven’t incorporated enough. On the other side of the coin, however, global supply chain pressures are easing quite quickly and that could turn out to be more of a dampening force than we are currently expecting. Conclusion The Australian economy has come out of the pandemic in a strong position but inflation is too high. It is increasingly broadly based and our central forecast is that it won’t peak until the end of the year. After that we expect rising interest rates and cost-of-living pressures to drive a moderation in consumption that brings demand more in line with supply. This should help to get inflation back down to our target over the next couple of years. But forecasting is inherently difficult, particularly when there are so many unusual forces bearing on the outlook. There are many uncertainties about the behaviour of households and businesses as well as the potential for unforeseen shocks. This is why it is important that we are continually reviewing the incoming data and testing the forecasts. Thank you for your interest and I look forward to answering your questions. R E S E R V E B A N K O F AU S T R A L I A | reserve bank of australia | 2,022 | 11 |
Address by Mr Philip Lowe, Governor of the Reserve Bank of Australia, at the Committee for Economic Development of Australia Annual Dinner, Melbourne, 22 November 2022. | Speech Price Stability, the Supply Side and Prosperity Philip Lowe[*] Governor CEDA Annual Dinner Address Melbourne – 22 November 2022 It is an honour to be able to continue the tradition of the RBA Governor addressing CEDA’s Annual Dinner. Thank you very much for the invitation. This is the first time in many years that your annual dinner is being held against the backdrop of high inflation. For most of the past decade the issue was that inflation was a bit too low, not too high. And for the couple of decades before that, inflation varied from year to year, but averaged 2½ per cent in Australia. An inflation rate of 7 or 8 per cent was something that was widely thought to be consigned to the history books. So the current bout of high inflation has come as quite a shock. I would like to begin this evening by emphasising the importance of ensuring that this episode of high inflation is only temporary. I will then discuss some reasons why inflation might be more variable over the years ahead and the implications of this for economic policy. Finally, I will say a few words about the Reserve Bank Board’s recent policy decisions. The scourge of inflation First, a bit more history. In the 1960s, the inflation rate varied between –1 and 5 per cent, averaging 2 per cent (Graph 1). Inflation then took off in the 1970s and reached a peak of nearly 18 per cent in 1975. It stayed high throughout the 1980s and it was not until the early 1990s that it returned to low single digits. Since then, under the inflation targeting regime, inflation has varied in a fairly narrow range up until this year. Graph 1 Consumer Price Inflation* Year-ended % % -5 -5 * Excludes interest charges prior to the September quarter of 1998; adjusted for the tax changes of 1999–2000. Sources: ABS; RBA The high inflation of the 1970s and 1980s damaged the Australian economy and hurt our living standards. It made it harder for businesses to plan and invest. And Australians had to devote their time and energy to protecting themselves as best they could against the ravages of inflation. The high inflation undermined our prosperity; it eroded people’s savings, distorted resource allocation and increased inequality in our society. This experience also put paid to the idea that by allowing more inflation, we could have more growth and jobs. Rather, the reverse was true. High inflation meant lower growth, fewer jobs and lower real wages. Another lesson from these decades is that bringing inflation back down again after it becomes ingrained in people’s expectations is very costly and almost certainly involves a recession. This next graph shows the inflation and unemployment rates during the disinflation episodes in Australia and the United States after the period of high inflation (Graph 2). In both cases, bringing inflation back down required high interest rates and was associated with a deep recession and a rise in the unemployment rate of at least 5 percentage points. The high unemployment then persisted for years and left deep scars in the labour market and damaged our communities. It was very costly. R E S E R V E B A N K O F AU S T R A L I A Graph 2 Disinflationary Episodes* % United States % Australia Inflation Unemployment * Shading indicates labour market downturns, from trough to peak in unemployment rate. Sources: ABS; RBA; Refinitiv This experience lies behind the determination of the world’s central banks to ensure that the current period of high inflation is only temporary. The evidence shows that economies work better with low inflation and that once inflation becomes entrenched, it is very costly to stamp it out. It is for these reasons that the Reserve Bank Board is resolute in its determination to return inflation to target and we will do what is necessary to achieve that. Our central forecast is that inflation will peak later this year at around 8 per cent, and then decline gradually over the next couple of years to be a little above 3 per cent by the end of 2024 (Graph 3). Graph 3 Headline Inflation* Year-ended % % 70 per cent interval 90 per cent interval -2 -2 * Confidence intervals reflect RBA forecast errors since 1993. Sources: ABS; RBA There are a number of factors that lie behind this expected decline in inflation. The first is that the COVID disruptions to supply are being resolved: delivery times and shipping costs have declined and the pressure on goods prices is abating. The second is that commodity prices have stabilised and, in many cases, have declined to be back around their levels at the beginning of the year; in time, the effect of this will be evident in consumer prices. And third, the increase in interest rates here and around the world will result in slower growth in aggregate demand. In time, this means less pressure on capacity and lower inflation. As always, there is uncertainty around this outlook. We can’t rule out further bad news abroad that throws us off this path. And domestically, we need to avoid a price-wage spiral. To date, while wages growth in parts of the private sector has picked up materially, aggregate wage outcomes in Australia have been consistent with a return of inflation to target. In contrast, a number of other advanced economies are experiencing much faster rates of wages growth. So this is an area we are watching carefully. The supply side matters I would now like to switch gear and discuss some longer term changes in the global economy that are likely to affect the dynamics of inflation, central bank policy and the way business operates in Australia. For the past three decades, most central banks have viewed the job of managing inflation largely through the prism of managing aggregate demand. If inflation was too low, it was because demand was too weak and this called for monetary stimulus. Conversely, if inflation was too high, it was because demand was too strong and this called for monetary tightening. We recognised that the supply side mattered, but supply was largely treated as something that evolved fairly slowly in the background. The task was to manage aggregate demand with interest rates. Central banks came to this general view partly because developments on the supply side were either mostly benign or favourable for managing inflation. Strong growth in international trade and deepening financial linkages between countries meant that the supply side of the global economy became very flexible. As a result, it was increasingly possible to alleviate capacity pressures at home by tapping global markets. In addition, rapid economic growth in China lowered the relative prices of manufactured goods and demographic trends around the world led to an increase in the supply of labour engaged in the global economy. Importantly, we also largely avoided the major wars that have been sources of inflation in the past. These developments on the supply side of the global economy made it easier for central banks to deliver low and stable inflation. Together with monetary policy frameworks that emphasised price stability, they helped deliver a world in which there was very little variation in inflation from year to year. Looking forward, the supply side looks more challenging than it has been for many years and it is likely to play a more prominent role in inflation outcomes. The very recent past has served as a powerful reminder of just how influential the supply side can be, with COVID disruptions and Russia’s invasion of Ukraine contributing to the highest inflation in decades. But beyond these recent shocks, there are a number of longer-term developments that are likely to create more variability in inflation than we have become used to.[1] I would like to draw your attention to four of these developments. The first is the reversal of globalisation. Over recent decades, international trade increased very significantly relative to the size of the global economy (Graph 4). Production became increasingly integrated across borders and this lowered costs and made supply very flexible. This growth in international trade helped lift average living standards around the world, and Australia was a major beneficiary of the expansion in international trade. R E S E R V E B A N K O F AU S T R A L I A Graph 4 World Trade* Per cent of GDP % % * Trade refers to the average of exports and imports. Sources: CEIC Data; Oxford Economics; RBA; World Bank Now, international trade is no longer growing faster than the global economy. Trading blocs are emerging and there is a step back from closer integration. Unfortunately, today barriers to trade and investment are more likely to be increased than removed. This will inevitably affect both growth in living standards and the pricing of goods and services in global markets. The second important supply-side factor is demographics. Up until recent years, the working-age population of the advanced economies was increasing steadily (Graph 5). The working-age population of China and Eastern Europe – both of which were being progressively integrated into the global economy – was also increasing. The participation of women in the labour force was also on the rise. The result was a substantial increase in the number of workers engaged in the global economy, and advances in technology made it easier to tap into this global labour force. Graph 5 Working-age Population* Age 15–64 m m China and Eastern Europe 1,200 1,200 1,000 1,000 Advanced economies * Dashed lines represent projections. Sources: RBA; United Nations This trend in working-age population has now turned. The working-age population is now declining and this decline is projected to accelerate. The impact of this is evident in the rising ratio of younger and older people in the population, particularly in the advanced economies (Graph 6). While the global population is still rising, it is mostly in countries that are not yet closely integrated into the global economy. Graph 6 Dependency Ratio* ratio ratio 0.6 0.6 Advanced economies 0.5 0.5 0.4 0.4 China and Eastern Europe 0.3 0.3 * The number of people aged younger than 15 years or older than 64 years relative to the number of people aged between 15 and 64 years inclusive; dashed lines represent projections. Sources: RBA; United Nations The third important supply-side issue is climate change. Globally, the frequency of extreme weather and climate events has increased over recent decades and it is likely that this trend will continue (Graph 7).[3] Over the past 20 years, the number of major floods has doubled and the frequency of extreme heatwaves and droughts has also increased significantly. Graph 7 Extreme Weather Events Globally no. 6,000 no. Flood Storm Extreme temperature Drought Wildfire 6,000 4,000 4,000 2,000 2,000 1940–59 1960–1979 1980–99 Sources: Emergency Events Database; RBA R E S E R V E B A N K O F AU S T R A L I A 2000–2019 These climate events disrupt production and they affect prices. We know this all too well in Australia, where recent floods are one of the factors pushing inflation up at present. But it is not just food production that is affected by extreme weather. It also disrupts the production of commodities and the transport and logistics industries. These disruptions affect prices in global markets and it is likely that we will see more of these disruptions in the years ahead. The fourth supply-side factor that I want to highlight is the energy transition in the global economy. There is very significant investment in renewable energy around the world as we transition to green energy. But, at the same time, the existing capital stock that is used to produce energy is depreciating quickly, through decommissioning or lower levels of sustaining investment. It is difficult to make predictions here, but it’s probable that the global capital stock that is used to produce energy will come under recurring pressure in the years ahead. If so, we could expect higher and more volatile energy prices during the transition to a more renewables-based energy supply. In this context, it is interesting to compare the investment response in Australia to the current boom in the terms of trade with that of a decade ago (Graph 8). In the earlier boom, higher commodity prices led to a surge in investment in the resources sector. This substantially added to Australia’s capital stock and thus our ability to supply resources to the market. In contrast, the investment response this time has been negligible and there are few signs that firms are planning to increase supply in response to the higher prices. The reasons for this are complex, but if supply does not respond to higher prices, we will likely have more supply constraints in the future. And supply constraints mean more variable prices. Graph 8 Terms of Trade and Resources Investment index index Terms of trade 2019/20 = 100 % % Resources investment* Share of nominal GDP * Financial year. Sources: ABS; RBA All four of these supply-side developments are first-order issues that are likely to affect the environment for Australian business over the years ahead. They are also likely to affect the inflation dynamic here and elsewhere, leading to more variability in inflation from year to year. This extra variability in inflation can come through two channels. The first is an increase in the prevalence of supply shocks. As has been evident over the past couple of years, supply shocks can generate large and rapid changes in prices. More supply shocks mean more variable inflation. The second channel is through the global supply curve being less elastic than it has been over the past decade or so. Less elastic supply means that a given change in demand generates a larger change in prices and thus more variability in inflation. If this assessment about the future operating environment is close to the mark, it has a number of implications for monetary policy and the design of the monetary policy framework. The first is that it is increasingly problematic to set a narrow range that inflation is always supposed to be within. There are limits to what can be achieved and we are likely to have to live with more variability in inflation. The second is that a strong nominal anchor is more important than ever. Without a strong nominal anchor, expectations of inflation will adjust when inflation is away from the target range, making it harder to return to target. We will get better outcomes if people are confident that when we get pushed away from the target, we will return to target. The design of the monetary policy framework can help here. In my view, it is best if the nominal anchor has a medium-term focus, not a short-term one. In this respect, the longstanding formulation of the Australian inflation target with its focus ‘on average over time’ is appropriate. So too is the flexibility in having the medium-term target specified as a range – in our case 2 to 3 per cent – although this is an issue that is worthy of examination as part of the current review of the RBA. A third implication of more variable inflation is that the monetary policy environment is likely to be more challenging for central banks. In a world in which central banks are managing fluctuations in aggregate demand with a relatively flat supply curve, the monetary response to demand shocks is relatively straightforward. Life is more complicated in a world of supply shocks; an adverse supply shock increases inflation and reduces output and employment. Higher inflation calls for higher interest rates but lower output, and fewer jobs call for lower interest rates. It is likely that we will have to deal with this tension more frequently in the future. None of the developments that I have spoken about undermine our ability to achieve the inflation target on average, but they are likely to complicate the task. They also have implications for other areas of economic policy. As a country, we need to do what we can to make sure that the supply side of our own economy is flexible. In a world of more frequent supply shocks, we will be better off if there is flexibility in our labour and product markets so that we can respond quickly and effectively. This includes flexibility in terms of fiscal policy, which requires maintaining a strong underlying structural budget position. The productivity agenda is also important here. By becoming more productive we can lift our own ability to supply goods and services to the market. We have work to do here as a nation. Over recent times, labour productivity growth has averaged a bit less than 1 per cent a year, which is slower than in previous decades (Graph 9). While, we can’t affect the international environment, we can affect our own ability to produce goods and services efficiently. Doing what we can here is an important element in securing our own prosperity, and there has been no shortage of ideas in this regard. R E S E R V E B A N K O F AU S T R A L I A Graph 9 Labour Productivity* March 1993 = 100, log scale index 1993–2002 2003–2014 2015–2022 0.9% 1.2% index 2.4% * Blue line denotes quarterly GDP per hour worked; black lines denote linear trend; labels show average annual growth. Sources: ABS; RBA Monetary policy I would now like to turn back to here and now and the Reserve Bank Board’s recent deliberations. At our meeting in early November we conducted a review of our experience with forward guidance about the cash rate during the pandemic and considered our approach going forward. That review was published last week and is available on our website. Our policy package during the pandemic included being more specific than we had in the past about our expec tations for the future path of the cash rate. As part of this we set out the conditions that needed to be met before the Board would increase interest rates. We also took the additional step of indicating the timing when we expected these conditions to be met. We adopted this approach to reinforce our commitment to doing all that we could to support the economy in what were extraordinarily difficult times. We wanted to provide insurance to the country against the worst possible outcome. Fortunately, we avoided the worst possible outcome and, in hindsight, the full insurance package was not needed. But we also had difficulties with our communication. The message about the expected timing of the first increase in interest rates dominated the message about the conditions under which rates would be increased. Indeed, our statements were widely reported as a commitment that the Board would not raise rates until 2024. This meant that when we did lift interest rates in May this year, many people saw us as going back on this commitment and this has hurt our reputation. We are committed to learning from this experience. Following the first increase in the cash rate, the Board has returned to the approach to forward guidance that it used prior to the pandemic. That approach is qualitative in nature with any forward guidance focused on the short term. We value the flexibility in that approach and, in future, will avoid communication that focuses on the calendar or is too specific. We are, though, strongly committed to providing the information that allows people to make their own judgements about future movements in interest rates. This information includes our economic forecasts, the issues and uncertainties that the Board is focusing on and how the Board is using the policy framework to make its decisions. We hope this transparency is helpful for people in understanding how monetary policy is set. As you would be aware, the Board has increased the cash rate significantly since May, with the cash rate currently standing at 2.85 per cent (Graph 10). We needed to remove the pandemic emergency settings and respond to the high rate of inflation. We had previously taken out an insurance policy and it was no longer needed. Graph 10 Australian Cash Rate Target % % Source: RBA We understand that many people are finding the rise in interest rates difficult. It is necessary, though, to ensure that the current period of higher inflation is only temporary. As I spoke about earlier, if high inflation were to persist, all Australians would pay a heavy price. Given our mandate for price stability and full employment, the Board expects to increase interest rates further over the period ahead. We are not on a pre-set path though. We have not ruled out returning to 50 basis point increases if that is necessary. Nor have we ruled out keeping rates unchanged for a time as we assess the state of the economy and the outlook for inflation. The Board’s priority is to return inflation to target over time. It is resolute in its determination to make sure that this current period of high inflation is only temporary. As we take our decisions over coming meetings, we will be paying close attention to developments in the global economy, the evolution of household spending and wage and price setting behaviour. Developments in each of these three areas will affect the pace at which inflation returns to target and whether the economy can remain on an even keel over the next couple of years. So we will be watching these issues carefully over the months ahead. Thank you for listening. I am happy to answer your questions. Endnotes [*] I would like to thank David Jacobs for assistance in the preparation of this talk. See Carstens A (2022), ‘A story of tailwinds and headwinds: aggregate supply and macroeconomic stabilisation’, speech at the Jackson Hole Economic Symposium, Wyoming, 26 August. See Goodhart C and M Pradhan (2020), The Great Demographic Reversal: Ageing Societies, Waning Inequality, and an Inflation Revival, Palgrave Macmillan, [London]. See IPCC (2021), ‘Summary for Policymakers’ in Climate Change 2021: The Physical Science Basis. Contribution of Working Group I to the Sixth Assessment Report of the Intergovernmental Panel on Climate Change, Cambridge University Press, Cambridge, United Kingdom and New York, NY, pp. 3−32. Available at <https://www.ipcc.ch/report/ar6/wg1/downloads/report/ IPCC_AR6_WGI_SPM.pdf>. R E S E R V E B A N K O F AU S T R A L I A Of note is the Productivity Commission’s five-yearly review of Australia’s productivity performance, which has received public submissions, provided interim reports and will provide a final report to the government in February 2023. See Productivity Inquiry – Productivity Commission. Available at <https://www.pc.gov.au/inquiries/current/productivity#report>. RBA (2022), ‘Review of the RBA’s Approach to Forward Guidance’, 18 November. | reserve bank of australia | 2,022 | 11 |
Speech by Mr Philip Lowe, Governor of the Reserve Bank of Australia, at the Austrailian Payments Network Summit 2022, Sydney, 14 December 2022. | Speech An Efficient, Competitive and Safe Payments System Philip Lowe[*] Governor Keynote Address at Australian Payments Network Summit 2022 Sydney – 14 December 2022 Thank you for the invitation to speak at AusPayNet’s annual Summit. It is a privilege to be with you again. The world of payments is changing rapidly. It is a world of innovation, of changing business models and of investment that is reshaping our financial system. So it is an exciting time in the world of payments. The Reserve Bank has a broad mandate to help shape this changing world so that it works in the best interests of Australian households and businesses. We do this through a combination of suasion, regulation and working with industry participants to help overcome the coordination issues that can bedevil payment systems. We also directly support innovation where we reasonably can and we are working with the government to make sure that the regulatory architecture is fit for purpose. Australians expect payments to be fast, low cost, reliable and easy to use. At the RBA, we share these expec tations. We want to see an Australian payments system that is competitive, safe to use, and dynamic and innovative. This morning I would like to highlight some of the issues we are working on in support of these objectives. These include our efforts to: 1. lower the costs that merchants pay for payment services 2. support the development of Australia’s fast payments system 3. lower the cost and increase the speed of international payments 4. support innovation that will help Australia be well placed for the digital future. Lowering payment costs for merchants through competition First, to merchant payment costs. This has been an area of focus for us for many years and progress has been made in reducing merchant costs. This first graph shows the average fees that merchants pay for the various types of card payments (Graph 1). In the mid-2000s, merchants paid an average of 1.4 per cent on Mastercard and Visa transactions. Today, they pay 0.7 per cent. The cost of accepting most other payment cards has also declined. Graph 1 Total Merchant Fees* Per cent of transaction values acquired % % 2.5 2.5 American Express 2.0 2.0 1.5 1.5 Mastercard and Visa 1.0 Mastercard and Visa credit** Mastercard and Visa debit** 0.5 1.0 0.5 eftpos 0.0 * ** 0.0 Break in September 2020 due to change in reporting forms. Prior to changes in reporting methodology in June 2018, the average fee reported for Visa and Mastercard debit cards was slightly overstated and the average fee reported for Visa and Mastercard credit cards was slightly understated; the overall average fee for Visa and Mastercard was unaffected by the reporting change. Source: RBA The big reduction in fees followed the Bank stepping in to regulate interchange fees and giving merchants the choice as to whether they recover their payment costs through surcharging. While surcharging is not popular with consumers, it has resulted in pressure on card schemes to lower fees and this has resulted in lower payment costs. Another important influence on merchant payment costs is the mix of payments they accept. There are large differences in the cost of different cards, so the mix can matter a lot. Over the past decade, there has been a shift away from high-cost credit cards to lower-cost debit cards, which has tended to lower merchant costs (Graph 2). The RBA’s interchange regulation played a role here too, by increasing the relative attractiveness of debit cards due to smaller ‘rewards’ being offered on credit cards following the reduction in interchange fees. R E S E R V E B A N K O F AU S T R A L I A Graph 2 Merchant Fees and Card Transactions % Average merchant fee* Debit card share of total card transactions** 1.2 % Credit cards 0.9 All cards 0.6 Debit cards 0.3 0.0 * Prior to changes in reporting methodology in June 2018, the average fee reported for scheme debit cards was slightly overstated and the average fee reported for scheme credit cards was slightly understated; the overall average fee was unaffected by the 2018 reporting change. There was also a change in the calculation of the average merchant fees for debit and credit cards in September 2020. ** By value; seasonally adjusted. Source: RBA The other big shift in the mix of payments is the declining use of cash. This shift away from cash accelerated during the pandemic and is evident in the sharp drop in the value of withdrawals from ATMs (Graph 3). The value of cash withdrawals is down by 17 per cent from where it was three years ago, while over the same period, the value of nominal spending in the economy has risen by 27 per cent. Despite this decline in the use of cash for day-to-day transactions, there is still strong demand for banknotes as a store of wealth, with 38 $50 banknotes and 18 $100 banknotes on issue for every Australian (Graph 4). Graph 3 Value of Cash Withdrawals Monthly, seasonally adjusted* $b $b ATM (LHS) 2.4 1.8 1.2 Debit card cash outs (RHS) 0.6 * Series break between February 2018 and May 2018 due to changes in collection and reporting methodology. Source: RBA Graph 4 Banknotes in Circulation Per Capita* no. no. $5 $10 $20 $50 $100 * Calculated using March 2022 population figures and banknotes in circulation as at end-November 2022. Sources: ABS; RBA While it is pleasing to see merchant payment costs trend lower, three developments are working in the other direction. The first is the shift to higher-cost international scheme debit cards and away from eftpos; on average, the international debit schemes cost merchants over 20 basis points more to accept than eftpos. The second is the shift to online commerce, where merchants typically face higher payment costs. And the third is the greater use of mobile wallets offered by Apple Pay, Google Pay and Samsung Pay. Use of these wallets is growing very quickly and they are often more expensive for merchants to accept (Graph 5). Graph 5 Mobile Wallet Transactions Share of card transactions % % Total Debit Credit M J S D M J S D M J Source: RBA I would also like to highlight the fact that there are large differences in the payments costs incurred by small and large businesses (Graph 6). Small businesses, on average, pay twice what large businesses pay to process the same transaction. While economies of scale explain some of this difference, they are not the full story. R E S E R V E B A N K O F AU S T R A L I A Graph 6 Cost of Acceptance by Merchant Size* Per cent of value of card transactions, 2020/21 % % 1.5 1.5 1.0 1.0 0.5 0.5 0.0 <$100k $100k– $1m $1m– $10m >$10m 0.0 Merchant size * Weighted average. Merchant size based on annual value of eftpos, Mastercard and Visa transactions. Source: RBA Given these various developments, the RBA’s focus is on increasing competition to help further drive down payment costs. This is where giving merchants choice over which payment network is used – so called least-cost routing (LCR) – is particularly important and it is a priority of the Payments System Board. LCR allows merchants to choose the lowest-cost card network to process their debit transactions. It also increases the competitive pressure between the debit networks, providing greater incentives to lower the wholesale fees that are ultimately paid by merchants. This is especially important for small businesses that typically can’t negotiate discounted fees with the card schemes. For in-store transactions, least-cost routing is now available to 85 per cent of merchants, although only half of all merchants are actually using it. This low take-up suggests that the industry has more work to do in promoting the benefits to merchants. Some financial institutions also have more work to do to complete their rollout and have not met the expected timetable. To provide greater transparency on how individual institutions are progressing, the RBA will, next year, start publishing institution-level data on LCR availability and take-up. In terms of online payments, the Payments System Board expects least-cost routing to be available by the end of this year. Overall, the industry is largely on track to meet this deadline. While there are some payment service providers that are running behind, most of these will have least-cost routing for online transactions up and running in the first half of 2023. As for in-person transactions, the RBA will give public visibility to how individual institutions are performing. The next frontier for LCR is in-store mobile wallet transactions. Over recent months, the RBA has been consulting with the major mobile wallet providers, issuers, acquirers and terminal providers. On the basis of this consultation, the Payments System Board has formed the view that it would be both feasible and desirable for the industry to deliver LCR functionality for mobile wallet transactions by the end of 2024. The next step is for the mobile wallet providers to finalise their plans and share these plans with the industry so that the necessary investments across the payments ecosystem can get under way. Overall, we are optimistic that least-cost routing will help counter the forces that are adding to merchants’ payment costs, particularly for small businesses. Looking ahead, other regulatory and market developments are expected to help increase competition and maintain the downward pressure on payment costs. Modernisation of the Payment Systems (Regulation) Act 1998 (PSRA), as proposed by the Farrell Review, would open up the possibility of regulating newer entities in the payments ecosystem. Greater transparency of merchant payment costs through an expansion of the Consumer Data Right could also help drive increased competition between acquirers. And new payment methods could emerge over time to compete with card payments, including through the use of QR codes for account-to-account payments at retailers. Enhancing Australia’s fast payments system The second broad issue I want to talk about is the need to continue to build on the architecture of Australia’s fast payments system, the NPP. The NPP is now available to the customers of more than 110 financial institutions, and is used to make around a quarter of all account-to-account payments. Over the past year, the NPP processed over a billion transactions, worth more than $1 trillion, and usage continues to grow. Overall, take-up of fast payments by Australians compares favourably with similar systems in other advanced economies (Graph 7). Graph 7 Use of Fast Payments Systems Transactions per capita, annualised no. no. MobilePay NPP (Australia) (Denmark) Swish (Sweden) FPS (Hong Kong) FAST (Singapore) FPS (UK) 5 6 7 8 9 10 11 12 13 Years after launch Sources: FPSL; Getswish; HKICL; MAS; MobilePay; National statistics agencies; NPPA The use of PayIDs has also grown. PayIDs are a simple way of addressing payments, for example to a registered mobile number, email address or business number. Almost 13 million PayIDs have been registered, with PayIDs used to initiate around a fifth of NPP payments. Apart from being convenient, PayIDs provide a safer way to make payments from one account to another. When a payment is addressed to a PayID, the payer is shown the name of the person or business they are paying before they confirm the payment. This can help to reduce the chance of mistakenly paying the wrong person. It can also help the payer avoid being deceived into sending a payment to the account of a scammer rather than of the intended recipient. A recent survey commissioned by NPP Australia shows that one in four PayID users have stopped or edited a PayID payment where they noticed that the recipient’s details were wrong. Even so, we are not yet realising the full benefits of this feature of the system and financial institutions have more work to do to promote awareness and adoption of this functionality among their customers. R E S E R V E B A N K O F AU S T R A L I A More generally, the NPP has been constrained to date by the fact that it catered for push payments only – that is, payments that are initiated by the customer, such as when we send payments to one another. PayTo, which launched in June this year, is set to change this. PayTo will modernise the way we make direct debits, giving customers greater control over payments authorised to come out of their accounts. It is also expected to support a wave of innovation, including from fintechs. It could, for example, streamline business billing and account management processes, and be used as an alternative to cards for payments to merchants. Only one of the major banks has met the previously agreed timeline for the development of the PayTo Payer system. The reasons for this are complex, but slow progress by the major banks imposes a cost on the rest of the industry. Investments have to be put on hold as successful uptake of the system requires a critical mass to be operational. The new agreed timeline to complete the necessary work is April 2023. The RBA expects this timeline to be met. Cheaper and faster cross-border payments The third broad issue is addressing the cost and speed of cross-border payments. The G20 countries have committed to making cross-border payments cheaper, faster, more transparent and more accessible. Australia needs to play its role here. The cost of international payments is too high. This is a particular problem for our neighbours in the South Pacific, where too often people on low incomes face very high charges for sending money back home. Progress is being made in this area, but it is slow. In part, this progress is coming about because of increased competition, with a number of cheaper digital non-bank money transfer operators entering the market and pushing costs down. There has also been an improvement in transparency through improved online calculators that show the total cost, including all fees and FX mark ups, following the ACCC’s guidance published a few years ago. In addition, some of Australia’s largest banks are now waiving fees on some transactions in the South Pacific corridors. There is a lot more to be done here, and we need the assistance of Australia’s financial institutions to make further improvements. One current issue is the speed of cross-border payments. According to data from SWIFT, more than 80 per cent of the time taken for a cross-border payment to reach an Australian recipient is due to the final Australian dollar leg.[1] A number of other comparable countries process incoming payments more quickly, including some in similar time zones. We need to do better here. The delivery of the NPP International Payments Business Service will help us make progress. This service will allow the final Australian dollar leg of inbound cross-border payments to be processed through the NPP. Because the NPP offers real-time processing of transactions on a 24/7 basis, this will speed up payment times. The industry committed to providing this new service by 1 December 2023 in the NPP Roadmap released last month.[2] We expect this deadline to be met by all the banks participating in the NPP. Delays will hurt Australian customers and hold back Australia’s progress in meeting its G20 commitments. A related development is the adoption of the ISO20022 messaging format, which will replace the legacy SWIFT message format. In time, use of this richer, internationally harmonised messaging system should lower costs and speed up payment times. It is also possible that over time, various countries’ fast payment systems will be linked up. Last year, Singapore and Thailand became the first countries to do this and it has reduced costs to consumers.[3] A number of similar projects are being explored elsewhere in the world. As part of this exploration, the BIS Innovation Hub has been developing a bridging platform for the connection of numerous fast payment systems through the standardisation of business and technical payment processes. We are engaged in this work and I sit on the Advisory Board for the BIS Innovation Hub. Whether or not this is the best solution is still to be determined, but the direction of change is clear. Next year, the RBA is planning to work with the Australian industry to study the economic, business and technical issues involved with linking up our fast payments system with those elsewhere in the world. Supporting innovation The final issue is supporting the innovation that will ensure Australia is well placed for the digital future. Some of the issues that I have already discussed will help here, but I would like to mention two others: the RBA’s work exploring a central bank digital currency (CBDC) and the work under way to modernise Australia’s regulatory architecture. Central bank digital currency My colleague, Brad Jones, spoke last week about some of the issues we are working through regarding the possibility of a CBDC for retail purposes.[4] We have an open mind as to whether a public policy case will emerge to go in this direction. However, as things stand today, that case has not yet been established. We are, though, exploring the possibilities in case this assessment changes. As part of this effort, we have embarked on a project with the Digital Finance Cooperative Research Centre involving the issuance of a pilot CBDC that has real value, circulating in a ring-fenced environment. We have invited industry participants to propose use cases to test in this environment, the idea being that this could help us understand new business models and payment solutions that a CBDC could support. We are also looking at potential use cases for a wholesale central bank digital currency, which could supplement the existing Exchange Settlement accounts we offer. Interest in participating in the project has been very strong, with over 140 submissions of use cases. Testing will commence soon and we look forward to publishing the results next year. We are also looking at the pros and cons of an alternative form of a digital Australian dollar – a payments stablecoin that is issued by the private sector, just as banks issue deposits. If we were to go in this direction, the payment stablecoins would need to be backed by a strong regulatory regime, just as applies to deposits. Modernising the regulatory regime The RBA is also working with the government to make sure that the regulatory regime is fit for purpose. The Bank welcomes the release of the consultation paper on the strategic plan for the payments system. This plan helps to provide guidance for industry and regulators on the government’s key priorities for the payments system and we look forward to working with interested parties. From our perspective, one reform priority is the establishment of a new licencing regime for payment service providers (PSPs). This could help overcome some of the challenges faced by PSPs seeking to enter the Australian market. The Bank is also working on a set of common requirements for PSPs seeking to access payment systems, as part of the new licensing regime. The aim is to create a more level playing field for non-ADI payment service providers in a way that balances the needs of the payment system operators and PSPs. The Bank is also developing a new regulatory regime for industry bodies that set technical standards for the payments industry. A second priority is the development of regulatory arrangements for payment stablecoins. As I mentioned a moment ago, we can envisage a possible future in which stablecoins are used for payments, as long as they are well designed and well regulated. In many ways, the regulatory issues are similar to some stored value facilities, such as pre-paid travel cards and digital wallet services. R E S E R V E B A N K O F AU S T R A L I A A third priority is the modernisation of the Payment Systems (Regulation) Act 1998. A lot has changed in the payments system since the PSRA was introduced over 20 years ago. The payments ecosystem is now much more complex, there are many new business models and new technologies are continuing to emerge. The changes proposed by the Farrell Review would allow the Payments System Board to help shape that complex world in the public interest more effectively. Conclusion As I said at the start, the payments world is changing rapidly, and we all have a lot to do. Some of the items on the to-do list are for immediate attention and it is important that financial institutions meet the deadlines they committed to. Some of the other items on the to-do list are not as well defined, but they have the potential to reshape how the financial system works and deliver better services to people. AusPayNet is a valuable partner as we undertake this journey and plays an important role in the governance of the Australian payments industry. I look forward to continuing the cooperation between AusPayNet and the Reserve Bank as we navigate this fast-changing world in the interests of the Australian public. Thank you for listening and I am happy to answer some questions. Endnotes [*] I would like to thank Ellis Connolly, Chay Fisher, Troy Gill, Elizabeth Kandelas, Chris Thompson and Grant Turner for assistance in the preparation of this talk. Nilsson T, R Bouther, M Van Acoleyen and L Cohen (2022), ‘SWIFT gpi data indicate drivers of fast cross-border transfers’, Bank for International Settlements Committee on Payments and Markets Infrastructures Paper, February. Available at: <https://www.bis.org/cpmi/publ/swift_gpi.htm> NPP Australia, (2022), ‘NPP Roadmap’, October 2022. Available at: <https://nppa.com.au/wp-content/uploads/2022/11/NPPOctober-2022-Roadmap.pdf> Baker McKenzie (2022), ‘PayNow-PromptPay / PromptPay-PayNow Linkage White Paper’, Available at: <https://abs.org.sg/docs/ library/PayNow-PromptPay_Linkage_White_Paper.pdf> Jones B (2022), ‘The Economics of a Central Bank Digital Currency in Australia’, Speech at 17th Central Bank Conference on the Microstructure of Financial Markets, Sydney, 8 December. | reserve bank of australia | 2,022 | 12 |
Opening statement by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Canberra, 17 February 2023. | Philip Lowe: Opening statement - House of Representatives Standing Committee on Economics Opening statement by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Canberra, 17 February 2023. *** Good morning chair and members of the Committee. Thank you for holding this hearing. Last week, the Reserve Bank Board increased interest rates by a further 25 basis points. This brings the cumulative increase in interest rates since May last year to 3¼ percentage points, with the cash rate target currently standing at 3.35 per cent. I would like to begin today by discussing why the increase in interest rates has been necessary and the outlook for the next couple of years. High inflation and interest rates At its core, the rise in interest rates has been required to make sure that the current period of high inflation is only temporary. This is our job as Australia's central bank. In the December quarter, the inflation rate reached 7.8 per cent. This is the highest rate since 1990. The inflationary pressures were broadly based, with the prices of almost three-quarters of the items in the CPI basket increasing by more than 4 per cent last year. In underlying terms, the inflation rate reached 6.9 per cent in the December quarter. Again, this is the highest rate in a number of decades and it is higher than we were expecting just a few months ago. High inflation is damaging and corrosive. It hurts people, puts pressure on household budgets and erodes the value of people's savings. It increases inequality and hurts people on low incomes the most. High inflation also damages longer-term economic performance, making the environment uncertain for planning and investing. And if inflation does become ingrained in people's expectations, bringing it back down again is very costly. History teaches us that once inflation becomes ingrained the end result is even higher interest rates and even greater unemployment to bring inflation back down. It would be dangerous, indeed, not to contain and reverse this period of high inflation. This episode of high inflation has its origins mainly in developments on the supply side but, over time, demand-side factors have become more prominent. It emerged in the wake of the COVID supply chain disruptions and Russia's invasion of Ukraine, and also strong domestic demand due to the bounce-back from COVID and the large policy stimulus during the pandemic. 1/5 BIS - Central bankers' speeches Most advanced economies are in a similar position to Australia, and have responded with higher interest rates, in some cases to a level substantially higher than that in Australia. In broad terms, the RBA and many other central banks are managing two risks. One is the risk of not doing enough, which would result in high inflation persisting and then later proving very costly to get down. The other is the risk that we move too fast, or too far, and that the economy slows by more than is necessary to bring inflation down in a timely way. The path here is a narrow one. It is still possible for us here in Australia to navigate this path, especially if inflation and wage expectations remain contained and issues on the supply side continue to be resolved. But it is also possible that we are knocked off that narrow path. Not surprisingly, given the uncertainties, there are a range of views in the community about where the main danger lies. Some are more concerned about the prospect of a sharp rise in unemployment in the near term, while others are more concerned about the prospect of inflation staying too high, which would in time entail even higher interest rates and a sharper rise in unemployment. As the central bank, we have a critical mandate to preserve medium-term price stability and we are committed to that objective. If we don't get on top of inflation and bring it down in a timely way, the end result will be even higher interest rates and more unemployment in the future. The instrument that we have to achieve this is interest rates which, I acknowledge, can be a blunt instrument. We are very conscious that the impact is being felt very unevenly across the community. Around one-third of households have a home loan, and many are finding managing the higher interest rates very difficult. This is only one channel through which monetary policy works, though. Changes in interest rates also affect asset prices, including housing prices and the exchange rate, and they alter the incentive for all households to save and spend. They also affect expectations of the future, which can affect spending plans and price- and wage-setting behaviour. These various transmission channels take time to work and their effects are not felt evenly across the community. As difficult as this unevenness is, our job as Australia's central bank is to deliver low inflation for all Australians and to do so in a way that best contributes to the collective economic welfare of the Australian people. The central forecasts and some uncertainties I would now like to turn to the Bank's updated central forecasts, which were released last week in our quarterly Statement on Monetary Policy. Those central forecasts have the Australian economy staying on that narrow path that I spoke about. They have: inflation returning to target over the next couple of years; the economy continuing to grow, albeit at a fairly slow rate; and unemployment rising, but remaining below the prepandemic low. 2/5 BIS - Central bankers' speeches Our assessment is that inflation is likely to have peaked around the end of 2022 and will now start declining. The central forecast is for CPI inflation to decline to 4¾ per cent over 2023 and to around 3 per cent by mid-2025. We have not yet seen evidence of a moderation of goods price inflation in Australia, but we have seen it elsewhere around the world and we expect the same to take place here. Supply chain problems are being resolved, shipping costs are normalising and oil prices are off their peaks. These lower prices, or lower rates of inflation in global markets, should flow through into prices in Australia. While this will help inflation return to target, it is unlikely to be enough without also observing some ongoing moderation in demand. In terms of economic growth, our central forecast is for GDP growth to slow to around 1½ per cent this year and next. The bounce-back in spending following the pandemic has largely run its course. More broadly, the combination of higher interest rates, costof-living pressures and the decline in housing prices is expected to weigh on household spending. A contraction in residential construction is also expected following the pandemic-related boom. In contrast, the outlook for business investment remains reasonably positive, with many firms operating at a high level of capacity utilisation. The labour market remains tight, with the unemployment rate near a 50-year low. The share of working-age Australians with a job has never been higher than it has been recently, youth unemployment has declined and underemployment is the lowest it has been for decades. These are good outcomes for our country. Job vacancies remain at a very high level, although some firms report that it has been less difficult to find workers recently than it was a few months back. The central forecast is that the unemployment rate gradually increases from here due to slower growth to reach 4½ per cent by mid-2025. This rate of unemployment is below that prevailing in the years prior to the pandemic. If we can achieve an outcome that is something like this, the country will have managed a sustained reduction in unemployment. This would be something that we could all welcome. I would like to highlight a few of the many sources of uncertainty around these central forecasts. The first is the global economy, which is in a challenging position. The synchronised tightening of monetary policy, high energy prices and cost-of-living pressures mean that global growth is expected to be quite weak over the next couple years. It remains to be seen what effect the cumulative and substantial tightening of monetary policy has on overall spending; there are risks that central banks have done too much but there are also risks that they have not done enough. There is also the possibility of new shocks, including from geopolitical or climate events. More positively, the change in China's COVID policy and a shift to more growth-oriented policies by the Chinese authorities are positive developments for the near term. Lower energy prices in Europe have also reduced some of the downside risk to the global economy, but there are still substantial risks here. A second source of uncertainty is the outlook for household spending in Australia. 3/5 BIS - Central bankers' speeches People are finding jobs and having more success in obtaining the hours they want to work. This is supporting growth in nominal household income. Furthermore, since the onset of the pandemic, households have saved an additional $300 billion over and above what they normally would do. This very substantial stock of extra savings is equivalent to around 20 per cent of annual household disposable income. Moreover, the national accounts suggest that, at least in the September quarter, households were still saving at a slightly higher rate than before the pandemic. In contrast, the finances of many households are under very real pressure from high inflation – including for rents – rising interest rates and falling housing prices. This is a challenging environment for many people. We recognise that the full effect of higher interest rates is yet to be felt, with some borrowers still benefiting from low-interest fixedrate loans. In total, there are 880,000 loan facilities with fixed rates maturing this year, with an outstanding value of around $350 billion. These borrowers will face very significant increases in loan repayments. It remains to be seen how these various influences on household spending balance out. There are plausible scenarios in both directions. The pool of extra household savings is not evenly spread across the population, being concentrated in households with higher incomes. It is not clear whether households will want to spend these savings in coming months or whether they see them as long-term wealth to be spent gradually over a long period of time. It is also possible that the resilience evident in consumer spending on services is because this was the first holiday period for three years that COVID restrictions were not in place. If what we have seen is extra spending as people enjoyed their usual freedoms, a period of belt tightening could follow. But it is also possible that the extra savings and jobs are giving part of the population sufficient confidence to keep spending, just at the same time that others are finding things very difficult. So, it is a complicated picture at present. The third uncertainty that I want to highlight is around price and wage expectations. If people expect high inflation to continue, then it is likely to continue, with the higher inflation expectations reflected in wage settlements and firms' pricing decisions. So, it is important that people expect that the high inflation is only temporary. Currently, inflation expectations remain well anchored and aggregate wage outcomes are not inconsistent with inflation returning to target over time. If either of those things were to change, we would face a much more difficult environment. Now, returning to the outlook for interest rates. Based on the currently available information, the Board expects that further increases will be needed over the months ahead to ensure that inflation returns to target and that this period of high inflation is only temporary. How much further interest rates need to increase will depend on developments in the global economy, how household spending evolves and the outlook for inflation and the labour market. 4/5 BIS - Central bankers' speeches The Board is conscious that there are risks in both directions. It meets every month, which gives it frequent opportunities to evaluate how these various risks are evolving and to respond flexibly as appropriate. We will do what is necessary to make sure that inflation returns to the target range. $5 banknote On a completely different matter, earlier this month, we announced that the Reserve Bank Board had decided to update the Australian $5 banknote to feature a new design that honours the history and culture of the First Australians. This new design will replace the portrait of the late Queen Elizabeth II. The other side of the note will continue to feature the Australian Parliament building and its forecourt. Given the national significance of the issue, the Board decided to consult the Australian Government before it made a decision. In response, the government indicated its support for a design that honoured the First Australians. The new note will continue the RBA's proud tradition of having First Australians' imagery on Australia's banknotes. Some of you might recall the $1 dollar paper banknote issued in 1966 and the first $10 polymer banknote issued in 1988, both of which featured the art and culture of First Nations peoples. Australia's coins, which are produced by the Royal Australian Mint, will continue to have the image of the monarch on one side. The RBA is now embarking on a process of consultation with First Australians on the new design. We anticipate it will be at least a couple of years before the new banknote is ready for circulation. The current $5 banknote will continue to be issued until then and it will still be able to be used once the new banknote enters circulation. Thank you for your attention. Next time we meet, the review into the Reserve Bank will have been completed and we look forward to discussing the results and recommendations with you. Today, my colleagues and I are here to answer your questions. 5/5 BIS - Central bankers' speeches | reserve bank of australia | 2,023 | 2 |
Keynote address by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to the Financial Review Business Summit 2023, Sydney, 8 March 2023. | Speech Inflation and Recent Economic Data Philip Lowe [ * ] Governor Keynote Address to the Financial Review Business Summit 2023 Sydney – 8 March 2023 Thank you very much for the invitation to join this year’s AFR Business Summit. It is a pleasure to be able to join you again. The number one near-term economic challenge facing Australia is to make sure that the current episode of high inflation is only temporary. High inflation is corrosive and damaging. If it were to persist, it would require even higher interest rates and more unemployment to bring it back down. So, it would be dangerous indeed to allow the current period of high inflation to continue. The RBA’s job, as Australia’s central bank, is to deliver low and stable inflation. The Board is resolute in its determination to do this by making sure that inflation in Australia returns to the 2–3 per cent target range. Some legacies of the pandemic The high inflation that we are currently experiencing is one of the legacies of the pandemic and of Russia’s invasion of Ukraine. The pandemic interrupted the supply side of the global economy and this pushed up costs and prices. And on top of this, the monetary and fiscal policy response to the pandemic underpinned a strong recovery in demand that has also pushed up costs and prices. Before I discuss inflation and the monetary policy response in more detail, I would like to highlight another remarkable, but less remarked upon, legacy of the pandemic – that is, the significant improvement in Australia’s labour market. This is a positive legacy and it is in the national interest to preserve as much of this as we can. Over recent months, the unemployment rate has been around 3½ per cent (Graph 1). The last time the unemployment rate was this low was in 1974 – that’s nearly 50 years ago. Over recent times, Australians have not only found it easier to get a job, but have also found it easier to obtain more hours of work. As a result, measures of underemployment are around multi-decade lows. Graph 1 Unemployment and Underemployment Per cent of labour force % % Unemployment rate* Underemployment rate * Quarterly data from 1959 to 1964 are spliced from historical national accounts data. Sources: ABS; RBA These outcomes have coincided with a record number of Australians joining the labour force. The participation rate has increased and the share of working-age Australians with a job has never been higher than it has been recently. The youth labour force participation rate is the highest it has been in a long time and the youth unemployment rate is the lowest that it has been in many decades (Graph 2). Female labour force participation has also been at a record high. Graph 2 Youth Labour Market Outcomes % Unemployment rate % % % Participation rate Source: ABS These are positive outcomes for the country and society as a whole. For decades, Australia struggled to achieve what was considered to be full employment. Too many people couldn’t find a job or the working hours they wanted. This was one dark spot on what has otherwise been a very successful economy over recent decades. There are still significant issues in our labour market, but the outcomes I have just highlighted are much better than most people thought likely, or perhaps even possible. There is a positive social and economic dividend to this. Our communities are stronger when people who want to work can find a job and the hours they want. Paid work not only generates incomes, but it also helps people develop skills and progress up the ladder of opportunity. The positive labour market outcomes largely reflect the policy stimulus during the pandemic – the same factor that lies behind some of the recent inflation. For a while, the disruptions caused by the pandemic made it more difficult for firms to operate and some had to hire extra workers to deal with this. But the more important factor has been the support to aggregate demand provided by both fiscal and monetary policy through the pandemic. This support was primarily designed to protect against catastrophic economic outcomes, which it successfully did. But, it also had the effect of underpinning a strong recovery in aggregate demand that has created jobs and achieved a substantial reduction in unemployment. As we battle with inflation, it is worth remembering there is another side too. I would now like to return to the battle against inflation. In the December quarter, the headline inflation rate reached 7.8 per cent (Graph 3). This is the highest rate in more than three decades. Graph 3 Consumer Price Inflation* Year-ended % % -5 -5 * Excludes interest charges prior to the September quarter of 1998; adjusted for the tax changes of 1999–2000. Sources: ABS; RBA As we know from the 1970s and 1980s, high inflation is damaging and undermines people’s living standards. While the circumstances that gave rise to the current inflation are different, the effect of inflation is the same. It erodes the value of savings, puts pressure on household budgets and hurts people on low incomes the most. And the economy doesn’t work well when inflation is high. It is harder for businesses to plan, and people spend time protecting themselves against inflation rather than on more productive activities. And if inflation becomes ingrained in expectations, it requires higher interest rates and a large increase in unemployment to get it back down again. To illustrate the point, in both the United States and Australia, when high inflation became entrenched in the 1970s and the 1980s, the unemployment rate ultimately ended up rising by at least 5 percentage points to get inflation back down (Graph 4). Graph 4 Disinflationary Episodes* % United States % Australia Inflation Unemployment * Shading indicates labour market downturns, from trough to peak in unemployment rate. Sources: ABS; RBA; Refinitiv This is one reason why the Reserve Bank is determined to ensure that this current period of high inflation is temporary. We will do what is necessary to make sure that high inflation does not become ingrained. The tool that we have to do this is interest rates. I acknowledge that the effects of higher interest rates are felt unevenly across the community. The most direct effect for households is on the cash flows of people with variable-rate mortgages. But this is only one of the many channels through which monetary policy works. Higher interest rates also affect the prices of all assets, including the exchange rate and the prices of housing. They affect the cost of new finance for borrowers and the incentive for everybody to save and spend. Higher interest rates affect residential construction activity and the investment environment facing all firms. They also affect expectations of the future and thus the pricing decisions of firms and wage outcomes. So, there are many channels through which monetary policy works, other than the impact on mortgage rates. These various channels take time to work, but they do work, and they are working to establish a better balance between supply and demand in the economy. As I have discussed on previous occasions, the Reserve Bank Board is navigating a narrow path. We are seeking to bring inflation down in a timely way while keeping the economy on an even keel. If we can successfully navigate that narrow path, inflation will return to target in a reasonable time and we will be able to preserve some of the gains in the labour market that I spoke about earlier. That is our ambition. It is still possible to achieve this, but we do need to be prepared for other outcomes as well, including a sharper rise in unemployment. Given the world we are living in, there are many sources of uncertainties at present and we could be knocked off that narrow path. Recent data As the Board navigates this path, it is paying close attention to developments in the global economy, household spending and the outlook for inflation and the labour market. I would like to say a few words about each of these in light of the recent data. First the global economy, which is in a challenging position. The IMF is predicting a period of weak growth, especially in advanced economies (Graph 5). Even so, recent forecast revisions have tended to be to the upside, following stronger news on labour markets and household spending on services in several countries. A change in China’s COVID policy has also improved the near-term outlook there. Graph 5 Advanced Economy GDP Growth* PPP-weighted % IMF forecast % -2 -2 -4 -4 -6 * -6 IMF estimate for 2022; IMF forecast for 2023 and 2024. Source: CEIC Data The main global issue though is still inflation. Headline inflation has peaked in most economies and is now coming down due to the resolution of supply side problems, softer demand for goods and a decline in some commodity prices (Graph 6). Even so, there is still uncertainty about how quickly inflation will come back down. In many countries, the prices of services are still increasing quickly and wages growth is above the rate that is consistent with sustainable achievement of inflation targets. Reflecting this, in underlying terms, inflation is proving to be uncomfortably persistent. While most central banks are forecasting that inflation will be back to target within two to three years, there is a range of other plausible scenarios where it occurs quicker or slower. Graph 6 Consumer Price Inflation Year-ended % United States Euro area % % -2 Canada United Kingdom % -2 Sources: RBA; Refinitiv In Australia, the monthly CPI indicator for January published last week provided support to the idea that headline inflation has also peaked in Australia (Graph 7). This monthly indicator is still experimental and can be volatile from month to month, so some caution is required. But the year-ended inflation rate showed a welcome decline from 8.4 per cent in December to 7.4 per cent in January. Graph 7 Monthly CPI Indicator Headline inflation, year-ended % % -2 -2 Source: ABS Within the aggregate result, we now have the first sign that the slower rate of goods price inflation in global markets is being transmitted to Australia. In January, clothing prices declined and the prices of household furnishings fell for the first time in quite a while (Graph 8). This is just one monthly figure, of course, so we will be looking for further evidence of a deceleration in goods price inflation over the months ahead. In contrast, the prices of many services are continuing to rise briskly. Over the summer, strong demand for travel, accommodation and entertainment contributed to large price increases in these sectors. Rents are also rising rapidly, with rental vacancy rates at very low levels in many parts of the country. Graph 8 Monthly CPI – Select Items September 2017 = 100, non-seasonally adjusted index index Furnishings, household equipment & services* Clothing & footwear * Two-thirds of this inflation category by weight are goods; none of the services items in this category are measured in the first month of the quarter. Sources: ABS; RBA Overall, we expect that inflation will trend lower this year and next, but there is still uncertainty about the exact path. Inflation is still too high and it will be some time yet before we are back within the 2–3 per cent target range. As part of the Board’s assessment of the future path of inflation, it is paying close attention to trends in household spending, with the recent data showing a clear moderation. In the December quarter, household consumption increased by just 0.3 per cent, which, in per capita terms, represents a small decline (Graph 9). The bounce-back in spending following the pandemic has now largely run its course. More fundamentally, the combination of cost-of-living pressures, higher interest rates and the decline in housing values is weighing on consumption. The household saving rate has declined from the very high rates of recent years to be now slightly below its pre-pandemic average. A further decline is expected due to the ongoing pressure on household finances. Graph 9 Household Consumption and Saving Quarterly % % Real consumption growth -5 -5 -10 -10 % % Net saving ratio Average (2015–2019) Sources: ABS; RBA Within the overall consumption figures there are divergent patterns (Graph 10). Per capita spending on goods has softened recently, after surging during the pandemic. In contrast, per capita spending on services has been strong, following its COVID slump. Spending on many services is now back in line with the pre-pandemic trend, although spending on international travel is one exception. These divergent patterns are also evident in the Bank’s liaison, with some firms reporting that demand is still strong, while others are reporting a noticeable softening. It is also worth noting that business surveys continue to report that trading conditions are above average. Graph 10 Household Consumption per Capita December 2019 = 100 index Goods index Services Trend (2014–2018) Sources: ABS; RBA Looking forward, we expect a period of subdued consumption growth, especially in per capita terms. This slower growth will help establish a better balance between supply and demand in the economy and support the return of inflation to target. There is a range of offsetting factors bearing on this outlook. On the positive side, households’ wage and salary income increased by more than 10 per cent over the past year, people have been finding jobs, and a large stock of additional savings was accumulated over the pandemic period. On the other side, though, interest payments are increasing quickly at a time when inflation is also high; based on the interest rate increases that have already occurred (including yesterday’s), total required mortgage payments are expected to reach 9½ per cent of household disposable income later this year, which will be around a record high (Graph 11). Housing prices have also been declining, although it is difficult to determine the effect of this on spending as there had earlier been a large run up in prices. And the pool of additional savings is spread unevenly across the community. Given this wide range of factors influencing consumption, the Board will be closely monitoring the spending data at each of its monthly meetings. Graph 11 Housing Mortgage Payments Quarterly; share of household disposable income % Scheduled payments % projections Historical estimate Interest Scheduled principal Extra payments Sources: ABS; APRA; RBA Turning now to the labour market, the recent data suggest that conditions remain tight, although the rapid pace of hiring in some sectors last year has slowed. The number of job vacancies is still very high and many firms in the Bank’s liaison program are reporting that they are planning to increase headcount further (Graph 12). Notwithstanding this, in January employment declined by 11,500 and the unemployment rate ticked up to 3.7 per cent. Our interpretation is that this decline in employment largely reflects changing seasonal patterns in hiring. It was notable that in early January there were around 100,000 more people than usual indicating that they had a firm offer to start a job within the next four weeks. We expect that many of these people will begin work by February as planned and we will be looking to see evidence of this in the February data. Graph 12 Job Advertisements Per cent of labour force % % Sources: ABS; Jobs and Skills Australia; RBA In terms of wages, we recently received new readings on the Wage Price Index and average earnings from the National Accounts. Both indicate that wages growth is stronger than it was a few years ago, which is a welcome development. It is also positive that the rate of wages growth remains consistent with the inflation target, provided that productivity growth picks up to something like its pre-pandemic pace. In the December quarter, the Wage Price Index increased by 0.8 per cent, bringing the year-ended increase to 3.3 per cent (Graph 13). This is the strongest year-ended outcome in a decade, confirming a pick-up in wages growth in response to both the tight labour market and the high inflation. Graph 13 Wages Growth Year-ended % % Average earnings per head* Wage Price Index** -2 * ** -2 Non-farm. Excluding bonuses and commissions. Source: ABS The National Accounts measure of average earnings per head increased by 0.9 per cent in the quarter and 4.2 per cent over the year. The per hour measure increased by just 2.5 per cent over the year. These measures have been volatile over recent times due to large compositional shifts in the labour market and changes in hours worked. This has made interpretation difficult, but the general message from these data is similar to that provided by the Wage Price Index. Together, these data suggest that the risk of a prices-wages spiral remains low. This is helpful as we navigate that narrow path and it means that Australia is in a better position than some other countries. Notwithstanding this, we remain alert to the risks here given the combination of a tight labour market, the high level of capacity utilisation and the run of high inflation numbers. If this risk did materialise, the costs would be very high. In particular, if prices and wages were to chase one another, the end result would be persistently high inflation, even higher interest rates and higher unemployment. It is in our collective interest to avoid this. Monetary policy I will conclude with yesterday’s decision by the Board to increase the cash rate by a further 25 basis points to 3.60 per cent. This brings the cumulative increase in interest rates since May last year to 3½ percentage points (Graph 14). The initial increases were required to remove the extraordinary policy support provided during the pandemic. Our assessment is that the more recent rate increases have moved monetary policy into restrictive territory, which has been necessary to ensure that the current period of high inflation is only temporary. Graph 14 Australian Cash Rate Target % % Source: RBA When the Board makes its decisions each month, it is managing two risks. One is the risk of not doing enough, which would result in high inflation persisting and then later proving very costly to get down. The other is the risk that we move too fast, or too far, and that the economy slows by more than is necessary to bring inflation down in a timely way. It is a complex environment in which to be making policy decisions, with many of the variables we monitor at near record highs or lows. The inflation rate is at a three-decade high. The unemployment rate is around a five-decade low. Australia’s terms of trade are close to their highest level ever. There has been a record boost to savings over recent years and interest payments as a share of household income will soon be at a record high. At the same time, measures of consumer confidence are as low as they have been in a long while. This all means that there is range of scenarios for the economy and there are uncertainties in both directions. Given these uncertainties, the Board is monitoring the data very carefully month to month. It has the flexibility to respond as needed. Our judgement, though, remains that further tightening of monetary policy is likely to be required to bring inflation back to target within a reasonable timeframe. Inflation is still too high and while it looks to be on a declining path it is likely to remain higher than target for a few years. If we don’t get inflation down fairly soon, the end result will be even higher interest rates and more unemployment. At our Board meeting yesterday, we discussed the lags in monetary policy, the effects of the large cumulative increase in interest rates since May and the difficulties that higher interest rates are causing for many households. We also discussed that, with monetary policy now in restrictive territory, we are closer to the point where it will be appropriate to pause interest rate increases to allow more time to assess the state of the economy. At what point it will be appropriate to pause will be determined by the data and our assessment of the outlook. Thank you for listening. I would be happy to answer your questions. Endnotes [*] I would like to thank David Norman for assistance in preparing this talk. The materials on this webpage are subject to copyright and their use is subject to the terms and conditions set out in the Copyright and Disclaimer Notice. © Reserve Bank of Australia, 2001–2023. All rights reserved. The Reserve Bank of Australia acknowledges the Aboriginal and Torres Strait Islander Peoples of Australia as the Traditional Custodians of this land, and recognises their continuing connection to Country. We pay our respects to their Elders, past, present and emerging. | reserve bank of australia | 2,023 | 3 |
Speech by Mr Christopher Kent, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, at the KangaNews DCM Summit, Sydney, 20 March 2023. | Speech Long and Variable Monetary Policy Lags Christopher Kent [ * ] Assistant Governor (Financial Markets) KangaNews DCM Summit Sydney – 20 March 2023 It’s great to be back at the KangaNews Summit. Last year I discussed the Reserve Bank’s move to quantitative tightening (QT). Today I’ll provide a brief update on the unwinding of our unconventional policies before turning to more conventional monetary policy issues, which will be the focus of my presentation. The unwinding of unconventional monetary policies We are currently pursuing passive QT, whereby we allow our holdings of government bonds to roll off as they mature. [ 1] The next maturity of substance is $13 billion of the April 2023 Australian Government bond. Some central banks have slowed QT by reinvesting some of their maturing bonds; others have done the opposite, pushing QT along by selling bonds well ahead of maturity. While QT will contribute to a moderate decline in our balance sheet over the next few years, the roll-off of the Bank’s Term Funding Facility (TFF) will lead to a sizeable reduction in our balance sheet this year and next (Graph 1). Graph 1 TFF and Government Bond Maturities On RBA balance sheet; annual* $b $b TFF Semis AGS * Face value of outright holdings. Source: RBA Banks are preparing for that in advance. When the time comes, they will use some of the balances held in their Exchange Settlement (ES) accounts at the Reserve Bank to repay loans they have obtained under the TFF. In return, they will receive back the collateral secured against those loans. If that collateral was in the form of securities issued by the Australian Government or the states and territories, there will be no net effect on a bank’s liquid asset ratio. But much of the collateral pledged for the TFF was in the form of self-securitised assets, which do not count towards a bank’s liquidity for regulatory purposes. Accordingly, as they run down their ES balances to repay funds borrowed under the TFF, banks will need to obtain high-quality liquid assets (HQLA). [ 2] They could also source more of their funding in products like term deposits to reduce the amount of liquid assets they need to hold. Meanwhile, banks have been issuing more long-term bonds in what had been relatively favourable conditions in global bond markets. Our liaison with the banks suggests they are planning for further issuance of bonds as they prepare for the roll-off of the first tranche of $76 billion of the TFF between April and September this year. However, conditions in global bond markets have been strained recently following the failure of Silicon Valley Bank in the United States. Volatility in Australian financial markets has picked up but markets are still functioning and, most importantly, Australian banks are unquestionably strong – the banks’ capital and liquidity positions are well above APRA’s regulatory requirements. Banks are already well advanced on their bond issuance plans for the year and could defer their bond issuance for a while. Even if markets remain strained for a time, Australian banks’ issuance will continue to benefit from the strength of their balance sheets. As loans from the TFF mature and are replaced with funding at higher cost, this will tend to push up banks’ funding costs. The TFF accounted for around 5 per cent of banks’ overall funding at its peak. However, much of the funding was hedged, either by issuing term-matched fixed-rate mortgages or by using derivatives to convert the fixed rate TFF payments back to floating rates. Hence, the rise in the cash rate and interest rates more broadly has already had some effect on the cost of banks’ funding from the TFF. Inflation targeting in Australia It was 30 years ago this month when the Bank first raised the concept of inflation targeting in a speech by then Governor Bernie Fraser. His description closely matches the formulation that is used now – namely, a flexible medium-term inflation target whereby the Bank aims to keep inflation within the range of 2–3 per cent on average over time. [ 3] Currently, the Bank is focused on bringing inflation back down to the target range. High inflation imposes a significant burden on the finances of all Australians. The rise in interest rates, which is needed to rein in inflation, imposes an extra burden on mortgage holders, but that burden will be higher still if we don’t bring inflation down in a timely manner. The transmission of tighter monetary policy through to economic activity and inflation takes time. Monetary policy affects the spending and investment of businesses and households with a lag. In turn, those changes in demand take time to have their full effect on the setting of prices and wages. These lags mean that central banks need to set monetary policy with a view to the future when it will be having its strongest effects. If instead the transmission of policy was rapid, we could use timely course corrections to navigate the economic path. However, the presence of lags in transmission adds a challenge to the setting of monetary policy. Monetary policy lags: Two reasons for recent changes The lags in the transmission of policy are not only long, but they are variable, changing over time in response to cyclical and structural changes in the economy. Further complicating matters, the lags are different across the different channels of monetary policy. Today I’ll mention two temporary changes that, by themselves, are likely to have lengthened the time it currently takes for monetary policy to affect spending via its effect on the cash flows of borrowers. I’ll stress at the outset though that this cash flow channel is just one way in which monetary policy is transmitted through the economy. There are other critical channels and, as I’ll emphasise later, these appear to be operating in the usual way. Fixed-rate mortgages The first change contributing to slowing the cash flow channel is the high share of fixed-rate mortgages by Australian standards. Unlike variable-rate borrowers, whose required mortgage repayments have risen alongside increases in the cash rate, fixed-rate borrowers face a large and delayed jump in their mortgage payments, depending on the term of their fixed-rate loan. Fixed-rate loans peaked slightly above 35 per cent of all housing credit in early 2022, compared with a pre-pandemic average of closer to 20 per cent (Graph 2). [ 4] While fixed-rate loans have been rolling off since then, and borrowers have generally switched onto variable-rate loans, this adjustment still has some way to play out. Graph 2 Fixed-rate Housing Loans Share of outstanding credit* % % * Dashed line assumes housing credit remains constant and all fixed-rate loans roll-over to variable rates; alternative scenarios assuming the current share of fixed-rate lending continues yields similar estimates. Smoothed across end 2023 and end 2024. Sources: APRA; RBA So, the unusually high share of fixed-rate loans when the Bank started to tighten monetary policy has added an extra delay to the pass-through to outstanding mortgage rates. We can see the effect of the high share of fixed-rate mortgages in Graph 3. Since last May, the average outstanding mortgage rate across all loans has increased by around 110 basis points less than the cash rate. More than half of this difference owes to the effect of fixed-rate mortgages that haven’t yet rolled onto higher interest rates. Also, the average outstanding rate for variable-rate mortgages has risen by around 40 basis points less than the cash rate as a result of competition among lenders for good-quality borrowers. Graph 3 Change in Housing Lending Rates Cumulative change since April 2022 bps All loans Variable-rate loans bps Cash rate Outstanding New M J J A S O N D J F M J J A S O N D J F Sources: APRA; RBA A few days ago, we published detailed material on fixed-rate borrowers. [ 5] I won’t repeat that here, other than to note that increases in the cash rate have been passing through to a sizeable number of loans that rolled off their earlier fixed rates last year (about 590,000 loans, or around 10 per cent of the value of all loans). Half of the remaining fixed-rate loans are due to roll off over the course of this year (or about 880,000 loans). As those fixed-rate loans reset at a higher interest rate, borrowers will be faced with a sizeable jump in their required mortgage payments. This reduction in borrowers’ free cash flows will place pressure on their budgets – in addition to that associated with the burden of high inflation – and require an adjustment of their spending and/or saving behaviour. That’s not quite the end of the story though. We need to think about the timing of those cash flow effects on the spending of those borrowers. One issue is the extent to which fixed-rate borrowers make adjustments in anticipation of rolling over to a higher rate mortgage to better smooth their spending. [ 6] If all fixed-rate borrowers did this to a significant degree, it would mean that the timing of the cash flow channel would be largely invariant to the share of fixed-rate borrowers. But that seems unlikely. I suspect many fixed-rate borrowers do not adjust their spending in advance, but rather wait until they roll onto the higher rate. [ 7] Even those that are more forward-looking are likely to make moderate adjustments at first, with further adjustments required at the time of the switch. [ 8] Hence, despite the potential for some forward-looking behaviour, it is plausible that the high share of fixed-rate loans has contributed to a longer lag for the cash flow channel. Estimates of how much further scheduled mortgage payments will rise as fixed-rate borrowers roll off their loans this year are provided in Graph 4. Scheduled mortgage payments – interest plus scheduled principal repayments – are shown in the blue bars. These rose by about 1.1 percentage points of household disposable income over 2022. The blue dashed line provides an estimate of how much further scheduled mortgage payments will rise based on the current cash rate: around 1.5 percentage points further by the end of 2024, with the bulk of that flowing through by the end of this year. Hence, only about 45 per cent of the rise in the cash rate to date had passed through to total scheduled mortgage payments at the end of 2022, though slightly more will have passed through in the early months of this year. Graph 4 Housing Mortgage Payments Quarterly; share of household disposable income % Scheduled payments projections** Historical estimate* % Interest and scheduled principal * ** Extra payments Estimated scheduled payments using credit foncier model. Based on cash rate increases to date. Projections incorporate the observed gap between cash rate increases and increases to variable loan rates. Sources: ABS; APRA; RBA Savings buffers There’s a second important factor that is likely to be adding to the lag in the transmission of monetary policy to household spending – the large run up in the stock of household savings during the pandemic, with some of that undertaken by borrowers. We can see that in the sharp rise in extra mortgage payments during the pandemic shown as the violet portion of the bars in Graph 4. These are payments into offset and redraw accounts. Balances in these accounts are a source of savings that mortgage holders can draw upon, if they choose, to help sustain their spending in the face of rising interest rates and other cost-of-living pressures. Even though these extra mortgage payments declined a little through 2022 as scheduled mortgage payments rose, borrowers in aggregate were still adding to this stock of savings. [ 9] The stock of these extra payments is high (relative to incomes) compared with historical experience. Graph 5 shows the quarterly flows into offset and redraw accounts. Over the decade or so prior to the pandemic, these payments averaged about 2 per cent of households’ disposable income. This reflects the fact that borrowers in Australia tend to pay down their mortgages well before the typical contracted term of 25 years. [ 10] From 2012–2015 households steadily made above-average payments and so built additional buffers in their offset and redraw accounts. Interest rates were being cut at the time and borrowers saved some of the reduction in their scheduled mortgage payments. Then, from 2017–2019, borrowers’ payments into offset and redraw accounts declined below 2 per cent. This occurred at a time of weak income growth, so reducing their actual mortgage payments in this way helped to sustain stronger consumption than would have otherwise been the case. [ 11] During the pandemic, borrowers again built up their mortgage buffers at a faster rate than normal, adding a similar additional amount to their buffers as they had done in the earlier episode. Indeed for a number of quarters during the pandemic, extra mortgage payments were as much as 2 percentage points above the historical average (as a share of quarterly disposable income). Extra mortgage payments dipped below 2 per cent in the December quarter, but the additional mortgage buffer still constitutes an important part of the additional savings of households overall. [ 12] To give a sense of the size of this additional mortgage buffer, if borrowers decided not to make any extra mortgage payments for a time, it would take around four quarters for the additional buffer built up during the pandemic to run down (again this is all relative to their historical norms of Australians paying down their mortgages more quickly than required). Graph 5 Extra Mortgage Payments* Quarterly; share of household disposable income % % Actual 2008–2019 average * Net payments into offset and redraw accounts. Sources: ABS; APRA; RBA Indebted households’ willingness to draw on these and other savings buffers will have an important bearing on how the economy evolves from here. If borrowers allow these additional savings to run down even to some extent, it will help to sustain their current spending in an environment of higher interest rates and cost-of-living pressures. That is, they can choose to delay some or all of the effect of the cash flow channel of monetary policy on their spending for a time. Whether they will do this, however, is uncertain. They may act much like they did in 2017–2019, running down their buffers by reducing payments into offset and redraw accounts to well below their historical average during a period of weak income growth. Or, borrowers may instead decide to hold onto their additional buffers, or at least run them down gradually over a much longer period. Indeed, higher interest rates create an incentive to save more and pay down mortgage balances more quickly – this effect is known as the ‘intertemporal’ channel of monetary policy. At the same time, there will be some borrowers whose budgets are under substantial pressure and so they will have to run down their buffers to meet higher living and interest expenses. Importantly, this additional stock of savings is not distributed evenly among borrowers. Those with relatively new loans and on lower incomes are likely to have more modest buffers, if any, and they will be feeling more pressure to adjust their spending than others. The Bank is very conscious of the challenges facing borrowers, particularly as interest rates have risen quickly over the past year. That said, a wide range of borrowers appear to have built up sizeable buffers, across different income groups and among both fixed- and variable-rate borrowers (Graph 6). For those on variable rate loans, borrowers with lower incomes added $17,000 on average to buffers in offset and redraw accounts over the past three years; this compares with the average of $39,000 accumulated by the highest income borrowers. But loan balances of borrowers on lower incomes, and hence their loan payments, are also smaller on average – $230,000 compared with $575,000. One final caveat is that, even within the income quartiles, the average is skewed by some borrowers accumulating much larger balances than others. Graph 6 Average Cumulative Extra Payments by Borrower Income Quartile* Variable-rate owner-occupier loans in Securitisation System $ 4th (lowest) 3rd 2nd 1st (highest) $ 15,000 15,000 10,000 10,000 5,000 5,000 -5,000 D J FMAM J J A SOND D J FMAM J J A SOND D J FMAM J J A SOND D J FMAM J J A SOND -5,000 * Borrowers' reported income at loan origination, grown by WPI. Sources: RBA; Securitisation System Conclusion In summary, the lagged effect of the cash flow channel of monetary policy is likely to be somewhat elongated currently due to the high proportion of fixed-rate loans and sizeable buffers held by many borrowers. This means that it’s likely to take longer than usual to see the full effect of higher interest rates on household cash flows and household spending. However, only one-third of households have a mortgage and the cash flow channel is only one way in which higher interest rates affect the economy. Ultimately, what matters for demand and inflation is how businesses and households overall – not just the borrowers among them – respond to higher interest rates through all the channels of monetary policy. There is no reason to think that other channels of monetary policy are more or less effective than usual. For example, the sharp reduction in demand for new housing loans is in line with historical experience given the sharp rise in interest rates and the decline in turnover and prices in housing markets; the demand for new construction has also fallen noticeably. Higher interest rates are making it more attractive to save and more costly for firms to invest; they have also contributed to lower asset prices and so lower wealth, which will impinge on households’ willingness to spend. It may appear that with the Australian dollar little changed over the past year (on a trade-weighted basis), that the exchange rate channel is not operating as usual. But the rise in interest rates in Australia has helped to support the value of the Australian dollar and therefore the prices of imported goods and services are not as high as they otherwise would have been. In short, all of these other channels of monetary policy are helping to slow the growth of aggregate demand and bring down inflation. The Bank will continue to closely monitor the transmission of monetary policy and its impact on household spending, the labour market and inflation. The Board will respond as necessary to bring inflation back to target in a reasonable time. This will benefit all Australians, as high inflation imposes a significant burden on all of us, those with a mortgage, those with savings, and the most vulnerable that have neither. Endnotes [*] I thank Duke Cole, Anthea Faferko, David Jacobs, Anirudh Suthakar and Benjamin Ung for their excellent assistance in preparing this speech. Kent C (2022), ‘From QE to QT – The Next Phase in the Reserve Bank’s Bond Purchase Program’, Speech at KangaNews DCM Summit, Sydney, 23 May. For banks without large ES balances, they would look for funding to cover the TFF repayments but not necessarily need to also fund the purchase of new HQLA. Fraser B (1993), ‘Some Aspects of Monetary Policy’, Talk to Australian Business Economists (ABE), Sydney, 31 March. The fixed rate share of housing credit rose over 2020 and 2021 as borrowers were attracted by the historically large discount on fixed rates relative to variable rates available over much of this period. See RBA (2022), ‘Review of the Yield Target’. Lovicu G, J Lim, A Faferko, A Gao, A Suthakar and D Twohig (2023), ‘Fixed-rate Housing Loans: Monetary Policy Transmission and Financial Stability Risks’, RBA Bulletin, March. While it is difficult to observe savings behaviour, partial data suggest that many fixed-rate borrowers have accumulated similar savings to variable-rate borrowers. See Lovicu et al, n 4. While we have detailed data on mortgage payments of different borrowers, unfortunately we don’t also have data on their spending behaviour. One factor behind this is the fact that any early adjustment to spending by such borrowers would have been made on the basis of considerable uncertainty about the actual mortgage rate they would be rolling onto when the time came. It is also the case that most fixed-rate loans do not allow the use of offset or redraw facilities, and that many fixed-rate borrowers will have accumulated savings outside of such facilities. See Lovicu et al, n 4. It’s hard to say if this is the same average rate of prepayment we would see over a longer period, especially as interest rates were declining for much of the period shown, but it provides a helpful benchmark. Note, however, that even though the cumulative difference between actual offset and redraw payments and the historical average declined to zero in 2019, the stock of these buffers was not exhausted – it had just returned to its historical average prior to the pandemic. Our estimates suggest that, in aggregate, Australians accumulated additional savings during the pandemic equivalent to around 20 per cent of their annual disposable income (RBA (2023), Statement on Monetary Policy, February). The materials on this webpage are subject to copyright and their use is subject to the terms and conditions set out in the Copyright and Disclaimer Notice. © Reserve Bank of Australia, 2001–2023. All rights reserved. The Reserve Bank of Australia acknowledges the Aboriginal and Torres Strait Islander Peoples of Australia as the Traditional Custodians of this land, and recognises their continuing connection to country. We pay our respects to their Elders, past and present. | reserve bank of australia | 2,023 | 3 |
Address by Mr Philip Lowe, Governor of the Reserve Bank of Australia, at the National Press Club, Sydney, 5 April 2023. | Speech Monetary Policy, Demand and Supply Philip Lowe [ * ] Governor Address at the National Press Club Sydney – 5 April 2023 Thank you for the invitation to address the National Press Club once again. It is a pleasure to be here. I would like to begin by explaining yesterday’s monetary policy decision. I will also discuss the importance of returning inflation to target and the roles that both aggregate demand management and expansion of the supply side of the economy can play in maintaining low inflation. Yesterday’s monetary policy decision At yesterday’s meeting, the Reserve Bank Board held the cash rate unchanged at 3.6 per cent. This is after interest rates were increased at each of the previous 10 meetings (Graph 1). The decision to hold interest rates steady this month was taken to give the Board more time to assess the economic outlook and the impact of the increases in interest rates so far. Graph 1 Australian Cash Rate Target % % Source: RBA Since May last year, interest rates have been increased by 3½ percentage points. This is a large increase over a short period and it has been difficult for many people. The first increases were necessary to withdraw the support provided during the pandemic. And then the more recent increases have been required to move monetary policy into restrictive territory to combat the highest rate of inflation experienced in Australia in more than 30 years (Graph 2). To be clear, the alternative to the recent interest rate increases would have been more persistent inflation and, ultimately, even higher interest rates and more unemployment. Graph 2 Consumer Price Inflation* Year-ended % % -5 -5 * Excludes interest charges prior to the September quarter of 1998; adjusted for the tax changes of 1999–2000. Sources: ABS; RBA The decision to hold rates steady this month does not imply that interest rate increases are over. Indeed, the Board expects that some further tightening of monetary policy may well be needed to return inflation to target within a reasonable timeframe. It decided, though, that it was prudent to hold rates steady this month to allow more time to assess the impact of the increases in interest rates to date and the economic outlook. The Board is conscious that monetary policy operates with a lag and that the full effect of the increases to date is yet to be felt. It is also conscious that there are significant economic uncertainties at the moment. Given these lags and uncertainties, the Board judged that, with monetary policy now in restrictive territory, it was time to hold interest rates steady and accumulate more information. This approach is consistent with our practice in earlier interest rate cycles. In those earlier cycles, it was common for the Board to move interest rates multiple times, then wait for a while to assess the pulse of the economy, and move again if the situation warranted doing so. So, it is a return to that world. Some factors bearing on the outlook Given that monetary policy affects the economy and inflation with a lag and that interest rates have been increased quickly, it is important that the Board looks to the future when setting interest rates. At our meeting yesterday, we discussed some of the factors that are likely to bear on that future and I would like to share three of these with you. The first is the outlook for the global economy, especially in light of the recent banking stresses in the United States and Switzerland. Globally, inflation remains too high and services price inflation is proving to be worryingly persistent. Global economic growth has slowed to a below-average pace, and the outlook – even before the recent banking problems – was for this to continue. The past week or so has seen financial stability concerns ease a little, but even so the recent problems will result in tighter financial conditions around the world as banks reassess risk and seek to reassure depositors that their funds are secure, including by taking a more cautious approach to lending. It is still unclear what effect this will have on global economic growth, but it is another headwind. Here, in Australia, the impact of the banking stresses overseas has been limited. Our financial markets are working well and Australia’s banks remain well positioned to provide the credit and other financial services that the economy needs. Our banks have an unquestionably strong capital position and liquidity reserves that are well above prudential requirements (Graph 3). They also have diversified deposit bases and carry very limited interest rate risk, with APRA requiring the largest banks to hold capital against this risk as part of their core requirements – something that regulators elsewhere in the world have not done. This all means that, as APRA Chair John Lonsdale said last week: Australians can be confident that ‘their banking system is among the strongest and most resilient in the world, with prudential safeguards above and beyond minimum international requirements’. Graph 3 Banks' Capital and Liquidity % Capital* Liquidity coverage ratio % Tier 1 capital ratio CET1 capital ratio Regulatory minimum * Break in March 2013 due to the introduction of Basel III. Sources: APRA; RBA This assessment is reassuring, but it does not mean that Australia is immune to stresses abroad. While the authorities in the United States and Switzerland have taken decisive steps to maintain confidence in their banking systems, the situation is still fragile and recent events have put the spotlight on how shifts in sentiment can result in rapid outflows of deposits. Given this, the RBA and the other members of the Council of Financial Regulators are continuing to monitor the global situation carefully and we are in regular contact with our counterparts overseas. A second important factor bearing on the outlook is the strength of household consumption. It is increasingly clear that the higher interest rates are having an impact on aggregate household spending. This next graph shows quarterly consumption growth from the national accounts and our current estimate for the March quarter (Graph 4). Consumption growth has slowed considerably from the very fast rates during the COVID bounce-back and it is now below average. Graph 4 Household Consumption Growth* Quarterly % % 2.0 2.0 1.5 1.5 1.0 1.0 2010–2019 average 0.5 0.5 0.0 J S D M 0.0 * March quarter 2023 is an estimate based on partial data received to date. Sources: ABS; RBA Looking forward, we expect that consumption growth will remain subdued for some time. But there are uncertainties, with factors pulling in different directions. On the positive side of the ledger, unemployment is low and households, in aggregate, saved a lot more than usual during the pandemic. The unemployment rate is around the lowest that it has been since 1974 – that is nearly 50 years ago – and underemployment is at a multi-decade low (Graph 5). People are finding jobs and additional hours of work. And the additional savings accumulated during the pandemic are equivalent to around 20 per cent of annual aggregate household income. Partly reflecting these additional savings, the median owner-occupier with a variable-rate mortgage is more than a year ahead on their mortgage payments. Graph 5 Unemployment and Underemployment Per cent of labour force % % Unemployment rate* Underemployment rate * Quarterly data from 1959 to 1964 are spliced from historical national accounts data. Sources: ABS; RBA On the other side of the ledger, though, the cost-of-living pressures are squeezing household budgets across the country. The decline in housing prices has also reduced measured household wealth. And the 35 per cent of households with a mortgage are experiencing, or will experience, a significant increase in their required payments. The predominance of variable-rate mortgages in Australia means that this is a more powerful transmission mechanism of monetary policy than in many other countries. Since interest rates started rising, the average mortgage rate that Australians pay has increased more quickly than average mortgage rates paid in other countries (Graph 6). This increase in mortgage rates has had a significant effect on household budgets and we anticipate that required mortgage payments will reach a new record high of almost 10 per cent of household disposable income by the end of next year. Graph 6 Changes in Outstanding Mortgage Rates* Month preceding first policy rate increase = 0** bps bps Norway Australia NZ Canada UK -50 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 * ** -50 Data for Canada and NZ to January, remainder to February. Cumulative basis point increase in the average outstanding mortgage rate relative to the month immediately preceding first policy rate increase since the onset of the pandemic. Sources: APRA; central banks; RBA We are also conscious that the savings buffers are unevenly spread across households. While many households have built up large buffers in their mortgage offset accounts, around 30 per cent of owneroccupiers with variable-rate loans have an offset or redraw balance of less than three months’ repayments. And there are still many fixed-rates borrowers to transition to higher variable rates. It is also unclear how those who have built up additional savings will use them: will they treat them as wealth to be spent slowly over time or as funds that can be used to support spending this year and next? This all means that there are still significant uncertainties regarding how household spending will evolve and we are watching the indicators very closely. A third important factor that will shape the outlook is how price- and wage-setting behaviour responds to this period of higher inflation. To date, wage outcomes have been consistent with inflation returning to target, provided there is some pick-up in productivity growth – an issue I will return to later. Wages growth is higher than it was a few years ago and this is a welcome development (Graph 7). It is also noteworthy that the recent high inflation has not been driven by excessive wages growth. Graph 7 Wages Growth Year-ended % % Average earnings per head* Wage Price Index** -2 * ** -2 Non-farm. Excluding bonuses and commissions. Source: ABS In terms of price-setting, the experience differs across firms and industries. However, at the aggregate level, the share of profits in national income – excluding the resources sector, where prices are set in global markets – has not changed very much over recent times (Graph 8). A reasonable interpretation of this is that, while firms on average have been able to pass on higher costs and maintain profit margins, inflation has not been driven by ever-widening profit margins. Graph 8 Profit Share of Income* % % All industries Excluding mining** * ** Gross operating surplus of private non-financial corporations as a share of total factor income. Excluding mining sector profits and mining sector labour income. Sources: ABS; RBA Looking forward, it is important that wage increases remain broadly consistent with the inflation target and that a widening of profit margins does not become a source of ongoing upward pressure on prices. The Board is watching developments carefully in each of these areas that I have discussed. Our central view remains that economic growth will be below trend for a while, that unemployment will increase later this year and that inflation will decline gradually over time. It is a narrow path, though, and there are other plausible scenarios. Before we take our next interest rate decision in Perth in early May, we will conduct a full review of the forecasts and scenarios for the economy and inflation. The importance of returning to low inflation The Board’s priority remains to return inflation to the 2 to 3 per cent target range in a reasonable time. It is important that we do this, because persistently high inflation is corrosive and damages our economy. It erodes the value of savings, puts pressure on household budgets and hurts people on low incomes the most. High inflation makes it harder for businesses to plan and it distorts investment. And if inflation becomes ingrained in expectations, it requires even higher interest rates and a larger increase in unemployment to get it back down again. It is for these reasons that the Board remains resolute in its determination to return inflation to target and will do what is necessary to achieve that. A primary task of any central bank is to preserve the value of money. And the tool we have to do this is interest rates. In principle, different institutional arrangements could be designed and non-monetary tools could be developed to help contain inflation. In practice, though, things are more difficult and the use of other tools would raise a new set of complexities and operational and governance challenges. It is also worth recalling that the task of controlling inflation has been assigned to central banks following years of experience with other arrangements that did not work out so well. We do not operate in a vacuum, though, and other policies affecting aggregate demand and supply also affect inflation outcomes. Managing demand and expanding supply Broadly speaking, inflation is determined by expectations of future inflation and the balance between demand and supply. If demand is strong relative to supply, prices will rise more quickly. When firms are operating close to capacity, production costs increase and there is less incentive to discount. And when there is strong demand for labour relative to supply, workers tend to seek, and can achieve, larger wage increases. So both the demand-side and the supply-side of the equation matter for inflation, and policies on both sides can affect inflation outcomes. At the central bank, we work primarily on the demand-side of this equation. Our tool – interest rates – influences the level of aggregate demand in the economy. At any point in time, we take the supply-side of the economy as given, even though, in the long run, successful monetary policy can create conditions that promote investment and the expansion of supply. Our job is to make sure that demand grows in line with supply. Over recent times we have been working to slow the growth of demand to establish a better balance with supply, thereby shortening the period of high inflation and avoiding an unhelpful adjustment in longer term inflation expectations. Notwithstanding our focus on managing aggregate demand and expectations, supply-side considerations feature heavily in the Board’s deliberations as they influence inflation outcomes. We saw this very clearly during the pandemic with the problems in global supply chains. A good example is the price of shipping a container, which surged during the pandemic but has now normalised (Graph 9). Over time, lower shipping costs should be reflected in the prices of goods in Australia. Graph 9 Global Container Shipping Rates 2017–2019 average = 100 index index Sources: RBA; Refinitiv With the pandemic now behind us, our attention has turned to a few other supply-side issues. The first is the balance of supply and demand in the housing market. As rents make up 6 per cent of the CPI, what happens here can have a significant influence on overall inflation. Over recent years, growth in the number of dwellings in Australia has exceeded growth in population (Graph 10). This was especially so during the pandemic, when population growth declined to its slowest pace since the First World War. Despite this, there was only a modest increase in the rental vacancy rate. This is primarily because the demand for residential floorspace increased as people worked from home and the average number of people living in each household fell (Graph 11). Graph 10 Population and Dwelling Stock* Year-ended growth % % Dwelling stock 2.0 2.0 1.5 1.5 1.0 1.0 Population 0.5 0.5 0.0 * Dashed lines represent forecasts. Sources: ABS; RBA 0.0 Graph 11 Average Household Size* Capital cities no no 2.60 2.60 2.55 2.55 2.50 2.50 * Average number of persons usually resident in an occupied private dwelling; estimated using Labour Force Survey microdata; seasonally adjusted; smoothed line is a 13-period Henderson trend. Sources: ABS; RBA We are now in a different phase following the opening up of Australia’s international borders. Population growth has picked up sharply and it now seems likely that the annual rate of population growth will soon be around 2 per cent, which would be close to the peak reached during the resources boom. In contrast, the expansion in the supply side of the housing market is expected to be fairly modest. It takes a long time for housing supply to respond fully to shifts in population growth – in the previous episode of strong population growth, it took around five years. One possible adjustment over the near term is that the average number of people living in each dwelling might increase, reversing the pandemic-period fall. This would reduce overall demand for new dwellings. But even if this were to happen, it is likely that the balance between demand and supply in the housing market will result in rents inflation being quite high for a while. This will be one factor adding to inflation over the period ahead. Another area where supply-side factors are having an important bearing on inflation is in the energy sector. The price of electricity, as measured in the CPI, increased by 12 per cent last year and we are expecting a further increase of around 15 per cent this year. This surge in prices is not because the demand for electricity in Australia has been unusually strong. Total electricity consumption has been little changed over the past decade as people and businesses have found efficiencies and the nature of production changed (Graph 12). Yet prices increased significantly. Global supply-side factors are part of the explanation, but so too are domestic supply-side factors. These factors have since abated somewhat, but avoiding a mismatch in the timing between the ageing of existing generation capacity and the installation of new renewable supply capacity will remain a challenge. Graph 12 Electricity Consumption and Prices National Electricity Market, annual $/MWh TWh Consumption* Wholesale prices** (LHS) (RHS) * ** Lighter colour shows annualised consumption so far in 2023. Diamond shows average of prices to date in 2023 and futures prices for the rest of 2023. Sources: ABS; AEMO; ASX; OpenNEM; RBA Beyond these specific areas of housing and energy, there is a more general supply issue that it is important to remain attentive to, and that is productivity growth. Faster growth in productivity means that we can produce more with our resources. It means a bigger pie, higher real wages, a lift in our collective wealth and a more prosperous economy. It also means that, for a time, there is less upward pressure on inflation. Over recent years, Australia’s productivity performance – measured by output produced per hour worked – has slipped (Graph 13). Indeed, the level of labour productivity in the December quarter last year was the same as it was three years earlier. This compares with average growth in labour productivity of 1¼ per cent over the previous three decades. The fact that the supply-side of our economy is growing more slowly than it once did carries the implication that demand also needs to grow more slowly if we are to avoid persistently higher inflation. Graph 13 Labour Productivity Non-farm GDP per hour, December 1992 = 100, quarterly index index Sources: ABS; RBA Given the importance of lifting productivity growth, it was pleasing to see the Productivity Commission’s most recent five-year report. The good news in that report is that there are plenty of ideas on how we can lift our performance. The task now is to implement some of those ideas. I am raising these supply-side issues because they matter for inflation, and they help shape the context within which the Board makes its decisions. The standard view is that monetary policy can look through short-term supply shocks. This is provided that medium-term inflation expectations do not adjust to variations in inflation caused by these shocks. If inflation expectations remain anchored, inflation should return relatively quickly to target when the shock dissipates. This means that a monetary policy response is not needed. On the other hand, if inflation expectations do increase and wage- and price-setting behaviour responds to the higher inflation, an interest rate response is required. The more that prices and wages respond to higher inflation, the greater the need will be for interest rates to respond too. The situation is more complicated when the supply-side issues are persistent, leading to persistently higher price increases in parts of the economy. Here there is a greater risk that inflation expectations and price- and wage-setting behaviour adjusts. If this were to occur, a more decisive monetary policy response would be required. Our current forecast is that inflation returns to the top of the target range, but only by mid-2025. This forecast takes into account the supply-side considerations I just discussed. It is important to point out, though, that while supply-side factors are influencing how fast inflation declines, they cannot be a reason to tolerate higher inflation on an ongoing basis. Dealing with the supply-side issues will be harder, not easier, if inflation stays high for too long. The Board is committed to making sure this does not happen and the way we will do so is to manage aggregate demand with interest rates. To conclude, we face a challenging environment, but Australia is better placed than many other countries. Our banking system is strong, we have our lowest unemployment rate in decades, the prices of many of our exports are very high and many households saved a lot of extra money during the pandemic. At the same time, many households are feeling a painful squeeze on their budgets. Inflation is too high, although it is coming down due to both the resolution of some supply-side problems and the RBA’s earlier tightening of monetary policy. This month, the Board decided to hold the cash rate steady after increasing interest rates at the previous 10 meetings. This will provide more time to assess how the various influences on the economy balance out. At our next meeting, we will again review the setting of monetary policy with the benefit of an updated set of forecasts and scenarios. Thank you for listening and I look forward to answering your questions. Endnotes [*] I would like to thank David Norman for assistance in preparing this talk. The materials on this webpage are subject to copyright and their use is subject to the terms and conditions set out in the Copyright and Disclaimer Notice. © Reserve Bank of Australia, 2001–2023. All rights reserved. The Reserve Bank of Australia acknowledges the Aboriginal and Torres Strait Islander Peoples of Australia as the Traditional Custodians of this land, and recognises their continuing connection to country. We pay our respects to their Elders, past and present. | reserve bank of australia | 2,023 | 4 |
Speech by Mr Philip Lowe, Governor of the Reserve Bank of Australia, at a media briefing, Sydney, 20 April 2023. | Philip Lowe: Australia'a Bank Review Speech by Mr Philip Lowe, Governor of the Reserve Bank of Australia, at a media briefing, Sydney, 20 April 2023. *** Good afternoon. I would like to take this opportunity to welcome the conclusions of the Review into the Reserve Bank and thank the Review Panel for their excellent work. The Review has been timely, with the RBA facing an increasingly complex world and operating environment. The recommendations will help us deal with this more complex world and will strengthen the monetary policy process and governance of the RBA. The Review concludes that the RBA has a strong reputation domestically and internationally. It also concludes that we have played an important role in the economic success that Australia has experienced over recent decades. The Panel also notes that the RBA has a highly dedicated and professional staff who are focused on serving the public interest. But as times change, we need to change too. This Review will help us do this as we strive to promote the economic welfare of the Australian people. I would like to particularly welcome the Panel's support for the current monetary policy framework in Australia. Australia was an early adopter of flexible inflation targeting and this approach has served the country well. The 2–3 per cent target range is understood in the community and helps anchor inflation expectations. The flexible nature of the inflation target is also important and the Panel has some helpful suggestions as to how we can be clearer about how, and when, this flexibility is used. I would also like to welcome the support for the operational independence of the Bank. This is a cornerstone of our monetary policy framework and it is pleasing to see the strong endorsement for independence and the suggestions for strengthening it. It is also pleasing to see the support for the Council of Financial Regulators and the ideas for improving current arrangements. I also welcome the explicit recognition of the Bank's long-standing responsibility for financial stability. A major change recommended by the Panel is the establishment of separate boards for monetary policy and the governance of the Bank. I have thought for some time that there was a strong case to strengthen the governance of the RBA as an institution. The RBA is responsible for many nationally important functions in addition to monetary policy. These include being the banker to the government, the operator of critically important payments infrastructure, the printer of banknotes and passports, and the manager of Australia's foreign exchange reserves. So there is a lot more than just monetary policy. Under the Reserve Bank Act 1959, I, as the Governor, am charged with managing the Bank and I am also the accountable authority under the Public Governance, Performance and Accountability Act 2013. As you know, there is great deal of public 1/3 BIS - Central bankers' speeches visibility of, and commentary about, our monetary policy decisions, but there is much less oversight of how I discharge my responsibilities to manage the RBA. From a number of perspectives, current oversight arrangements fall short of contemporary standards. The proposed changes would address this and help the Governor manage the Bank and its many functions. The recommended changes could also strengthen the monetary policy process, by having a board whose sole focus is monetary policy. I very much welcome the conclusion that this board should include people with diverse perspectives and knowledge and who have experience in decision-making under uncertainty. It is also pleasing to see that the Panel recommended that the Treasury Secretary remain on the Board. The establishment of these two boards will require changes to the Reserve Bank Act, which is a matter for the Australian Government and Parliament. You would have already heard that the Treasurer intends to proceed with these changes. We will work constructively with the Government and Parliament with the aim of ensuring that any changes to legislation are effective in achieving their objectives. The Review also recommends that the Statement on the Conduct of Monetary Policy be updated. This is important because this Statement sets out the common understanding between the Government and the RBA on monetary policy. The Review sets out a number of issues that could be covered in this Statement – the suggestions make sense and have our support. The Board will work constructively with the Treasurer to finalise a new Statement. The Review includes a number of recommendations for how the Board works, including the frequency of meetings and the approach to communication. It recommends that the Board receive and consider a richer set of briefing materials, including on economic modelling, research and monetary policy strategy. It also recommends closer interactions between Board members and the Bank's staff in the expectation that this will support a stronger culture of challenge and debate within the RBA. The Board will consider these issues over coming meetings. It will develop a holistic response, given that many of the recommendations in this area are interrelated and will have flow-on effects for how we do our work and how parts of the Bank are structured. We will publish a detailed response later this year after the necessary work has been completed. The Review also includes a number of recommendations to strengthen the RBA's management, culture and operations. These include: the appointment of a Chief Operating Officer, enhancing the communications function, encouraging the culture of debate within the Bank, strengthening the role of research, and continuing to invest in leadership and management capabilities. These recommendations make sense and have our support. We will now develop an implementation plan under the leadership of a small team of experienced people. To conclude, I would like to again thank the Review Panel for their work. It is not often that central banks are reviewed, so it is important the job is done well and thoughtfully, and that the process is constructive. This is exactly what has been done here. It also 2/3 BIS - Central bankers' speeches makes sense, as the Panel recommends, for regular reviews to be conducted every five years. As the Panel notes, the Review has been about strengthening a well-functioning institution and ensuring the Bank is in a good position to meet the challenges of the future. Monetary policy has become more complex, as have the Bank's operations in the banking and payments areas. The recommended changes in this Review will help us do our job in this changing world and are consistent with our internal staff values, including serving the public interest and achieving excellence. I look forward to working with the Government, the Parliament, the Board and the Bank's staff on how we can best live up to those important values. I am happy to answer your questions. 3/3 BIS - Central bankers' speeches | reserve bank of australia | 2,023 | 4 |
Remarks by Mr Philip Lowe, Governor of the Reserve Bank of Australia, at the Reserve Bank Board Dinner, Perth, 2 May 2023. | Philip Lowe: Remarks at the Reserve Bank Board Dinner Remarks by Mr Philip Lowe, Governor of the Reserve Bank of Australia, at the Reserve Bank Board Dinner, Perth, 2 May 2023. *** Good evening. On behalf of the Reserve Bank Board, I would like to warmly welcome you to this community dinner. The pandemic meant that the Board was unable to meet in Perth for some time, but it is very good to be back in your beautiful city. Thank you very much for joining us tonight. The Board met this morning at our offices on St Georges Terrace. You will have already heard that we decided to increase the cash rate by a further ¼ of a percentage point to 3.85 per cent. I would like to use this opportunity to explain why we made this decision. The Board's central objective is to return inflation to the 2–3 per cent target range within a reasonable timeframe. It is important that we achieve this. High inflation makes life difficult for people and damages the functioning of the economy. And if high inflation were to become entrenched in people's expectations, it would be very costly to reduce later, involving even higher interest rates and a larger rise in unemployment. I know that higher interest rates are unwelcome for many people, but the alternative is persistent high inflation and ultimately even higher interest rates and a worse outlook for jobs. It is best that we avoid that. Last month the Board decided, after 10 consecutive interest rate increases, to hold the cash rate steady. It did this to provide us with more time to assess the pulse of the economy and the outlook. Since then, we have seen further evidence that the Australian labour market is still very tight, that services price inflation is proving to be uncomfortably persistent abroad, and that asset prices – including the exchange rate and housing prices – are responding to changes in the interest rate outlook. We also received confirmation that the peak in inflation in Australia is now behind us, but that has not changed our view that it will be some time yet before inflation is back in the target range. Goods price inflation is slowing, which is good news. But services and energy price inflation is still high and likely to remain so for some time. Looking overseas, we see worryingly persistent services price inflation. It is possible that circumstances might be different here in Australia, but the experience abroad points to an upside risk, especially given the high degree of commonality across countries in inflation dynamics recently. Given this flow of data and our assessment of the outlook, the Board judged that it was appropriate to increase interest rates again today. In broad terms, the Board is seeking to bring inflation down within a reasonable timeframe while also preserving as many of the gains in the labour market as possible. 1/4 BIS - Central bankers' speeches It took a long time for Australia to get back to conventional estimates of full employment. But, as a by-product of the pandemic and the policy responses, we got there. The unemployment rate is the lowest it has been in nearly 50 years. Underemployment is also lower than it has been for a long time, and a higher share of Australians have jobs than ever before. Our society is better off as a result and it is in our collective interest to maintain as many of these gains as we can. I acknowledge that we are travelling along a narrow path here. History teaches us that it is difficult to bring inflation down while keeping the economy on an even keel. So, we need to be realistic. At present, though, the data provide some confidence that we are still on this narrow path and it is possible that we can stay on it. If we are to stay on that path, Australians need to have confidence that inflation will come down and return to target. If people think inflation is going to remain high then, understandably, they will adjust their behaviour. Firms will be more willing to put up their prices and workers will seek larger pay rises. If this adjustment in expectations were to happen, high inflation would become entrenched and the end result would be even higher interest rates and a poorer outlook for jobs. It is for these reasons that the Board is resolute in its commitment to returning inflation to target within a reasonable timeframe. We don't need to get inflation back to target straight away, but nor can we take too long. We are taking a bit more time than some other countries, on the basis that doing so can preserve some of the gains in the labour market. But there is a limit here. If we take too long to get inflation back to target, expectations will adjust and life will become more difficult. Today's further adjustment in interest rates will help with the return of inflation to target in a reasonable period. This is the best way of sustaining as many of the gains in employment as is possible. Looking forward, some further tightening of monetary policy may be required to ensure that inflation returns to target in a reasonable timeframe, but that will depend upon how the economy and inflation evolve. The Board is not on a pre-set course. It will continue to pay close attention to developments in the global economy, trends in household spending and the outlook for inflation and the labour market. Once again, we will do what is necessary to bring inflation back to target. I want to acknowledge that the combination of higher interest rates and other cost-ofliving pressures is squeezing many people's budgets and that it is a difficult time for many families. Real wages have fallen and those with high debt have experienced a very large rise in their mortgage payments. I want to assure you that the Board is very focused on understanding these pressures and we are taking them into account in our decisions. At our meeting today, in discussing the Western Australian economy, we heard how retail spending has slowed here. We heard that community organisations are experiencing increased demand for emergency relief, including crisis accommodation. There has also been increased demand for financial assistance and counselling. So, it is a difficult time for many people. 2/4 BIS - Central bankers' speeches We also heard about the very tight rental market here in Western Australia. There is a very limited supply of rental properties and rents in Perth have been rising even faster than elsewhere in the country. On a more positive note, unemployment in Western Australia has generally been lower than in the rest of the country. The outlook for investment in the resources sector is also positive. And the state has been benefiting from the high prices available in global markets for iron ore and LNG. So as in much of the rest of the country, there are challenges but there are also many positive elements as well. As you may be aware, it is not just interest rates that have been keeping the RBA in the news recently. A couple of weeks ago, the Australian Government released the report of an independent review into the RBA, which has generated a lot of interest. The Board had an initial conversation about the Review today and is committed to a holistic and comprehensive response. Broadly speaking, the recommendations make sense and they will help the RBA deal with the ever more complex world in which we live. There has been a lot of coverage of the areas where we can do better and this is understandable and appropriate. But I want to draw your attention to some other findings that have received less coverage. The Review Panel rightly concluded that the RBA has made a substantial contribution to Australia's economic success. Our flexible inflation targeting framework has served the country well and the overall economic outcomes in Australia have been at least as good as those elsewhere. The Panel also concluded that the RBA is held in high regard internationally and that its staff are highly dedicated and skilled. We are a strong institution that is served by a dedicated, diverse and highly experienced Board whose members have to grapple with very difficult issues. We have a strong focus on doing what is right for the country as a whole over the medium term, even if it is difficult for some people in the short term. Today's decision by the Board is an example of that. I would like to take this opportunity to pay a tribute to two Reserve Bank Board members who will soon be retiring. Today's meeting was the final one for Wendy Craik, and Mark Barnaba's term on the Board will end in August. Both Wendy and Mark have served on the Board with great distinction. They have had to deal with a period when inflation was too low, a global pandemic, unprecedented monetary policy actions, the economic effects of an horrific war in Europe, the transition in our energy system and the highest inflation in 30 years. All that in less than six years. In my view, their contributions over these years reinforce the argument for the monetary policy board continuing to have strong, experienced and independent members drawn from a wide variety of backgrounds. As I hope you know, the RBA has many other responsibilities other than setting interest rates. One of these is that we print and issue the nation's banknotes. This remains a very important function for us, despite banknotes being used less and less for payments. According to our latest survey of how Australians make their payments, cash now 3/4 BIS - Central bankers' speeches accounts for just 13 per cent of all consumer payments. Fifteen years ago, that figure was nearly 70 per cent. That is a big change and I expect that it will continue. Despite this, the stock of banknotes on issue has continued to grow over recent years. There is nearly $4,000 on issue for every Australian, including 18 $100 bills for every man, woman and child. I don't have my share and I don't know many people who do. The RBA is also investigating new forms of digital money, including a central bank digital currency. It is too early to tell where this will end up, but history teaches us that the nature of money changes with the available technology. To help us explore the various possibilities, we have recently issued a small amount of digital currency as part of a research project with the Digital Finance Cooperative Research Centre. This central bank digital currency is being used by the industry to explore possible use cases, and we are very interested to see the results. The RBA is also the banker to the Australian Government. This means that we process all social security payments, tax payments and Medicare refunds. That is a big and important job in itself. We also operate the core of Australia's payments system – when you send money from your bank to another it goes through the Reserve Bank. We operate a central part of Australia's 24/7 real-time payments system. I hope that you all have a PayID, so that you can take best advantage of this system. If you don't have one, I encourage you to go get one. PayIDs are not only convenient to use, but they can also reduce the incidence of some types of payment scams. The RBA is also the regulator of critical parts of the payments system and financial infrastructure. We have a broad responsibility for financial stability and are the lender of last resort in a liquidity crisis. And we are a large financial institution in our own right, with a balance sheet of $620 billion. These are all important functions that we perform for the nation. They are carried out by highly dedicated staff who are strongly motivated to serve the public interest. Finally, I would like to thank you again for joining us this evening and for your interest in the RBA. We look forward to learning more from you about how things are going here in the great state of Western Australia. I am happy to answer some of your questions. Thank you. 4/4 BIS - Central bankers' speeches | reserve bank of australia | 2,023 | 5 |
Address by Mr Philip Lowe, Governor of the Reserve Bank of Australia, at the Morgan Stanley 5th Australia Summit, Sydney, 7 June 2023. | Speech A Narrow Path Philip Lowe[*] Governor Address at the Morgan Stanley 5th Australia Summit Sydney – 7 June 2023 Thank you very much for the invitation to join Morgan Stanley’s Australian Summit. It is a pleasure to be able to join you. This morning, I would like to discuss the narrow path the Reserve Bank Board is seeking to navigate. That path is one where inflation returns to target within a reasonable timeframe, while the economy continues to grow and we hold on to as many of the gains in the labour market as we can. It is still possible to navigate this path and our ambition is to do so. But it is a narrow path and likely to be a bumpy one, with risks on both sides. Today, I would like to talk about the importance of the destination – that is, a sustainable return of inflation to target – and our strategy for getting there, including the decision yesterday to increase the cash rate again. I will then turn to some of the factors that the Board is considering as it navigates the path back to 2–3 per cent inflation. The return of inflation to target Recent inflation readings have been the highest for more than 30 years (Graph 1). The reasons for this are well known. They include supply-side disruptions caused by the pandemic, Russia’s invasion of Ukraine, and the large fiscal and monetary policy responses that supported economies during the pandemic. Graph 1 Consumer Price Inflation* Year-ended % % -5 * -5 Excludes interest charges prior to the September quarter of 1998; adjusted for the tax changes of 1999–2000. Sources: ABS; RBA. Our job at the central bank is to make sure that this period of high inflation is only temporary. It is important that we are successful here. High inflation is corrosive and damages our economy. It erodes the value of money and savings, puts pressure on household budgets, makes it harder for businesses to plan and distorts investment. It makes us all poorer and hurts people on low incomes the most. And if inflation stays high for too long, it will become ingrained in people’s expectations and high inflation will then be self-perpetuating. As the historical experiences shows, the inevitable result of this would be even higher interest rates and, at some point, a larger increase in unemploy ment to get rid of the ingrained inflation. The Board’s priority is to do what it can to avoid this. Over recent times the Australian economy has been operating at a very high level of capacity utilisation. This is evident in survey measures of capacity utilisation (Graph 2). It is also evident in the labour market, which has been very tight, with the unemployment rate having been at its lowest level in nearly 50 years. It is clear that total demand in the economy has been pushing up against supply, and that, recently, this has been contributing to the upward pressure on prices. R E S E R V E B A N K O F AU S T R A L I A Graph 2 Spare Capacity % % Capacity utilisation* % % Unemployment rate * Non-mining capacity utilisation; investment share weighted. Sources: ABS; NAB; RBA. The return of inflation to target requires a more sustainable balance between aggregate demand and supply. The tool that the RBA has to achieve this balance is interest rates. I acknowledge that the use of this tool comes with complications. Its effects are felt unevenly across the community, with rising interest rises causing significant financial pressure for some households. But this unevenness is not a reason to avoid using the tool that we have. It is certainly true that if the Board had not lifted interest rates as it has done, some households would have avoided, for a short period, the financial pressures that come with higher mortgage rates. But this short-term gain would have been at a much higher medium-term cost. If we had not tightened monetary policy, the cost of living would be higher for longer. This would hurt all Australians and the functioning of our economy and would ultimately require even higher interest rates to bring inflation back down. So, as difficult as it is, the rise in interest rates is necessary to bring inflation back to target in a reasonable timeframe. The evidence indicates that the higher interest rates are working and that inflation is coming down. The March quarter CPI confirmed that inflation peaked late last year at 7.8 per cent (Graph 3). Subsequent to this, the monthly CPI indicator showed a pick-up in the 12-month-ended inflation rate in April to 6.8 per cent. This was a higher outcome than expected, but it has not changed our assessment that inflation is trending lower. Excluding the volatile items and travel from the monthly CPI, inflation was 5½ per cent in six-month-annualised terms to April, compared with 7½ per cent to October 2022 (Graph 4). Graph 3 CPI Inflation Year-ended % % Monthly indicator Quarterly -2 -2 Source: ABS. Graph 4 Monthly CPI Indicator* Six-month annualised, excluding volatiles and holiday travel % % -2 * -2 Seasonally adjusted; volatiles are fruit, vegetables and automotive fuel. Sources: ABS; RBA. There is also evidence of declining inflation pressures in global markets (Graph 5). Oil prices have reversed much of the increase following Russia’s invasion of Ukraine, as have the prices of many base metals. And wholesale food prices, including for wheat and beef, have declined considerably. Similarly, the price of international shipping has normalised after the surge during the pandemic. In time, these developments should be reflected in the prices paid by Australian households. R E S E R V E B A N K O F AU S T R A L I A Graph 5 Commodity Prices US$/b Oil index Shipping* Brent crude oil Container index Wheat* index Beef* * 2023 2019 January 2019 = 100; indices produced using the US dollar price, except for beef, which uses the Australian dollar price. Sources: Bloomberg; MLA; RBA; Refinitiv. Working in the other direction, services price inflation in Australia remains high, rents are increasing quickly and there will be further large increases in electricity prices this year (Graph 6). In addition, unit labour costs are increasing briskly, an issue I will return to in a few minutes. These developments mean that it is too early to declare victory in the battle against inflation. Graph 6 CPI Inflation Select components, year-ended % Market services % Rents % Electricity Administered prices % -10 -5 -20 -10 Sources: ABS; RBA. The path back to 2–3 per cent inflation is likely to involve a couple of years of relatively slow growth in the economy. Even so, as the Board navigates that path it is seeking to preserve as many of the gains in the labour market as is possible. One of the unsung positive side-effects of the policy response to the pandemic is a once-in-a-generation improvement in the Australian labour market. Over recent months, a higher share of Australians have had a job than ever before, and youth unemployment has been the lowest it has been in decades (Graph 7). There are very tangible economic and social benefits to this. Our ambition is to return inflation to target while holding onto as many of these benefits as possible. Graph 7 % Labour Market Employment-to-population ratio Youth unemployment rate % 2023 1983 Source: ABS. I want to make it clear, though, that the desire to preserve the gains in the labour market does not mean that the Board will tolerate higher inflation persisting. There is a limit to how long inflation can stay above the target band. The longer it stays there, the greater the risk that inflation expectations adjust and the harder, and more costly, it will be to get inflation back to target. If inflation stays high, this will damage the economy and all Australians will feel the effects. Yesterday’s decision to increase interest rates again was taken to provide greater confidence that inflation will return to target within a reasonable timeframe. It follows recent information that has suggested greater upside risks to the Bank’s inflation outlook. Services price inflation is proving persistent here and overseas, and the recent data on inflation, wages and housing prices were higher than had been factored into the forecasts. Given this shift in risks and the already fairly drawn-out return of inflation to target, the Board judged that a further increase in interest rates was warranted. In making this decision, the Board had a detailed discussion of the slowdown in household spending and the stresses on household finances from higher interest rates and rents. But it also considered the costs for households and the economy of inflation staying too high for too long. It is in Australia’s interest that we get on top of inflation and we do so before too long. The Board will do what is necessary to achieve that. As we make our decisions over coming months, there are a number of factors that the Board will be paying close attention to. I would like to briefly discuss four of these. The global economy The first is developments in the global economy. Economic growth in advanced economies is slowing as restrictive monetary policy takes effect. Even so, labour markets have been surprisingly resilient, with unemployment rates still close to multi-decade lows. Headline inflation is declining as COVID disruptions are overcome, energy prices fall and food price inflation eases. But, concerningly, core services inflation is proving to be persistent. In six-month-annualised terms, it is still above 6 per cent in the United States and 5 per cent in the euro area (Graph 8). R E S E R V E B A N K O F AU S T R A L I A Graph 8 Core Services Inflation Six-month annualised % United States % Euro area Sources: BLS; RBA; Refinitiv. This persistence in services price inflation reflects the strong demand for many services and strong growth in wages, against the background of weak productivity growth. One source of ongoing uncertainty is how quickly services price inflation globally will moderate and whether the needed moderation will require further increases in interest rates. It is noteworthy that interest rates are higher in the other English-speaking advanced economies than in Australia and are expected to go a little higher still. The other significant source of uncertainty for the global economy is the strength of the economic recovery in China. The economic indicators for China were weak in April, after a strong initial bounce-back following the easing of the COVID restrictions late last year (Graph 9). And consistent with an economy operating with a fair degree of spare capacity, inflation in China is much lower than in the rest of the world. This has implications for Australia, not just in terms of the prices of goods in world markets but also for the prices of our resource exports, which have declined of late. Graph 9 China – Economic Indicators* index Retail sales December 2019 = 100 index % % Headline inflation Year-ended -2 * -2 Seasonally adjusted by the RBA. Sources: CEIC Data; RBA. Household spending The second consideration is the strength of household spending domestically. In aggregate, growth of household spending has slowed since mid-2022 as the post-pandemic spending bounce faded and both higher interest rates and the cost-of-living pressures began to bite. We expect that consumption growth will remain subdued for some time for these same reasons, although stronger population growth will provide some offset to this. There is, however, ongoing uncertainty about the outlook for consumption given the large number of factors influencing household finances and spending. Employment has been rising strongly, people have been getting more hours of work and nominal income growth has been strong (Graph 10). These are all positives. In addition, the headwind for household spending from falling housing prices looks to be coming to an end and could be replaced with a tailwind from increasing housing prices. On the other hand, real incomes have declined and required mortgage payments as a share of household disposable income will reach a record high later this year. Many households will transition from low fixed-rate loans over the next few months and experience the increase in repayments that has been occurring for variable-rate borrowers. Rents are also increasing quickly, putting pressure on some households’ finances. Graph 10 Household Indicators $b Retail trade values* index Housing prices** % 90+ day arrears rates*** m Employment 1.0 13.5 0.8 13.0 0.6 12.5 0.4 * 2023 2019 12.0 Three-month moving average. ** January 2020 = 100. *** Housing and personal loan arrears; there is a structural break in March 2022. Sources: ABS; APRA; CoreLogic; RBA. Another complicating element is the very mixed experience across households and firms. Retail spending on goods has been weak but spending on many services has held firm. And the data that the banks share with us suggest that spending is most subdued among households with a mortgage, especially those that borrowed large amounts relative to their incomes over recent years, and households that rent. At the same time, some households accumulated large additional savings during the pandemic and have not run these down. Other households have very limited savings and few financial buffers. One of the other indicators we are monitoring closely is mortgage arrears. These remain very low, although they have increased a little of late. Banks report that their customers are managing to make their mortgage payments, although many have had to cut back on other spending. So, it is a complicated picture. R E S E R V E B A N K O F AU S T R A L I A Given the importance of household spending to the overall economy, the Board will continue to pay close attention to all these indicators. Growth in unit labour costs A third consideration that the Board is playing close attention to is the rate of growth in unit labour costs – that is, the difference between growth in nominal labour costs and productivity. This is because, over time, there is a close relationship between inflation and the rate of growth in unit labour costs. Over the entire inflation targeting period, the cumulative increase in the CPI has closely matched that in unit labour costs, although there have been periods of divergence (Graph 11). Graph 11 CPI and Unit Labour Costs March quarter 1993 = 100 index index Unit labour costs* CPI** * RBA measure; adjusted for JobKeeper subsidies in 2020–2021. ** Seasonally adjusted; excludes interest charges prior to the September quarter of 1998; adjusted for the tax changes of 1999–2000. Sources: ABS; RBA. In recent times, unit labour costs have been increasing quite strongly (Graph 12). Over 2022, they increased by around 7½ per cent, which is one the largest annual increases during the inflation targeting period. While the causation with inflation runs both ways, ongoing strong growth in unit labour costs would underpin ongoing high inflation outcomes. The best way to achieve a moderation in growth in unit labour costs is through stronger productivity growth, which would also underpin durable increases in real wages and our national wealth and make more resources available to fund the public services that people value. Graph 12 Inflation and Unit Labour Costs Year-ended % % Unit labour costs* CPI -5 * -5 RBA measure; adjusted for JobKeeper subsidies in 2020–2021. Sources: ABS; RBA. Unfortunately, growth in productivity has been weak over recent times. Indeed, the level of output per hour worked in Australia today is the same as it was in late 2019. This means there has been no net growth in productivity since then (Graph 13). Graph 13 Labour Productivity Non-farm GDP per hour, December quarter 2019 = 100 index index Sources: ABS; RBA. The reasons for this are not well understood. Productivity growth was slowing before the pandemic and it is entirely possible that the disruptions caused by the pandemic made things worse. Many firms had to focus on survival, rather than growing their business. Supply chains were interrupted, there was both labour hoarding and labour shortages, investment was delayed and finance tightened up. None of this was helpful for productivity growth. Offsetting this, there was innovation R E S E R V E B A N K O F AU S T R A L I A as firms found new ways of working, but it is unlikely that innovation of this kind offset the detrimental effects of COVID on productivity. The uncertainty here, is what comes next. It is possible that with the pandemic now behind us, productivity growth will pick up. Advances in science and technology, including increased digitisation and the use of artificial intelligence, could also help. So too could further improvements in the way that services are delivered as well as reforms to public policy. But there is considerable uncertainty here. What is critical are the trends over time, not the outcomes from quarter to quarter. At the aggregate level, wages growth is consistent with inflation returning to target provided that trend productivity growth picks up. Given the importance of this issue and the increased risks on this front, the Board will continue to pay close attention to trends in productivity growth and their implications for the sustainable rate of growth in nominal wages. Inflation expectations A fourth important consideration is inflation expectations. As I discussed earlier, if people expect inflation to stay high, then it is likely to stay high. Firms will adjust their pricing behaviour and workers will seek bigger pay increases to compensate them for the higher inflation. Currently, measures of medium-term inflation expectations derived from financial market prices are around the middle of the 2–3 per cent target range (Graph 14). The same is true for professional forecasters. This suggests that financial market participants and economists expect that the RBA will be successful in containing inflation over the years ahead. Graph 14 Long-term Inflation Expectations % % Unions* Inflation swaps** * Average over the next 5–10 years. ** 5-years to 10-years forward. Sources: Australian Council of Trade Unions; Bloomberg; RBA; Workplace Research Centre. Measures of expected medium-term inflation for price- and wage-setters in the economy are, unfortunately, more difficult to obtain. One measure is from a survey of union officials that the RBA has run for many years, where we ask for the expected inflation rate over the next 5–10 years. This measure has increased significantly, after being very low for a number of years, although it is at a level seen prior to the pandemic when inflation was close to its target. For households, the main data on inflation expectations relate to just the year ahead; we lack measures of medium-term inflation expectations. Understandably, given the elevated inflation rate at the moment and the forecasts for the next year, short-term inflation expectations are high at present. Due to the importance of inflation expectations remaining contained, the Board will continue to monitor all these measures closely. Finally, putting all this together, we remain on the narrow path but there are significant risks. We are particularly attentive to the risk that inflation stays too high for too long. If that happens, expectations will adjust, high inflation will persist, interest rates and unemployment will be higher and the cost-of-living pressures on Australian families will continue. The Board is seeking to avoid this. Yesterday’s further increase in interest rates provides greater confidence that inflation will come back to target within a reasonable timeframe. Some further tightening of monetary policy may be required, but that will depend upon how the economy and inflation evolve. The Board will continue to pay close attention to developments in the global economy, trends in household spending, and the outlook for inflation and the labour market. It remains resolute in its determination to return inflation to target and will do what is necessary to achieve that. Thank you and I am happy to answer some questions. Endnotes [*] I would like to thank David Norman for assistance in preparing this speech. R E S E R V E B A N K O F AU S T R A L I A | reserve bank of australia | 2,023 | 6 |
Speech by Ms Michele Bullock, Deputy Governor of the Reserve Bank of Australia, at the Ai Group, Newcastle, 20 June 2023. | Speech Achieving Full Employment Michele Bullock[*] Deputy Governor Speech at the Ai Group Newcastle – 20 June 2023 Introduction I would like to thank the Australian Industry Group for the invitation to speak at this lunch today. It is great to be in Newcastle. In recent times, my colleagues and I have spent a lot of time talking about the current bout of inflation in Australia and globally. The reason for this focus is clear: inflation is too high, and the longer this persists, the more damaging it becomes. It is in all our interests to bring inflation down and the Reserve Bank Board has been increasing the cash rate to achieve this. But just because our inflation objective has been in focus recently, it does not mean that the other part of our mandate – maintaining full employment – has become any less important. Full employment is, and has always been, one of our two main objectives. When discussing full employment, in the context of a central bank’s mandate, economists typically talk about the non-accelerating inflation rate of unemployment – the NAIRU. I will come back to this concept. But, more generally, full employment means that people who want a job can find one without having to search for too long. As I will emphasise later, the number of hours of work that people can secure is also important in defining full employment. It is hard to overstate the importance of achieving full employment. When someone cannot find work, or the hours of work they want, they suffer financially.[1] However, the costs of unemployment and underemployment extend well beyond financial impacts; work provides people with a sense of dignity and purpose. Unemploy ment – particularly long-term unemployment – can be detrimental to a person’s mental and physical health. The costs of not achieving full employment tend to be borne disproportionately by some groups in the community – the young, those who are less educated, and people on lower incomes and with less wealth. In fact, for these groups, improved employment outcomes and opportunities to work more hours are much more important for their living standards than wage increases. In my remarks today I want to focus on the Reserve Bank’s full employment objective, while also giving an overview of how the labour market has evolved in recent years and months. I will start by giving an update on current labour market conditions and how we got here. I will then discuss how we think about employment in the context of setting monetary policy and how we are striving to preserve many of the gains in Australia’s labour market while bringing inflation back to target. Finally, I will explain how getting inflation under control within a reasonable timeframe will give us the best chance of securing sustainable full employment into the future. How we got here Before offering some remarks on the current state of the labour market, I wanted to first reflect on how we got here. Let me take you back to early 2020, when the outbreak of the COVID-19 virus and the resulting public health response led to the sharpest deterioration in labour market conditions in many decades. Hundreds of thousands of Australians lost their jobs, and an equally large number were stood down or had their hours cut. This was a time of extreme uncertainty, with a deadly virus threatening people’s health and livelihoods and no vaccines in sight. There were credible projections that the unemployment rate would rise to 15 per cent, and our own forecasts from the time had the unemployment rate remaining high for several years (Graph 1). Many Australians were facing the prospect of a prolonged period of unemployment. Graph 1 Unemployment Rate* % % May 2020 SMP forecast Actual** * ** Shaded areas represent rough dates of previous labour market downturns. Quarterly data from 1959 to 1964 are spliced from historical national accounts data. Sources: ABS; RBA. Concerns about labour market ‘scarring’ were front of mind for policymakers during this period. The sobering experience from previous recessions had taught us that these episodes leave long-lasting marks on individuals, communities and the economy. There are many forms this can take. For example, if people stay unemployed for too long, their skills may deteriorate or become obsolete and their prospects for re-engaging in meaningful work may decline.[3] This can result in more people in long-term unemployment or, alternatively, people withdrawing from the workforce. Monetary and fiscal policy responded quickly to support the community and to reduce the likelihood of this outcome. The size of the policy response was large and was designed to insure against catastrophic economic outcomes – which it did.[4] A particular focus of the fiscal policy response was to keep employees attached to their jobs, even if there was little work for them during periods of lockdown. With the benefit of hindsight, however, some argue that policymakers here and around the world took out too much insurance. Nonetheless, it ultimately allowed us to avoid the long-term scarring effects on employment that had been a hallmark of previous recessions. It is also possible that the particular nature of the pandemic recession – driven by health restrictions and social distancing – allowed for a faster recovery than previous recessions. R E S E R V E B A N K O F AU S T R A L I A A remarkable recovery The pace and extent of the recovery has been remarkable – much faster than any previous downturn (Graph 2).[5] Labour market outcomes over the past three years have consistently exceeded the expectations of the Bank and other forecasters; the labour market has proved very resilient. Graph 2 Labour Market Underutilisation* Monthly change since the beginning of labour market downturn ppt ppt Previous downturns COVID-19 pandemic -3 -6 -3 * Months -6 The underutilisation rate is the sum of the unemployment and underemployment rates; labour market downturn is defined as the trough in the underutilisation rate. Sources: ABS; RBA. The share of the Australian population in employment has never been higher. The number of Australians in a job has increased by over 1.1 million since late 2021 and the level of employment is now almost 8 per cent above its pre-pandemic level. Almost all the gains in employment since the onset of the pandemic have been in full-time employment (Graph 3). Strong demand for labour has enabled many previously part-time employees to move into full-time work. This has allowed people to move closer to their preferred working hours, pushing the underemployment rate (which captures both those looking for more work and those looking to increase their current hours) to levels not seen since 2008. Graph 3 Employment Cumulative change since February 2020 ’000 ’000 Full-time Part-time -250 -250 -500 -500 -750 M J S D M J S D M J S D M J -750 Source: ABS. The rate at which people participate in the labour force is also at a record high. The rise in participation since the onset of the pandemic is mostly attributable to women entering (or re-entering) the labour force in large numbers. This has been underpinned by strong labour market conditions, more flexibility in working arrangements and a continuation of long-run trends. The unemployment rate has fallen sharply and is currently a little over 3½ per cent. Not only did the pace and extent of decline in unemployment surprise forecasters, the improvement since late 2019 has also been large compared with other countries (Graph 4). While this partly reflects Australia having had more spare capacity in the labour market than some other countries at the onset of the pandemic, these gains have been remarkable. So remarkable, in fact, that our judgement is that we are at or even perhaps above estimates of full employment for the first time in decades. I will come back to why we think this a little later. R E S E R V E B A N K O F AU S T R A L I A Graph 4 Unemployment Rates Change since December 2019 -2.0 New Zealand Germany -2.0 Japan -1.5 Sweden -1.5 United States -1.0 United Kingdom -1.0 China -0.5 Canada -0.5 Norway 0.0 Denmark 0.0 South Korea 0.5 France 0.5 Australia ppt Italy ppt Sources: ABS; RBA; Refinitiv. The benefits have been shared widely across the community One of the encouraging things about the strength in employment is how broadly based it has been across the country. It has not been confined to the cities or to individual states and regions. This has meant that the benefits of the strong labour market have been shared among many communities. The unemployment rate is at or below 4 per cent in three-quarters of all regions (Graph 5). Graph 5 Share of Regions with an Unemployment Rate Below 4 Per Cent* % % * 87 SA4 regions; unemployment rates smoothed. Sources: ABS; RBA. Newcastle is a prime example of a region that has undergone a considerable tightening in the labour market. At around 3 per cent, the unemployment rate for Newcastle is now considerably lower than it was prior to the pandemic and a fair bit lower than the nationwide unemployment rate (Graph 6). That translates to an additional 25,000 residents in this area having work. Messages we hear through the Bank’s liaison program in the Newcastle area are also consistent with what we are hearing elsewhere in the country: despite the slowing in economic growth, businesses are facing labour availability constraints stemming from a lack of suitable labour, high levels of job switching and a shortage of housing. Graph 6 Unemployment Rates % % Newcastle* Nationwide** * Smoothed using a 13-term Henderson trend. ** Seasonally adjusted. Sources: ABS; RBA. People on lower incomes and with less education have benefited most As has been the case in previous economic cycles, it has been people on lower incomes and with less education who have benefited the most from the strong labour market conditions.[7] Declines in unemployment since the onset of the pandemic have tended to be larger in local labour markets that had weaker labour market conditions to begin with. Labour market outcomes for people without any post-secondary education or training have also improved considerably. The labour market for younger people – whose opportunities for employment tend to decline most during recessions – has also improved by much more than at the aggregate level (Graph 7). Since late 2019, the decline in the unemployment rate of people aged 15–24 years has been more than double the size of the nationwide decline.[8] The fact that the youth labour market recovered so strongly upon the end of lockdowns helped to alleviate a key concern that policymakers held during the worst of the pandemic – that a cohort of Australians early in their working life would find themselves more permanently at a disadvantage when seeking employ ment in the future. R E S E R V E B A N K O F AU S T R A L I A Graph 7 Youth and Aggregate Labour Market Outcomes % % Unemployment rate Youth Total % % Participation rate Source: ABS. Tight labour market conditions have also enabled many people who were previously unemployed for long periods to find work. Over 2022, a record number (and share) of long-term unemployed persons found a job, and fewer exited the labour market as discouraged jobseekers (Graph 8). Furthermore, the tight labour market meant that the risk of becoming long-term unemployed declined significantly. Reflecting these positive developments, the long-term unemployment rate is currently close to its lowest level in decades. In many ways, what we have seen is the opposite of the ‘scarring’ concern I discussed earlier – people who would typically have trouble getting employment have, in fact, been drawn into work. Graph 8 Transition Rates* Over a month, 12-month trailing average % From long-term unemployment to % From short-term unemployment to Outside the labour force Employment Long-term unemployment * Data has been adjusted for sample attrition. Sources: ABS; RBA. It is important to note that not everyone has been able to reap the benefits of a tight labour market. Structurally high unemployment remains a problem in some parts of the country and among some groups, such as our First Nations Australians. These structural issues – which are a focus of the Australian Government’s Employment White Paper – are beyond the ability of monetary policy to address. Monetary policy’s primary role in supporting full employment over the longer term is to ensure that inflation remains low and stable. Although, as I hinted at earlier, it may have some impact at the margin if a strong labour market permanently lowers the unemployment rate that we typically associate with full employment. Developments in recent months In recent months, the balance between labour demand and supply has improved somewhat as the sharp increase in net arrivals from overseas may have helped to alleviate shortages in some areas and labour demand has moderated as the post-pandemic recovery has run its course. The significant tightening in monetary policy over the past year has also played a role in this, as intended. This moderation in labour demand can be seen in a range of indicators, such as job advertisements and employment intentions (Graph 9). The unemployment rate has also bottomed out, and there are signs that turnover is declining and labour shortages in some areas are easing. Nevertheless, the labour market remains tight, with many firms still finding it challenging to hire workers and there are still roughly as many vacancies as there are unemployed people. Graph 9 Job Ads and Employment Intentions Likert score % 1.0 2.4 Employment intentions* (LHS) 0.5 1.8 0.0 1.2 Job advertisements** (RHS) -0.5 -1.0 0.6 0.0 * Over the year ahead; smoothed using a 13-month Henderson trend. ** As a share of the labour force. Sources: ABS; Jobs and Skills Australia; RBA. Monetary policy and full employment So, how do we think about full employment in the context of setting monetary policy? I noted at the beginning that, simply put, full employment means that people are able to find a job without having to search for too long. This does not mean an unemployment rate of zero. There will always be frictions in the labour market that mean it takes time to find a suitable job, including because the skills required do not match the candidates available or there are structural impediments to employment. These issues are best addressed by government policies. For monetary policy, our price stability mandate requires a narrower concept of full employment. We think of full employment as the point at which there is a balance between demand and supply in the labour market (and in the markets for goods and services) with inflation at the inflation target; this is the level of employment that is sustainable with our price stability mandate in the longer term. Deviations from full employment have implications for price and wage growth. When labour demand outstrips supply, there will be upward pressure on wages growth and inflation (Graph 10). Conversely, when there is not enough demand, there is spare capacity in R E S E R V E B A N K O F AU S T R A L I A the labour market and downward pressure on wages growth and inflation. For this reason, our objectives of price stability and full employment are usually closely intertwined. Graph 10 Underutilisation, Wages and Inflation % % Underutilisation rate % % Wage Price Index* % % Trimmed mean inflation* * Year-ended. Sources: ABS; RBA. A key challenge that we face is that ‘full employment’ is not directly observable. Rather, we need to infer how close we are to full employment based on things we can observe. One way of thinking about this is in terms of the ‘non-accelerating inflation rate of unemployment’ or NAIRU. The idea is that, as described above, there is a short-run trade-off between inflation and unemployment – at lower levels of unemployment, wage and price pressures rise and vice versa at higher levels of unemployment. But, if unemployment remains too low for too long, inflation expectations will rise, which will make it that much harder for the monetary authorities to bring inflation back down. Hence the concept that there is an unemployment rate at which inflation is neither rising nor falling – the NAIRU.[10] But while the NAIRU is an important concept, it is only one of the ways the Bank assesses whether it is meeting its full employment objective. Because we cannot observe the NAIRU or full employment more generally, we use statistical models to infer how much spare capacity is in the labour market at any point in time, based on the signals we are getting from indicators like the unemployment rate, wages and inflation. These models only give a rough guide, and there is substantial uncertainty around the estimates they produce. They also do not account for the full array of supply shocks that can drive a wedge in the relationship between inflation and the labour market, such as those seen during the pandemic. An added complication is that ‘full employment’ is a moving target – it changes over time as the structure of the economy and labour market evolves. Aside from statistical models, we consider a broad range of indicators of conditions in the labour market. One of the most important of these is the underemployment rate, which I discussed earlier. The underemployment rate has grown in importance as a measure of spare capacity in the labour market over time and plays an increasingly significant role in our assessment of full employment.[13] The recent experience of a rapidly tightening labour market has also demonstrated the importance of other measures of labour market tightness, such as the number of job vacancies relative to jobseekers, and the share of workers who choose to switch jobs (Graph 11). Graph 11 Labour Market Tightness % Unemployment rate Underemployment rate % % Vacancies-to-unemployment % 4.0 Job mobility* 3.5 3.0 2.5 2.0 * 1.5 Proportion of employed persons who changed jobs. Sources: ABS; RBA. Our assessment is that, for the first time in decades, firms’ demand for labour exceeds the amount of labour that people are willing and able to supply. That is, employment is above what we would consider to be consistent with our inflation target. At the same time, with demand for goods and services high relative to the economy’s capacity to supply those things, inflation is well above the 2–3 per cent target range. As the Bank has highlighted frequently over the past year, high inflation makes life difficult for people and damages the functioning of the economy. It erodes the value of savings, hurts family budgets, makes it harder for businesses to plan and invest, and worsens income inequality. That is why the Board has been increasing the cash rate. One of the channels through which higher interest rates work to bring down inflation is by reducing the demand for goods and services and hence overall demand for labour. There are other channels too, but this channel is important. What this means is that labour market conditions will invariably soften as inflation is contained. Inflation versus employment Some may hear this and think that the Reserve Bank Board is prioritising its inflation objective ahead of its full employment objective. Although it is true that we are resolute in returning inflation to target, this does not mean that employment has taken a backseat. There are two important points to make here. The first is that the Board has been willing to accept a somewhat more gradual return of inflation to target than many other central banks. A faster return to target would likely mean more job losses in the short term. Our judgement is that if we can return inflation to target in a reasonable timeframe – while preserving as many of the employment gains as we can – that would be a better outcome. Indeed, our most recent forecasts have inflation returning to target by mid-2025, while employment growth slows but does not contract. The unemployment rate is expected to rise to 4½ per cent by late 2024 (Graph 12). While 4½ per cent is higher than the current rate, this outcome would still leave us below where it was prepandemic and not far off some estimates of where the NAIRU might currently be. In other words, the economy would be closer to a sustainable balance point. R E S E R V E B A N K O F AU S T R A L I A Graph 12 Labour Market Outcomes* % Unemployment rate Forecasts % 2015–2019 average % % Trimmed mean inflation** * Forecasts are as at the May 2023 Statement on Monetary Policy. ** Year-ended. Sources: ABS; RBA. Of course, these forecasts are subject to a considerable amount of uncertainty. We do not have a crystal ball – there will be developments in the future that none of us foresee. The second point is that we need to think about the consequences for the labour market of not getting inflation under control. Price stability is a prerequisite for a strong economy and full employment. Indeed, it is very difficult to sustain full employment without price stability. If high inflation were to become entrenched in people’s expec tations, it would be very costly to reduce later, involving even higher interest rates and a larger rise in unemploy ment. A deep and long-lasting recession would be likely, which would mean a substantial rise in the unemploy ment rate. Our goal is to return the labour market (and the market for goods and services) back to a level more consistent with full employment – something like the endpoint in our forecasts. We think this can be achieved if employ ment and the economy more generally grow at a below trend pace for a while. This would help to bring demand and supply into better balance and give us the greatest chance of securing sustainable full employment into the future. Thank you for your time. I am happy to take your questions. Endnotes [*] I am grateful to James Bishop and Jess Young for excellent assistance in preparing this speech, and to Alex Ballantyne for his valuable input and comments. Job loss can be financially costly for workers, particularly when a long-term job is lost. See Lancaster D (2021), ‘The Financial Cost of Job Loss in Australia’, RBA Bulletin, September. Mathers C and D Schofield (1998), ‘The Health Consequences of Unemployment: The Evidence’, Medical Journal of Australia, 168(4), 178–182. See also Cassidy N, I Chan, A Gao and G Penrose (2020), ‘Long-term Unemployment in Australia’, RBA Bulletin, December. See, for example, Day I and K Jenner (2020), ‘Labour Market Persistence from Recessions’, RBA Bulletin, September; Cassidy et al, n 2; Borland J (2020), ‘Scarring Effects: A Review of Australian and International Literature’, Australian Journal of Labour Economics, 23(2), 173–187; Kroft K, F Lange and MJ Notowidigdo (2013), ‘Duration Dependence and Labor Market Conditions: Evidence from a Field Experiment’, The Quarterly Journal of Economics, 128(3), 1123–1167; Cohen JP, AC Johnston and AS Lindner (2023), ‘Skill Depreciation During Unemployment: Evidence From Panel Data’, NBER Working Paper No 31120; Jarosch G (2021), ‘Searching for Job Security and the Consequences of Job Loss’, NBER Working Paper No 28481. Lowe P (2023), ‘Inflation and Recent Economic Data’, Keynote Address to the Financial Review Business Summit, Sydney, 8 March. This outperformance of previous downturns is also true of other labour market aggregates, such as the employment-topopulation ratio and unemployment rate. See Coates B and A Ballantyne (2022), ‘No One Left Behind: Why Australia Should Lock In Full Employment’, Grattan Institute Report No 2022-07. See der Merwe M (2016), ‘Factors Affecting an Individual’s Future Labour Market Status’, RBA Bulletin, December; RBA (2018), ‘Box B: The Recent Increase in Labour Force Participation’, Statement on Monetary Policy, May. Coates and Ballantyne, n 5. This is consistent with Dhillon Z and N Cassidy (2018), ‘Labour Market Outcomes for Younger People’, RBA Bulletin, June, which found that the unemployment rate for younger workers has a largely contemporaneous relationship with the aggregate unemployment rate but tends to move twice as much. A large body of evidence suggests that early-career labour market outcomes can affect future outcomes: see, for example, de Fontenay C, B Lampe, J Nugent and P Jomini (2020), ‘Climbing the Jobs Ladder Slower: Young People in a Weak Labour Market’, Productivity Commission Staff Working Paper, July; e61 Institute (2022), ‘The Effect of the Covid-19 Recession on the Youth Labour Market in Australia’, Discussion Paper, July. Treasury research found that when the youth unemployment rate goes up 5 percentage points, wages for graduates are around 8 per cent lower than they would have otherwise been, and remain depressed for years: Andrews D, N Deutscher, J Hambur and D Hansell (2020), ‘The Career Effects of Labour Market Conditions at Entry’, Treasury Working Paper No 2020-01. [10] For further discussion on the Reserve Bank’s NAIRU model, see Cusbert T (2017), ‘Estimating the NAIRU and the Unemployment Gap’, RBA Bulletin, June; Ellis L (2019), ‘Watching the Invisibles’, The 2019 Freebairn Lecture in Public Policy, University of Melbourne, 12 June. Treasury also maintains a NAIRU model: see Ruberl H, M Ball, L Lucas and T Williamson (2021), ‘Estimating the NAIRU in Australia’, Treasury Working Paper No 2021-01. [11] If you are interested in more information on these concepts, I refer you to our website where a number of explainers on employment and the NAIRU can be found. [12] For a discussion, see Ellis, n 10. [13] Underemployed workers represent additional labour supply that can be called upon before there is upward pressure on wages. See Chambers M, B Chapman and E Rogerson (2021), ‘Underemployment in the Australian Labour Market’, RBA Bulletin, June. [14] Lowe P (2023), ‘Monetary Policy, Demand and Supply – Transcript of Question and Answer Session’, Address at the National Press Club, Sydney, 5 April. Related Information • RBA (2023), ‘Unemployment: Its Measurement and Types’, Explainer. • RBA (2023), ‘The Non-Accelerating Inflation Rate of Unemployment’, Explainer. • RBA (2022), ‘The Costs of High Inflation’, Video, October. R E S E R V E B A N K O F AU S T R A L I A | reserve bank of australia | 2,023 | 6 |
Address by Mr Philip Lowe, Governor of the Reserve Bank of Australia, at the Economic Society of Australia (Qld) Business Lunch, Brisbane, 12 July 2023. | Philip Lowe: The Reserve Bank of Australia Review and monetary policy Address by Mr Philip Lowe, Governor of the Reserve Bank of Australia, at the Economic Society of Australia (Qld) Business Lunch, Brisbane, 12 July 2023. *** I would like to thank David Norman for assistance in preparing these remarks. Thank you for the invitation to address the Economic Society of Australia, here in Queensland. This is the fourth time that I have had the honour to do so, and it is a great pleasure to be back in Brisbane. Just a few months ago, the Australian Government released the findings of the independent review into the Reserve Bank. Since then, the Reserve Bank Board and staff have been working through the recommendations and their implications. Today, I would like to talk about where we are up to in that process and some of the changes we will be making. I will then finish with some remarks about last week's monetary policy decision. The Review concluded that Australia's current monetary policy framework is fit for purpose. The core elements of that framework are a central bank with operational independence and a flexible inflation target centred on 2–3 per cent. In my view, and that of the Review Panel, these arrangements have served the country well. The Review also concluded that the RBA has a dedicated staff who are focused on serving the public interest; they are skilled and professional and carry out their jobs to a high standard. Furthermore, the RBA is highly regarded internationally – something I hear often when I travel overseas. But as times change, we too need to change. The world we face is increasingly complex and it is right to re-examine how we make and communicate monetary policy decisions and how the RBA is managed. The Board and the Bank's staff have supported the Review, and we have been working constructively on the recommendations. Broadly speaking, the Review's recommendations cover three general areas: (i) the legislation the RBA operates under; (ii) our monetary policy processes and communication; and (iii) the way the RBA is managed as an organisation. The legislation is a matter for the Australian Government and the Parliament. The other two areas are largely for the Board and the Bank's management to consider, and so this is where I will focus today. Monetary policy processes and communication 1/6 BIS - Central bankers' speeches At its recent meetings, the Board has spent time discussing the Review's recommendations, particularly those that relate to monetary policy decision-making and communication. As a result of these discussions, we have decided on the following: 1. From 2024, the Board will meet eight times a year, rather than 11 times as is currently the case. Four of the meetings will be on the first Tuesday of February, May, August and November. The other four meetings will be held midway between these meetings. The exact dates for 2024 will be published soon and the dates for future years will be published well in advance. 2. The Board meetings will be longer than is currently the case. They will typically start on the Monday afternoon and then continue on the Tuesday morning. The outcome of the meeting will be announced at 2.30 pm on the second day, typically a Tuesday as is the case now. 3. All Board members will have the opportunity to attend an internal staff meeting some time before the Board meeting. This will allow them to hear directly from, and ask questions of, a broader range of staff. 4. The post-meeting statement announcing the decision will be issued by the Board, not, as is currently the case, the Governor. 5. The Governor will hold a media conference after each Board meeting to explain the decision. The media conference is expected to be held at 3.30 pm. 6. The quarterly Statement on Monetary Policy will be released at the same time as the outcome of the Board meeting (in February, May, August and November), rather than on the following Friday as is currently the case. Given this and other changes, we are reviewing the structure of this document. 7. The Board, rather than just the Governor, will be the signatory to the Statement on the Conduct of Monetary Policy, which is the document that records the common understanding on monetary policy between the RBA and the Australian Government. The new Statement is expected to be finalised later this year. 8. The Board will oversee the Bank's research agenda as it relates to monetary policy and aspects of financial stability. 9. The Bank will continue with its current approach to climate change analysis, focusing on the implications of climate change for the economy, inflation and the financial system. 10. The Board will work with the Treasury to undertake five-yearly open and transparent reviews of the monetary policy framework. Together, these changes are significant and represent a substantial response to the recommendations of the Review. The less frequent and longer meetings will provide more time for the Board to examine issues in detail and to have deeper discussions on monetary policy strategy, alternative policy options and risks, as well as on communication. Likewise, the staff will have more time for analysis, with less time spent preparing summaries of recent developments. The Board will also be able to hear directly from more staff and have greater opportunity to request work on particular topics. And the post-meeting media conferences will provide a timely opportunity to explain the Board's decisions and to answer questions. This will complement our existing communications, including through speeches with Q&A. Together, this is a significant package of reform that will contribute to better decision-making and communication. 2/6 BIS - Central bankers' speeches The Review also made a number of other recommendations that, in the Board's view, are best considered after the legislative process has been completed and the new Monetary Policy Board is up and running. This will avoid the current Board locking the new Board into a particular approach. These recommendations relate to: the publication of an unattributed vote count all Board members making regular public appearances to discuss their thinking and decisions on monetary policy the establishment of an expert advisory group to engage with the Board board papers being published with a five-year lag. These issues are interrelated. Practices differ across central banks, and they are often tailored to the country's particular circumstances and institutional structure. The current Board has therefore judged that these four issues are best considered by the new Monetary Policy Board as a package. In each of these areas, there is no universally accepted definition of best practice. The current Reserve Bank Board structure, and that recommended by the Review, is unusual by international standards. In almost every other central bank, most of the decision-makers are insiders – that is, they spend the bulk of their time inside the central bank. In our case, only two of nine Board members are insiders. The other seven spend the bulk of their time outside the RBA and this will remain the case. This is a significant difference between the RBA and other central banks. The Australian model has the advantage of ensuring there is diversity of thought and it helps bring a wider perspective to monetary policy decisions. However, it does have implications for the way those decisions are communicated and the appropriate accountability mechanisms. In my view, it is right to allow the new Board to consider these issues and make its own decisions after due deliberations. The Bank, together with members of the Council of Financial Regulators, has also been considering the recommendations that relate to financial stability. We have agreed to update the MoUs between the members of the Council and the RBA and APRA will also update our MoU to set out clear and specific commitments regarding cooperation. We also agreed that it was appropriate for the new Monetary Policy Board, once it was established, to consider the nature of formal advice from the RBA to APRA. Another issue that the Review Panel discussed was the management of Board members' potential conflicts of interest. Before speaking about this, I want to note that the Panel did not hear any evidence of problems in this area and I know from first-hand experience that the Board members take their responsibilities very seriously. Nevertheless, the Board has reviewed the Code of Conduct and agreed to strengthen the already strong standards by making it crystal clear that members, and entities they control, are prohibited from transacting in interest rate and foreign exchange derivatives and from active trading in financial instruments. These same restrictions already apply to the Bank's staff. The Board also agreed that the Code of Conduct should be reviewed again by the Monetary Policy Board after it is established. One overarching principle the Board has sought to apply in working through the various recommendations is that the RBA should be as transparent as it reasonably can in a 3/6 BIS - Central bankers' speeches way that is useful to the community. We want the community to understand what we are doing, why we are doing it and the factors we consider in making our decisions. The changes I have laid out are a significant step in this direction and the new Board will have the opportunity to consider the merits of further steps. Management of the RBA I would now like to turn to the recommendations that relate to how the Bank operates internally. These recommendations are very much focused on ensuring the RBA is an open and dynamic organisation. The Review Panel identified opportunities for us to further empower our staff, provide stronger leadership, create a more open culture that encourages constructive challenge, and make greater use of the staff's technical skills. This all makes a lot of sense and is consistent with changes we have been making over recent years. And while we have made progress here, the Review rightly points out that we have further work to do. We are now embarking on a significant program of cultural change with these objectives in mind. Some first steps include updating the leadership goals that apply to all managers to make it clearer that they are expected to create an inclusive environment where staff can share ideas in an open and constructive way. In addition, a comprehensive 360-degree feedback process for all senior leaders will be introduced in the year ahead and we are exploring deeper and more consistent leadership training. We have also begun advertising more management vacancies externally and we will increase transparency around internal opportunities for rotations. As part of this journey of cultural change, we are also reviewing the internal processes and structure that support the Board's decision-making. The Review recommended that we appoint a Chief Operating Officer to help achieve the objectives of being an open and dynamic organisation and to ensure our operations are efficient. This recommendation also makes sense. The Bank has become a more complex organisation over time and standards of governance continue to rise. We are currently working through the appropriate span of control and reporting lines of the Chief Operating Officer and will begin the search process for this role later this year. In related work, we are reviewing our risk management framework and seeking to embed the three lines of accountability model more thoroughly across the organisation. This work was prompted not only by the RBA Review but also by an external review we commissioned after a major technology outage last October. In response to this technology review, we are undertaking a major body of work to uplift the operational resilience of the nationally important payments infrastructure that the RBA operates. The Review also recommended that we elevate the communications function within the RBA. We are proceeding with this recommendation and will establish a separate Communications Department. This new department will, among other things, provide strategic communications advice to the Governor and the Board. It will also bring the Bank's various communications activities together, including our education programs. We will soon start the search process for an executive to lead this function. 4/6 BIS - Central bankers' speeches Together, the various changes that I have spoken about today represent a substantive and meaningful response to the RBA Review. They will enhance our decision-making and our communication and will help us be the open and dynamic organisation that we aspire to be. We have an important job to do on behalf of the Australian community. The Bank staff are committed to doing that job to the highest possible standard. These changes will help us do that. The Review also includes some other recommendations that I have not spoken about today. We are working through these and will report on progress in due course. Monetary policy I would now like to turn to the Reserve Bank Board's monetary policy decision last week. As you know, the Board decided to hold the cash rate target unchanged at 4.1 per cent. This decision will provide the Board with more time to assess the state of the economy and the economic outlook and associated risks. The decision to hold interest rates steady this month follows a cumulative increase of 4 percentage points since May last year. This is a significant and rapid tightening of monetary policy. It is working to establish a better balance of supply and demand in the economy and thus to bring inflation down. It is worth noting that central banks in most advanced economies have also been increasing interest rates for the same reasons. So, Australia is not alone here. The Board is very conscious that monetary policy operates with a lag and that the full effects of the tightening to date have not yet been felt. It takes time for households and businesses to adjust their spending and investment plans, and there are still significant resets of low fixed-rate loans to come. Given the lags, economic growth is expected to be subdued over the next couple of years and it will take time for inflation to return to target. It remains to be determined whether monetary policy has more work to do. It is possible that some further tightening will be required to return inflation to target within a reasonable timeframe. Whether or not this is required will depend on how the economy and inflation evolve. At its next meeting, the Board will have an updated set of economic forecasts from the staff as well as a revised assessment of the balance of risks. The Board will also have new readings on inflation, the global economy, the labour market and household spending to help inform its decision. Our priority remains to ensure this period of high inflation is only temporary. High inflation hurts all Australians and damages the functioning of the economy. It erodes the value of savings, makes it harder for businesses to plan and invest, and worsens income inequality. And if high inflation were to become entrenched in people's expectations, it would be very costly to reduce later, involving even higher interest rates and a larger rise in unemployment. It is for these reasons that the Board is resolute in its determination to return inflation to target within a reasonable timeframe and will do what is necessary to achieve that. 5/6 BIS - Central bankers' speeches Our most recent set of forecasts, which were prepared in early May, have inflation returning to the top of the target band in mid-2025. Data received since then had suggested that the inflation risks had shifted somewhat to the upside. The Board responded to this shift in risk with a further lift in interest rates. The Board is continuing to assess the central forecast and the risks and will conduct a full review at its next meeting in early August. As part of that review, we will be assessing the many cross-currents affecting the inflation outlook. On the one hand, there are ongoing pricing pressures from several factors, including: the high level of capacity utilisation; strong growth in unit labour costs (mainly because of weak productivity growth); a big pick-up in rents; and higher prices for electricity. But, on the other hand, there are several factors working in the other direction, contributing to the easing of inflation. These include: an easing of the COVID supply chain disruptions; a decline in commodity prices in global markets; and slow growth in aggregate demand, particularly in household consumption. The slow growth in demand is expected to lead to some rise in unemployment and a moderation in growth in unit labour costs. It is also expected to reduce cost pressures on firms and to lead to greater discounting than has been the case over recent times. So, it is a complex picture and there are significant uncertainties regarding the outlook. The Board decided that, having already increased rates substantially, it was appropriate to hold interest rates steady this month and re-examine the situation next month. Thank you very much for listening. I look forward to answering your questions. 6/6 BIS - Central bankers' speeches | reserve bank of australia | 2,023 | 7 |
Opening statement by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Canberra, 11 August 2023. | Philip Lowe: Opening statement - House of Representatives Standing Committee on Economics Opening statement by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Canberra, 11 August 2023. *** Chair and members of the Committee. My first appearance before this Committee was nearly 20 years ago and this is my 16th and final appearance as Governor. These hearings are a critical part of the accountability process for the RBA, and my colleagues and I take them very seriously. As always, we look forward to answering your questions. Inflation and the outlook The RBA's main focus over the past year or so has been to get on top of the highest inflation rate in more than 30 years. We have made progress here and things are moving in the right direction, but it is too early to declare victory. At the previous hearing, I spoke about why it was so important that inflation returns to target and that we ensure this episode of high inflation is only temporary. I would like to reinforce that message today. High inflation is corrosive to the healthy functioning of the economy and it makes life more difficult for everybody, especially those on low incomes. It increases income inequality and eats away at people's hard-earned savings. And, if high inflation does become ingrained in people's expectations, history teaches us that the end result is even higher interest rates and even greater unemployment to bring inflation back down. It is for these reasons that the Reserve Bank Board remains resolute in its determination to return inflation to the 2–3 per cent target range within a reasonable timeframe and will do what is necessary to achieve that outcome. Inflation in Australia peaked late last year at 7.8 per cent. Since then, it has declined to 6 per cent and we expect further declines over the quarters ahead. Our central forecast is for CPI inflation to be around 3¼ per cent by the end of next year and to be back within the 2–3 per cent target range by late 2025. Within the aggregate inflation figures there are divergent trends, as there are overseas. Goods price inflation has slowed considerably as supply chain issues have been resolved and the demand for goods has eased. By contrast, the prices of many services are continuing to increase strongly and the momentum in rent inflation is particularly strong. There are also large increases in electricity prices taking place in many parts of the country. Another common feature across countries is that the high level of demand for goods and services has meant that labour markets have been resilient and remain tight. Here in Australia, employment growth has been strong and the unemployment rate has been 1/5 BIS - Central bankers' speeches close to around 3½ per cent for a year now, which is the lowest level of unemployment for almost half a century. The participation rate is also at a record high, and many women and young people are benefiting from this. This is one of the positive legacies of the policy response to the pandemic and it is something we should all welcome. The recent data indicate that there has been some easing in the labour market, with firms reporting that it is less difficult to find workers than it was late last year. Nonetheless, employment growth is still strong at a time of rapid population growth. We expect employment to continue to grow, but below the rate of growth in the labour force. As a result, the unemployment rate is forecast to rise gradually to reach around 4½ per cent late next year. The Australian economy is currently experiencing a period of below-trend growth and this is expected to continue for a while yet. Many households are facing a painful squeeze on their budgets and consumer demand has slowed considerably, not least because high inflation is eroding people's real incomes. The increase in interest rates is also weighing on disposable incomes for many households, although others are benefiting from the higher interest earned on their savings. The RBA's staff are working hard to look beyond the aggregate figures and to understand where the financial pressures are most acute and the impact these pressures are having on people. It is clear that some households who borrowed at low interest rates during the pandemic are finding conditions very difficult, as are some renters. Looking forward, the Bank's central scenario is that economic growth remains subdued for the rest of this year before gradually picking up to around 2¼ per cent by end 2025. The ongoing moderation in inflation will mean that real incomes start rising again and this will ease the financial pressures that people are feeling. Business investment has also been in an upswing as firms respond to the pressures on capacity utilisation. And dwelling investment is expected to increase again next year, after the recent difficulties in that sector. Recent monetary policy decisions I would now like to turn to the Reserve Bank Board's monetary policy decisions since the previous hearing in February. Since that hearing, there have been six Board meetings. At three of those the Board raised interest rates by 25 basis points, and at the other three it held rates steady. Up until the April meeting, the Board had increased the cash rate at each of its meetings since May last year. In April, it left the cash rate unchanged at 3.6 per cent. It did this to provide time to assess the impact of the earlier increase in interest rates. Subsequently, the incoming data suggested that the inflation risks were moving to the upside and the Board responded with further increases in interest rates in May and June. Since then, at the July and August meetings, the Board held the cash rate steady at 4.1 per cent. Again, this was to provide time to assess the impact of the increases to date and the economic outlook and the associated risks. 2/5 BIS - Central bankers' speeches The Board is mindful that interest rates have been increased by a large amount in a short period of time and that there are lags in the operation of policy. Monetary policy is in restrictive territory and it is working to establish a better balance between supply and demand in the economy. Given this, and the uncertainties surrounding the outlook, the Board judged that the right thing to do for now was to sit and assess. Looking forward, it is possible that some further tightening of monetary policy will be required to ensure that inflation returns to target within a reasonable timeframe. Whether or not this is the case will depend upon the data and the Board's evolving assessment of the outlook and risks. It is encouraging that the recent data are consistent with inflation returning to target over the next couple of years. The data are also consistent with the Australian economy continuing to travel along that narrow path that I have spoken about for some time – that path is one that leads to inflation coming down within a reasonable timeframe and the unemployment rate remaining below the levels of the past 40 years. There are, however, uncertainties and risks that we need to remain attentive to. I would like to highlight two of these. The first is the outlook for household consumption, given the large number of factors influencing household finances and spending at the moment. Employment has been rising strongly, labour force participation is at a record high and people have been getting more hours of work. Housing prices are also rising in most of the country, and some households built up large additional savings buffers during the pandemic that are still there. These are all positives. On the other hand, the decline in real incomes and higher interest payments are squeezing the budgets of many households. And, while around one million borrowers have already transitioned from low fixed-rate loans to loans with higher interest rates, a similar number will make that transition over the next 18 months. Consumer confidence is low and rents are increasing quickly as vacancy rates are very low across the country. So, it is a complicated picture and there are scenarios in which consumption is weaker than our central case and others in which it is stronger, with implications for the trajectory of inflation. We are watching developments here very carefully. The second risk is that services price inflation may stay high, prolonging the period of inflation being above target. The high services price inflation reflects a combination of factors, including strong demand for services in the wake of the pandemic, stronger growth in nominal wages and incomes, and weak productivity growth. This weak productivity growth is a particular problem for many reasons. Amongst these is that, in combination with a high level of aggregate demand, it is adding to the upward pressure on prices. The RBA's forecasts have been prepared on the basis that growth in productivity picks up to be close to the rate in the years before the pandemic, which would contribute to a 3/5 BIS - Central bankers' speeches moderation in growth in unit labour costs and thus inflation. If this pick-up in productivity does not occur, all else constant, high inflation is likely to persist, which would be problematic. One related concern is that persistent high inflation could see inflation expectations adjust upwards. At the moment, medium-term inflation expectations remain well anchored, which is positive. But the longer inflation stays high, the greater the likelihood that businesses and workers will come to doubt that inflation will return to target and, in response, they will adjust their behaviour. This would make the task of controlling inflation more difficult and likely lead to a sharper slowing in output and a greater loss of jobs. The Board is seeking to establish a credible path back to the inflation target over the next couple of years to avoid a damaging shift in inflation expectations. It is also seeking to strike the right balance between getting inflation down in a timely way and preserving as many of the gains in the labour market as possible. With inflation having been significantly above target for some time now, the Board wants to have reasonable confidence that inflation will return to target over the current forecast period. We will do what is necessary to achieve that outcome. The RBA Review I would now like to turn to the RBA Review. Since the previous hearing, the government released the findings of the Review and we have responded to many of the recommendations. From next year, there will be eight interest-rate decisions a year, rather than the current 11. The Board meetings will be held over two days and the Governor will give a media conference after each meeting to explain the decision. The post-meeting statement will be issued by the Board rather than the Governor and the Board will have more opportunities to hear directly from staff. And the quarterly Statement on Monetary Policy will be released at the same time as the Board's decision, not on the subsequent Friday. Internally, we are making changes to support these new arrangements, including elevating our communications function. We also plan to appoint a Chief Operating Officer to help achieve the objective of the RBA being an open and dynamic organisation and that operations are as efficient as they can be. Another priority is to strengthen and extend the capabilities of the Bank's leaders. There are a small number of recommendations that the current Board considers are best dealt with after the legislative process has been completed and the new Monetary Policy Board is up and running. The most significant of these relate to the publication of unattributed votes, public appearances by all Board members and the publication of Board papers. My own view is that it makes sense to take the time to get the details right here. This is especially so given the structure of the proposed Monetary Policy Board is unique, being very different from arrangements elsewhere in the world. Most of its members will spend most of their time outside, not inside, the central bank and the Board will include the Treasury Secretary. Both aspects are unusual internationally. There are very good 4/5 BIS - Central bankers' speeches arguments for this structure, but it does have implications for how the new Board works and communicates. My view is that these issues are best dealt with by the new Board and Governor, who I am delighted to be sitting next to today. The government has made an excellent appointment and I wish Michele all the best as she leads the RBA through a period of significant change. Over recent months, the RBA staff have been working closely with Treasury on the recommended changes to the Statement on the Conduct of Monetary Policy and the Reserve Bank Act 1959. The changes to the Reserve Bank Act will be the most significant since this Act was passed by Parliament in 1959. It is an important piece of legislation that is critical to the future prosperity of Australians. So, again, it is important that time be taken to get the details right. I will finish there. My colleagues and I look forward to answering your questions. Thank you. 5/5 BIS - Central bankers' speeches | reserve bank of australia | 2,023 | 8 |
Text of the Sir Leslie Melville Lecture by Ms Michele Bullock, Deputy Governor of the Reserve Bank of Australia, at the Australian National University, Canberra, 29 August 2023. | null | reserve bank of australia | 2,023 | 9 |
Speech by Mr Philip Lowe, Governor of the Reserve Bank of Australia, at the Anika Foundation, Sydney, 7 September 2023. | Philip Lowe: Some closing remarks Speech by Mr Philip Lowe, Governor of the Reserve Bank of Australia, at the Anika Foundation, Sydney, 7 September 2023. *** I would like to thank all the RBA staff members who have assisted so ably with my many speeches over the years. I would like to begin by thanking you all for your support of the Anika Foundation. Your generosity is critical to the success of the Foundation's work helping young Australians. Thank you, in particular, to the National Australia Bank for the sponsorship of this event over recent years – your support is greatly appreciated and is making a difference. This is the seventh and final time that I have had the honour of addressing the annual lunch of the Anika Foundation. My 43 years at the RBA, and my seven years as Governor, finish next week – hence, the title of my talk today, 'Some Closing Remarks'. The government announced my appointment as Governor on 5 May 2016. It turned out to be the most challenging day of my life – not because of the trepidation I felt about taking on the job, but because of a medical emergency. I was in Ottawa, Canada, at the time. I had just spoken at a conference organised by the Bank of Canada and had been congratulated on my appointment. As I left the stage, I felt very tired from what I thought was overwhelming jet lag. But the next thing I recall was that I was in a room with bright lights wearing just a flimsy gown. As I was trying to make sense of where I was, I thought about something I had previously read on the internet: that there was a secret society of central bank governors and that it had some strange initiation practices. I recall thinking maybe it is true here in Canada! But I was wrong – I can assure Michele there is no such society or initiation ceremony. Instead, the Canadians were into world-class health care. Unbeknown to me, the carotid artery in my neck had split, probably because of the way I had slept on the plane. This had led to a blood clot with potentially fatal consequences. But the fast action of the Bank of Canada staff and the excellent care at Ottawa Hospital got on top of this situation. Seven years later, I am finishing my term fit and healthy. I recount this story because it reinforced two lessons for me that have influenced how I have gone about my job. The first lesson is that uncertainty is a fact of life and we need to manage it – none of us has a crystal ball and the unexpected happens. The second is that there is a lot to be grateful for – that indeed, the glass is at least half full. I have had the great privilege of working with a group of very talented people at the RBA who are dedicated to serving the interests of Australians. I have also had the privilege of being the Governor of a widely respected central bank in a country that 1/7 BIS - Central bankers' speeches enjoys one of the highest living standards in the world. It is a challenging job, but an immensely rewarding one. Over my term as Governor there have been three main economic challenges that I have had to deal with. The first was a protracted period of inflation being a bit below target. The second was a global pandemic. And the third was the highest inflation rate in more than 30 years. None of these events were widely predicted and none were unique to Australia. Notwithstanding these events, underlying inflation has averaged 2.7 per cent over my term; in headline terms, inflation has averaged 3 per cent. These numbers are above the midpoint of the 2–3 per cent target range, but they are within that range and inflation expectations have been well anchored. Even so, inflation has been more variable over my term as Governor than it was in the previous two decades; over the past seven years, inflation has varied from a low of –0.3 per cent to a high of 7.8 per cent. My view is that it will be difficult to return to the earlier world in which inflation tracked in a very narrow range. The increased prevalence of supply shocks, deglobalisation, climate change, the energy transition and shifts in demographics mean either steeper supply curves or more variable supply curves. While this doesn't mean that the inflation target can't be achieved on average, it does mean that inflation is likely to be more variable around that target. In terms of the labour market, when I became Governor in 2016 the unemployment rate was in the 5½–6 per cent range. Over the past year, it has been around 3½ per cent – the lowest rate in nearly 50 years. The share of Australians with a job has never been higher than it is today and the number of people with a job has increased by more than 2 million since mid-2016. The current cycle still has way to run, but it is possible that Australia can sustain unemployment rates below what we have had over the past 40 years. If so, this would be a very good news for both the economy and our society. Notwithstanding these outcomes, the issue that has defined my term more than any other is the forward guidance about interest rates that was provided during the pandemic. That guidance was widely interpreted as a commitment, rather than a conditional statement, that interest rates would not increase until 2024. As you know, interest rates started being increased in May 2022 and there has been much criticism since, especially by those who borrowed during the pandemic based on our guidance. There is a lot to be learned from this experience, including about how to communicate in uncertain times. But I ask that people keep in mind the circumstances we faced in 2020. It was a very scary time. An unknown virus was sweeping the world, our international borders were closed, people couldn't move across state lines, we were being told to stay in our homes, temporary morgues were being set up, and a vaccine was thought to be years away. There were credible projections that the unemployment rate would rise to 15 per cent and that there would be a deep and lasting economic contraction. And even well into 2021 large parts of country were still in stringent lockdowns. The government and the RBA responded forcefully to the pandemic. At the RBA, we wanted to do what we could to build a bridge across to better times and to provide 2/7 BIS - Central bankers' speeches some insurance against the very worst outcomes. I know that the government had a similar mindset. This approach worked. The Australian economy avoided falling into the abyss and then bounced back well. With the benefit of hindsight, my view is that we did do too much. But hindsight is a wonderful thing. None of us can predict the future and we have had to make decisions under great uncertainty and with incomplete information. We got some things right, but we got other things wrong. I can assure you, though, that the staff of the RBA and members of the Reserve Bank Board have been relentless in their pursuit of doing the right thing and supporting the economic prosperity of the people of Australia. And I will leave the RBA after 43 years proud of our contribution to the stability of both our economy and financial system. Without a crystal ball, I have found it helpful over the years to return to some fixed points. I would like to return to four of these again today. Strong frameworks for policy The first is the importance of strong, credible frameworks for economic policy. For monetary policy, this means a strong nominal anchor in the form of a medium-term inflation target. And for fiscal policy, it means a credible fiscal framework that deals with the medium term and the intertemporal budget constraint. Since the early 1990s, Australia has been well served by a flexible inflation target centred on 2 to 3 per cent. This target has successfully anchored inflation expectations and provided the organising framework for monetary policy decisions. We have seen the benefits of this anchor over the past year or so; without it, we would have faced a much more challenging environment. At one point during my term, when inflation was low, there were calls to lower the target. And recently, some have called for a higher target, hoping to avoid the costs of disinflation. I have consistently argued against such calls. It wouldn't be much of a nominal anchor if the target was moved just because the tide was running in one direction for a while. People would rightly wonder what would happen when the tide ran the other way. Having chosen a target, it is best to keep with it unless there is a compelling case for change, which there is not. For fiscal policy, an anchor is also important. Governments face many demands on their budgets and when they borrow today, they need to be able to service that debt into the future. Some countries have not dealt with this intertemporal aspect of fiscal policy very well and public debt levels have kept rising, storing up problems for the future. Australia has done better on this front, but we are not immune to the pressures on the public purse and these pressures are growing. Given this, a strong commitment to a fiscal framework that addressed the intertemporal budget constraint would help. A credible medium-term framework is also useful in the area of infrastructure investment. Australia's growing population means that we need to keep investing in public assets. Some years ago, I spoke about my concerns that we were not doing 3/7 BIS - Central bankers' speeches enough here, partly due to governments seeking to avoid taking on debt. More recently, my concern has been that we were seeking to do too much, in too short a time. A wellestablished framework, based on rigorous independent cost-benefit analysis, would help the country plan and sequence public investment. It would also lower risk premiums on private-sector investments and give the public greater confidence that money was being spent wisely. Monetary and fiscal policy coordination A second fixed point that I have returned to is that we are likely to get better outcomes if monetary policy and fiscal policy are well aligned. My view has long been that if we were designing optimal policy arrangements from scratch, monetary and fiscal policy would both have a role in managing the economic cycle and inflation, and that there would be close coordination. The current global consensus is that monetary policy is the main cyclical policy instrument and should be assigned the job of managing inflation. This is partly because monetary policy is more nimble and it is not influenced by political considerations. Raising interest rates and tightening policy can make you very unpopular, as I know all too well. This means that it is easier for an independent central bank to do this than it is for politicians. This assignment of responsibility makes sense and it has worked reasonably well. But it doesn't mean we shouldn't aspire to something better. Monetary policy is a powerful instrument, but it has its limitations and its effects are felt unevenly across the community. In principle, fiscal policy could provide a stronger helping hand, although this would require some rethinking of the existing policy architecture. In particular, it would require making some fiscal instruments more nimble, strengthening the (semi) automatic stabilisers and giving an independent body limited control over some fiscal instruments. Moving in this direction is not straightforward, but some innovative thinking could help us get to a better place. During my term, there have been times where monetary and fiscal policy worked very closely together and, at other times, it would be an exaggeration to say this was the case. The coordination was most effective during the pandemic. During that period, fiscal policy was nimble and the political constraints on its use for stabilisation purposes faded away. And we saw just how powerful it can be when the government and RBA work very closely together. There are some broader lessons here and I was disappointed that the recent RBA Review did not explore them in more depth. The importance of lifting productivity A third fixed point that I have returned to is the importance of lifting productivity growth. 4/7 BIS - Central bankers' speeches I come back to it because productivity growth is central to our future prosperity. It means rising living standards, higher real wages, a lift in our collective wealth, a bigger pie to help finance the public services the community values and less inflation pressure. It makes most things easier. Unfortunately, the recent productivity record isn't encouraging. There have been many investigations into the underlying causes and what to do about this. So, there is no shortage of ideas, including in the areas of tax, human capital accumulation, energy and infrastructure, the design of our cities, the approach to regulation and competition policy, industrial relations and the provision of government services. There are improvement opportunities in all these areas. The problem is not a lack of ideas. Instead, it is in building the consensus within society to implement some of these ideas. This is, fundamentally, a political problem, and it is a major problem. If we can't build a consensus for changes, the economy will drift and there is a material risk that our living standards will stagnate. A related theme is the link between wages, inflation and productivity growth. For inflation to average 2½ per cent, we would expect that, on average, wages increase at the rate of productivity growth plus 2½ per cent. Given that the distribution of national income between wages and profits can and does vary, this relationship is not a hard and fast rule, but it is a reasonable benchmark. Early in my term, I drew attention to the low rate of wages growth, something I saw as a problem. Wages growth of around 2 per cent was contributing to inflation below target and there was a concern that workers were not getting their share of the benefits of productivity growth. At the time, I spoke about a diminished sense of shared prosperity and the dangers this posed. We are now in an environment of stronger growth in nominal wages, which is positive. My recent focus has been the risk that the period of high inflation could lead to wages growth and profits running ahead of the rate that is consistent with a sustainable return of inflation to target. While recent data provide some comfort on this front, we need to remain alert to this risk for if it were to materialise, inflation would become sticky, which would require tighter monetary policy and more economic pain later on. A lift in productivity growth will certainly be helpful here, allowing stronger growth in nominal and real wages and profits. Monetary policy, credit and asset prices The fourth fixed point that I have returned to is the link between monetary policy, credit growth and asset prices. There are two issues I want to highlight here. The first is that monetary policy can't ignore credit growth and asset prices. It is worth recalling that prior to the pandemic, economic cycles were increasingly being driven by developments on the financial side of the economy – that is, by swings in credit and asset prices. My view has long been that central banks shouldn't target credit growth or asset prices, but neither can they ignore them. Interest rates directly influence 5/7 BIS - Central bankers' speeches how much people want to borrow and the value of assets. This means that central banks can't wash our hands of what is happening on the financial side and we need to work closely with the prudential authorities to contain the build-up of financial and macroeconomic risk. Prior to becoming Governor, I wrote papers on the dangers of lowering interest rates when the economy was growing well and asset prices were surging, but inflation was a bit below target. I was concerned that the desire to get inflation up a bit with lower interest rates would encourage even more borrowing and over-valued asset prices, increasing the risk of instability down the road. I wrote about the importance of having a medium-term focus and the benefits of policies other than monetary policy providing a helping hand in ensuring that inflation was consistent with the target. Today, we obviously face a different set of challenges, but we could face this set of issues again. This means that it is still important to think through the right policy response in this situation, including how prudential and fiscal policies could help. There are limits to what monetary policy alone can do. The second point is that interest rates influence housing prices, but they are not the reason that Australia has some of the highest cost of housing in the world. It is certainly the case that the structurally lower nominal interest rates that followed the return of low inflation in the early 1990s contributed to the increase in housing prices. But the reason that Australia has some of the highest housing prices in the world isn't interest rates, which have been at roughly similar levels across most advanced economies. Rather, it is the outcome of the choices we have made as a society: choices about where we live; how we design our cities, and zone and regulate urban land; how we invest in and design transport systems; and how we tax land and housing investment. In each of these areas, our society and politicians have made choices that lead to high urban land and housing costs. It is by tackling these issues that we can address the high cost of housing in Australia, which I view as a serious economic and social problem. In summary then, in the absence of a crystal ball, these are four of the fixed points that I have returned to during my time as Governor: the importance of strong credible frameworks for economic policy; the benefits of monetary and fiscal policy coordination; the necessity of lifting productivity growth; and the need to pay attention to developments in credit and asset markets. In addition to these points, there are many other points that have been attributed to me, including: a promise that interest rates would not go up until 2024; everybody needs to get a flatmate; people need to work more hours to make ends meet; and young adults should stay at home because of the rental crisis. Yet, I did not make these points. Nor did I choose Justin Timberlake's Can't Stop the Feeling to accompany me as I walked a recent podium. My experience here highlights the difficulties of communicating in the social media and digital age. Despite these difficulties, I have always felt a responsibility to explain complex ideas, and the trade-offs and uncertainties we face. I know that some of my explanations have missed the mark. But the media has a responsibility too. My view is 6/7 BIS - Central bankers' speeches that we will get better outcomes if the public square is filled with facts and nuanced and informed debate, rather than vitriol, personal attacks and clickbait. As a society, we have got work to do here. I would like to close by wishing Michele and her team all the best. When Glenn Stevens was completing his term as Governor he presented me with a gift – his glass half full (or strictly speaking, his coffee mug half full). With Glenn's permission, I would like to regift this to the next Governor. Michele, I do so in the hope that as you navigate the uncertainties ahead, you will remember that that glass is indeed half full and that we have a lot to be fortunate about here in Australia. Finally, thank you for listening and for your support of the Anika Foundation. I look forward to answering your questions for one final time. 7/7 BIS - Central bankers' speeches | reserve bank of australia | 2,023 | 9 |
Address by Mr Christopher Kent, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to Bloomberg, Sydney, 11 October 2023. | Speech Channels of Transmission Christopher Kent [ * ] Assistant Governor (Financial Markets) Address to Bloomberg Sydney – 11 October 2023 I want to thank Bloomberg for organising this event. It’s great to be back at this venue. Since May 2022, the Reserve Bank has raised the cash rate target by 400 basis points with the goal of bringing inflation back into its target range of 2–3 per cent. Tighter monetary policy is working to slow the growth of demand and bring it into better balance with supply. This is contributing to the decline in inflation. Today I want to show how increases in the Bank’s cash rate target are transmitting through to demand and inflation. The most well-known element is the cash-flow channel, whereby a rise in the cash rate leads to higher interest payments for those who have debt, reducing the income borrowers have to spend on other things, leading to slower growth of demand and ultimately a decline in inflation. The cash-flow channel is felt with immediacy by borrowers with variable-rate debt and then with a lag for those with fixed-rate debt. It is this channel that is being felt most keenly at present, with many indebted households and businesses experiencing a painful squeeze on their finances. While this burden falls on only part of the population, there are other channels of monetary policy that spread across a broader range of people. Indeed, in economies such as the United States where a sizeable share of borrowing – particularly mortgages – is at rates fixed over very long periods, these other channels of monetary policy do most of the heavy lifting. My talk today will focus on how monetary policy moves through the economy in three steps – from the cash rate to a broad range of interest rates, from those rates to economic activity and from economic activity to inflation. I will discuss the five main channels of monetary policy and the impact these are having in Australia to bring down inflation. Step 1: From the cash rate to other interest rates The cash rate is the interest rate paid by banks that borrow from other banks in the overnight market. It is closely linked to other interest rates throughout the economy. When banks borrow at slightly longer terms – of say a month – they pay a similar rate of interest (to what they expect the cash rate to be over that time). If they faced a much higher rate, they would be better off borrowing overnight in the cash market and rolling that each day for the month. Going the other way, banks can leave spare cash with the RBA at the Exchange Settlement (ES) rate, which is just below the cash rate target. As such, they will be willing to lend spare cash to other banks so long as they get more than the ES rate in return. For these reasons, short-term interest rates are closely linked to the cash rate (Graph 1). Australian banks typically fund themselves with debt that pays interest linked to short-term interest rates – the three-month bank bill swap (BBSW) rate to be precise. Therefore, changes in the cash rate have a direct effect on banks’ funding costs. Banks pass this on to borrowers with variable-rate debt. Graph 1 Banks have also passed on much – though not all – of the rise in the cash rate to depositors. Since May 2022, Australian banks have passed on about 75 per cent of the increase in the cash rate to deposits, which is in line with past phases of rising interest rates. In fact, the extent of this pass-through to deposit rates has been relatively high compared with other economies (Graph 2). In New Zealand, for example, the equivalent figure is about 50 per cent, while in the United States it is about 35 per cent. Among other things, this difference may reflect Australian banks’ focus on variable-rate borrowing and lending. Graph 2 Bank Deposit Pass-through* Share of increase to policy rates passed through to deposit rates % % Australia * UK Norway NZ US Canada The cumulative change in average outstanding deposit rates divided by the cumulative change in policy rates from the start of each country’s post-pandemic hiking phase until end-August 2023. Sources: APRA; central banks; RBA. The link to the cash rate is not as tight for longer term interest rates. A higher cash rate usually results in long-term interest rates and yields rising, but by less than the cash rate. This is because other factors affect long-term rates, including yields offshore and expectations for the cash rate and inflation beyond the near term. Longer term yields are more important for the transmission of monetary policy in some economies such as the United States, where a lot of borrowing is at long-term fixed rates. They are much less important in countries like Australia where most borrowing is variable rate. That said, because changes in long-term interest rates have important effects on the valuations of other assets like equities, corporate bonds and the exchange rate, they are still relevant to the transmission of policy in Australia. I will come back to this point later. Step 2: From interest rates to economic activity Economists typically think of five channels through which monetary policy – via both current and expected future policy rates – affects economic activity and inflation. These are: 1. the cash-flow channel 2. the intertemporal substitution channel 3. the asset-price channel 4. the credit channel 5. the exchange rate channel. The cash-flow channel When interest rates go up, households pay more on their debt and earn more on their savings. Because the cash-flow channel is so noticeable, and felt so keenly by borrowers, it gets a lot of attention, particularly in Australia where most borrowing and much saving is done at variable rates. And even for borrowing that is at fixed rates, these tend to be for three years at most, which is short compared with many other economies. Since last May, required household mortgage payments – interest plus scheduled principal repayments – have risen from around 7 per cent of household disposable income to almost 10 per cent. This is above estimates of the peak reached in 2008 when the cash rate was 7¼ per cent. And for those households with a large mortgage, required payments are a much higher share of their income. Required payments will continue to rise a little further in the period ahead as fixed-rate loans taken out during the pandemic reach the end of their fixed-rate period. The share of such loans has already fallen substantially, from close to 40 per cent in early 2022 to about 20 per cent today. Many borrowers have had to cut back on spending to meet higher mortgage payments, while also feeling the pain of rapidly rising living costs. This has led to slower growth in demand for goods and services. Businesses with high levels of debt may also have reined in their investment spending. Conversely, households that have savings are now earning more interest and may spend more in response. To some degree, this counterbalances the households that are spending less. However, the stock of household debt in Australia is larger than the stock of household savings. Since rates have been rising, the contribution of interest received by those with savings to the growth of disposable income (the yellow bars in Graph 3) has been noticeably smaller than the extra interest payments made by those with debt (in orange). Moreover, people with savings typically spend less of each extra dollar they earn than those with debt, so any additional spending associated with extra interest received is not enough to offset the reduction in spending associated with extra interest paid. Graph 3 Household Disposable Income Growth Real, year-ended with contributions % % -5 -5 -10 -10 -15 Total Labour income Prices Interest payable Interest receivable Tax payable -15 Other net income Sources: ABS; RBA. Our estimates suggest that the 4 percentage point increase in the cash rate target since May 2022 will have reduced overall household spending by around 0.4–0.8 per cent per year through the cash-flow channel. Studies imply similar-sized effects in other countries with high levels of variable-rate debt. [ 1] Again, the cash-flow channel is less prominent in economies where most debt is locked in at fixed rates for lengthy periods (Graph 4). In the United States, mortgages are typically fixed for 30 years. That said, when rates are falling, existing US borrowers tend to refinance, while rising interest rates dampen the demand for new loans and turnover in the housing market declines, thereby reducing a range of associated spending. Monetary policy is still effective in such economies, including through the cash-flow channel, but it operates more intensively via other channels. Graph 4 Changes in Policy and Mortgage Rates* bps Policy rates Outstanding mortgage rates** US bps Canada Norway UK Australia NZ -100 S D M J S D M J S D S D M J S D M J S D * Cumulative basis point increase in the policy rate and average outstanding mortgage rate relative to the month immediately preceding first policy rate increase since the onset of the pandemic. ** Data for the US is interpolated between September 2022 and June 2023, Canada data to July 2023, and remainder to August 2023. Sources: APRA; Black Knight; central banks; RBA. -100 The intertemporal substitution channel Changes in interest rates also affect the incentive to spend versus save, through what is known as the intertemporal substitution channel (or the savingsinvestment channel). [ 2] For businesses, the interest rate affects the cost of capital, which helps to determine whether and when they’ll invest. For households, higher interest rates provide an incentive to save more today and postpone consumption and dwelling investment until another time. There is mixed evidence on the extent to which interest rates affect business investment in Australia directly. It can be difficult to find a relationship in the aggregate data. [ 3] But studies using firm-level data do suggest that business investment responds to changing interest rates. [ 4] Recent Bank model estimates imply that the 4 percentage point increase in the cash rate might contribute to business investment being around 4 per cent lower than otherwise after two to three years. [ 5] Dwelling investment typically responds quickly to changes in interest rates. Fewer homes are built and renovation activity declines when interest rates rise noticeably (Graph 5). This is the intertemporal substitution channel at work – people are saving their money and putting off major spending to a later date. That said, the asset-price and credit channels are also likely to be at play here. Graph 5 Private Dwelling Investment Quarterly, year-ended growth % % Cash rate target -5 -5 Dwelling investment -10 -10 Sources: ABS; RBA. In the current cycle, higher interest rates may have also played a role in slowing the rate at which many households have run down the sizeable stock of additional savings accumulated during the pandemic. This would contribute to slower growth of consumption than otherwise. In fact, the household savings ratio in Australia has only recently dipped below the pre-pandemic average after having been well above that for most of the pandemic period (Graph 6). Graph 6 Household Savings Gross savings rate, quarterly % % Additional savings 2014–2018 average Sources: ABS; RBA. The asset price channel A rise in interest rates contributes to lower asset prices. This is because asset prices – for shares, bonds and housing – depend on the discounted value of the expected future cash flows such assets produce (namely, dividends, coupon payments and rental income). A rise in interest rates increases the discount factor and hence lowers asset prices and in turn household wealth. [ 6] While details vary, empirical studies suggest that changes in wealth lead to changes in consumption. For Australia, various estimates suggest that each 1 per cent decline in wealth results in a fall in consumption of around 0.1–0.2 per cent, well within the range of estimates for other countries. [ 7] However, other factors also have an impact on asset prices. Indeed, while housing prices in Australia declined during the initial period of monetary policy tightening through 2022, they have been rising over much of this year even though credit growth has slowed and monetary policy has been tightened further. This is likely to owe, at least in part, to the surge in population growth combined with a relatively low level of new construction. [ 8] The credit channel Higher interest rates can also reduce the supply of loans to households and the availability of external funding to businesses, via the credit channel. Higher interest rates tend to make lending more risky, especially to lower net worth borrowers. It also makes it more costly for businesses to borrow at a time when weaker economic conditions are weighing on their ability to generate profits (which could otherwise help them to fund investment). Increases in the riskiness of the underlying loans will also raise banks’ funding costs. To the extent that some households and businesses are offered smaller loans than they would otherwise have preferred, and on less favourable terms, this will result in less borrowing and so slow the growth of overall demand. One way the credit channel operates in Australia is via the serviceability assessment that banks apply when deciding how much to lend to prospective borrowers. Under these assessments, the increase in the cash rate since May 2022 has seen the borrowing capacity for a typical household fall by around 30 per cent. [ 9] Accordingly, housing loan commitments have fallen by around the same amount since early 2022, although other factors such as lower demand for credit may also be playing a role (Graph 7). Graph 7 Housing Loan Commitments Seasonally adjusted; excluding refinancing $b Value Share of housing credit % 2.25 1.50 0.75 0.00 Sources: ABS; APRA; RBA. The exchange rate channel The exchange rate channel can be important, particularly for a small open economy like Australia. All else equal, a rise in Australian interest rates relative to interest rates offshore increases the demand for Australian assets and so increases the value of the Australian dollar. By itself, an appreciation of the Australian dollar will reduce the prices Australians pay for foreign goods and services, and increase the prices foreigners pay for goods and services produced here. So an appreciation of the Australian dollar would contribute directly to lower Australian inflation via lower prices for imports. It would also encourage both Australians and foreigners to divert some of their spending from goods and services produced here to those produced offshore. In the context of high inflation and demand that is greater than the economy’s capacity to supply goods and services, this diversion of spending offshore would be helpful. [ 10] But of course all else is not equal. While Australian interest rates have been rising to combat inflation, interest rates overseas have been rising for the same reason. As a result, despite increases in Australian interest rates from May 2022, the Australian dollar has depreciated by just a little more than 2 per cent on a trade-weighted basis since then. Other global developments have also played a role. In particular, over recent months there have been rising concerns about the economic outlook for China, which is a major user of Australian commodities and is our largest trading partner. Nevertheless, by raising the cash rate, monetary policy has helped to support the value of the Australian dollar in the face of these other influences. Step 3: From economic activity to inflation The first step of the transmission of the cash rate to other interest rates and the exchange rate is quick. The second step takes time, with changes in interest rates affecting the growth of demand via the various channels I’ve discussed. The third step – the link to inflation – takes longer still, with growth in demand typically slowing before there’s a broad-based reduction in inflation. The past year or so has been an exception to this, given that some of the sharp increase in inflation and then subsequent decline has reflected problems in global supply chains that are now resolved or improving. Nevertheless, the effect of slower demand growth on inflation is now building. For example, we are hearing in liaison that a range of retailers are discounting prices in the face of weak consumer spending. Which channel matters most? It is difficult to gauge the strength of these different channels because they operate at the same time and we only observe the net effects. [ 11] However, there is empirical evidence for the importance of each channel on elements of demand and/or inflation. We also know that monetary policy is effective in countries that have a much weaker cash-flow channel than Australia. For example, the significant increase in policy rates in Australia and the United States are contributing to broadly similar changes in key macroeconomic indicators. In particular, growth in domestic demand has moderated in both economies. Labour market conditions are easing as indicated by the decline in job vacancies as a share of unemployment. And inflation has declined, including in core terms. Graph 8 % Australian and US Economic Conditions Policy rates Domestic final demand United States Australia % Year-ended growth ratio Vacancies-to-unemployment 2.0 Core inflation* Year-ended % 1.5 1.0 0.5 M J S D M J S D M J S D MM J S D M J S D M J S D M * Excludes food, energy and fuel. Sources: ABS; RBA; Refinitiv; U.S. Federal Reserve. Conclusion The cash-flow channel is the obvious way in which monetary policy is transmitted to aggregate demand and inflation in Australia. Compared with earlier episodes of rising interest rates, this channel has been operating with a slight delay given the high initial share of fixed-rate loans. But around half of all loans that were fixed at a low rate have now rolled off, and most of the rest will do so over the next 12 months. Required mortgage payments are at a record share of household disposable income and will rise further as more fixed-rate loans expire. The cash-flow channel is felt acutely by those with variable-rate debt. But there are other important channels of monetary policy. In particular, the rise in interest rates has increased incentives to save. This is true even for households that had built up a lot of extra savings during the pandemic. Households with debt also have an incentive to save more; some may be able to pay down their debts ahead of schedule or at least run down their savings buffers more slowly than otherwise. These and the other channels of monetary policy are slowing the growth of demand and contributing to a decline in inflation. The lags of transmission mean that some further effects of rate increases to date are still to be felt through the economy, which will provide further impetus to lower inflation in the period ahead. Meanwhile, the Board is paying close attention to economic developments here and overseas, and some further tightening of monetary policy may be required to ensure that inflation, which is still too high, returns to target in a reasonable timeframe. Endnotes [*] I would like to thank Richard Finlay, Jonathan Hambur, Jeremy Lawson and Jack Mulqueeney, as well as a number of staff from Domestic Markets, Economic Analysis, Economic Research, Financial Stability and International departments for help with this speech. See La Cava G, H Hughson and G Kaplan (2016), ‘The Household Cash Flow Channel of Monetary Policy’, RBA Research Discussion Paper No 2016-12; Flodén M, M Kilström, J Sigurdsson and R Vestman (2021), ‘Household Debt and Monetary Policy: Revealing the Cash-Flow Channel’, The Economic Journal, 131(636), pp 1742–1771. Unlike the cash-flow channel, the intertemporal substitution channel does not depend on whether borrowing and saving is at fixed or variable rates. This is because the channel works through the opportunity cost of spending versus saving, which depends on the current interest rates available to prospective borrowers and savers. Hence, this channel should work in a similar fashion across different economies. See Lane K and T Rosewall (2015), ‘Firms’ Investment Decisions and Interest Rates’, RBA Bulletin, June. See Jonathan Hambur and Gianni La Cava (2018), ‘Do Interest Rates Affect Business Investment? Evidence from Australian Company-level Data’, RBA Research Discussion Paper No 2018-05. Gibbs CG, J Hambur and G Nodari (2018), ‘DSGE Reno: Adding a Housing Block to a Small Open Economy Model’, RBA Research Discussion Paper No 2018-04. Higher interest rates may also reduce the supply of credit, which can influence the prices of assets that are typically purchased with borrowed funds, such as housing. For a review of recent wealth effect studies, see May D, G Nodari and D Rees (2019), ‘Wealth and Consumption’, RBA Bulletin, March. RBA (2023), Statement on Monetary Policy, August. Based on current prudential requirements, when deciding how much they can lend to a prospective borrower, Australian banks must assess the borrower’s ability to service the debt were interest rates to rise by a further 3 percentage points from current levels. See APRA (2023), ‘Housing Lending Standards: Reinforcing Guidance on Exceptions’, Letter to all authorised deposit-taking institutions (ADIs), 9 June. To get a sense of the orders of magnitude, our internal modelling suggests that a 100 basis point increase in the cash rate should lead, all else equal, to a 5–10 per cent appreciation in the trade-weighted exchange rate. The effect of such an appreciation would lead to an estimated reduction in inflation in the vicinity of ¼ to ½ of a percentage point after two years. Many models imply that the intertemporal substitution channel is dominant, but this is by assumption in models that do not allow for credit constraints, which are relevant to several channels including the cash-flow, credit and asset-price channels. Other models characterise the channels differently to how I’ve discussed them above – for example, some emphasise indirect employment effects, while others emphasise the role of redistribution between different types of households (e.g. Kaplan G, B Moll and GL Violante (2018), ‘Monetary Policy According to HANK’, American Economic Review, 108(3), pp 697–743; Auclert A (2019), ‘Monetary Policy and the Redistribution Channel’, American Economic Review, 109(6), pp 2333– 2367). By contrast, in one of the Bank’s key models, MARTIN, most of the effect of monetary policy comes via the exchange rate channel and the channels affecting the housing sector. In the longer term, the picture from MARTIN is less clear cut, as the contribution of each channel is sensitive to the assumptions used to calculate the decomposition. The materials on this webpage are subject to copyright and their use is subject to the terms and conditions set out in the Copyright and Disclaimer Notice. © Reserve Bank of Australia, 2001–2023. All rights reserved. The Reserve Bank of Australia acknowledges the Aboriginal and Torres Strait Islander Peoples of Australia as the Traditional Custodians of this land, and recognises their continuing connection to country. We pay our respects to their Elders, past and present. | reserve bank of australia | 2,023 | 10 |
Speech by Mr Brad Jones, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, at the Australian Financial Review Cryptocurrency Summit, Sydney, 16 October 2023. | null | reserve bank of australia | 2,023 | 10 |
Speech by Ms Michele Bullock, Governor of the Reserve Bank of Australia, at the 2023 Commonwealth Bank Global Markets Conference, Sydney, 24 October 2023. | Speech Monetary Policy in Australia: Complementarities and Trade-offs Michele Bullock[*] Governor 2023 Commonwealth Bank Global Markets Conference Sydney – 24 October 2023 Good evening. Thank you for inviting me to speak at this event. It is my first speech as Governor, and a good opportunity to talk about a topic at the core of the Reserve Bank’s responsibilities: monetary policy and the framework within which it is considered. Before I begin, however, I would like to comment briefly on recent monetary policy. As I’m sure you are all aware, the Reserve Bank Board decided earlier this month to keep the cash rate target at 4.1 per cent, where it has been since the most recent rate rise in June. Our focus remains on bringing inflation back to target within a reasonable timeframe, while keeping employment growing. It is possible that this can be done with the cash rate at its current level but there are risks that could see inflation return to target more slowly than currently forecast. The Board will not hesitate to raise the cash rate further if there is a material upward revision to the outlook for inflation. At the same time, the Board is mindful that growth in demand and the rate of inflation have been moderating, and that there are long lags in the transmission of monetary policy. The Board will receive several pieces of information before its next meeting that will be important for this assessment. This includes a full update of the staff’s forecasts. We will reconsider the outlook for the economy in light of incoming information and will have opportunities to explain our assessment in the media release and Statement on Monetary Policy that will follow the November meeting. The focus of this speech, however, is the broader framework we use when making monetary policy decisions. My remarks are shaped by the fact that, while we target low and stable inflation, there are other objectives that the Board considers in formulating monetary policy. In many ways, the Board’s various objectives complement each other. But there are times when they may seem at odds with one another and the Board must consider how to balance its objectives. This potential for trade-offs can arise between our objectives for price stability (or low inflation) and full employment, or between those two and our objective of maintaining financial stability. To preface my key observation, while there are sometimes balances to be struck, there are many more ways in which our objectives complement each other. Inflation and full employment Most of you will be well acquainted with the RBA’s monetary policy objectives – maintaining low and stable inflation and full employment.[1] These have long been at the centre of our monetary policy framework. The independent Review of the Reserve Bank of Australia recognised that this framework has served Australia well. It recommended some enhancements to modernise and clarify the objectives. I am currently working with the Treasurer to do this. These changes won’t, however, fundamentally change the way we formulate monetary policy. The inflation objective is widely understood, having been the centrepiece of monetary policy since the early 1990s. The Board has targeted a rate of consumer price inflation of between 2 and 3 per cent on average over time. This inflation target is central to monetary policy because it contributes to the economic prosperity and welfare of Australians in two ways. The first is by avoiding the direct damage that high inflation does to households and businesses. High inflation erodes the value of savings and reduces the purchasing power of households. It especially hurts those on low incomes. As former Governor Philip Lowe often stated, history has taught us that sustained high inflation also inevitably leads to higher interest rates and unemployment. The second way that achieving the inflation target helps Australians is by laying the foundations for economic growth and jobs creation. Maintaining low inflation gives households and firms more certainty when planning for the future. It also facilitates a better allocation of resources. Both of these, in turn, support increased investment and productivity growth. The Board’s second objective is to maintain full employment. As I have noted previously,[2] it is hard to overstate the importance of full employment. Being employed not only supports people financially, but also provides them with a sense of purpose. It helps to foster mental and physical wellbeing. These benefits are especially felt by those that find it harder to get jobs, such as the young or less educated. And there are broader societal benefits from higher workforce involvement, such as an increased prospect of more, and more diverse, ideas being generated. The RBA has always had a full employment mandate alongside low and stable inflation. We are now adopting the Review’s recommendation to make that ‘dual mandate’ more explicit. So what is full employment? In theory, it is the level of employment at which there is a balance between demand and supply in the labour market (and in the markets for goods and services) with inflation at the inflation target; this is the maximum level of employment that is consistent with our price stability mandate. When demand for workers is well below this and unemployment is high, inflation will typically fall below our target, wages growth will be low and Australians will suffer the financial and social costs of unemployment. By contrast, when demand for workers is very strong and the unemployment rate is very low, inflation will be high. It can also become more difficult to acquire goods and services as we need them, as firms struggle with high vacancies and staff turnover. These outcomes are not just observations from the distant past, as some claim – they have been the experience of the past 10 or 20 years (Graph 1). R E S E R V E B A N K O F AU S T R A L I A Graph 1 Inflation and Labour Underutilisation Trimmed mean inflation* % Mar 2020 – Jun 2023 Mar 1993 – Dec 2019 * Labour underutilisation rate (hours based) % Year-ended inflation rate. Sources: ABS; RBA. While inflation, appropriately, has a numerical target, it would be unwise to specify a fixed numerical target for full employment. For one, full employment can change over time, as the structure of our economy evolves. It is also not a concept that can be directly measured. And it cannot be comprehensively summarised by a single statistic such as the unemployment rate. As the Government’s recent white paper on employment explained, the modern workforce includes almost 2½ million people who either want to work but are not counted as unemployed or would like to work more hours than they currently do.[4] These considerations mean it is not straightforward, nor desirable, to set a numerical and enduring target for full employment. Much has been written over the past month on whether full employment means different things to the Reserve Bank and the Government. The answer is no – our objectives are complementary. But we typically have different time horizons to work with. The focus of monetary policy is the short to medium term – a period of between a few quarters and a few years. But governments rightly have a longer horizon when thinking about full employment. And over a longer horizon, the level of employment that can be sustainably achieved while keeping inflation consistent with the target can be influenced by various forces, including government policies. So how do we judge where full employment is at any time? One way of trying to gauge what labour market outcomes are currently consistent with this definition of full employment is to estimate the non-accelerating inflation rate of unemployment, or NAIRU. This concept has generated a bit of debate over recent months. It is a statistical measure estimated by observing the joint behaviour of inflation and unemployment (along with various other influences).[5] I want to emphasise, however, that it can only be a starting point for assessing labour market conditions because the NAIRU is estimated imprecisely, especially in real time. It also doesn’t capture all of the relevant information. So our assessment of what labour market conditions currently constitute full employment therefore incorporates a lot of judgement. Other factors – such as how broader measures of underutilisation are evolving relative to unemployment, trends in wage-setting mechanisms and mobility and, importantly, wage and inflation outcomes – are all part of our considerations. There has also been much discussion about the potential balance between the Board’s objectives. Some commentators have expressed concern that a more explicit employment objective would mean we de-prioritise inflation. Others are worried that the Board has unduly prioritised lowering inflation over preserving jobs. While it is true that there can sometimes be a need to consider how to balance these objectives, there are more complementarities between them than is often recognised. Over time, low inflation and full employment go hand in hand. Low and stable inflation is a prerequisite for strong and sustainable employment growth because it creates favourable conditions for households and businesses to make decisions about how to use their resources. It is also true that when unemployment is persistently away from full employment, inflation will persistently deviate from its target. So our two objectives are complementary over the longer term. Even in the shorter term, the two objectives are often complementary. That is certainly true when economic cycles are being driven mainly by strengthening or weakening demand. When that happens, employment and inflation tend to rise and fall together. As a result, the policy response that returns inflation to target also moves the labour market towards full employment. The employment and inflation objectives are also complementary when there are influences that expand the productive capacity of the economy – like strong productivity growth, successful innovation and expansions in the capital stock. It is only when faced with negative supply disruptions that there may be a need to think about potential tradeoffs. For example, disruptions to energy supply or natural disasters can cause inflation to rise above target at the same time as unemployment increases. It is not wise to specify in advance a fixed rule for how to balance our objectives, because the appropriate response will depend on the circumstances. If a supply disruption is transitory and modest, monetary policy should mostly ‘look through’ it. By contrast, when the shock has a longer lasting effect on the economy and inflation, or there are a series of supply shocks in one direction, there are stronger grounds for monetary policy to respond. Which brings us to the important role of inflation expectations. When households and businesses have a high level of confidence that the Board will do what is needed to return inflation to target, we can afford to look through a greater share of negative supply shocks – even those that will last for a lengthy period. Of course, there are limits here. The longer a central bank permits inflation to remain outside target, the more likely it is that inflation expectations will shift. And if they do, it will require even higher interest rates and unemployment to bring inflation back to target. Given these considerations, the Board’s approach – when faced with a need to balance its objectives – is to explain how these are being managed and why. Over the past year, this has been done through the analogy of aiming to tread a ‘narrow path’ in which inflation returns to target within a reasonable timeframe while employment continues to grow. As we have been saying for some time, it might have been possible to get inflation back to target sooner by raising the cash rate more sharply. However, doing so would have caused greater hardship for households and businesses and ultimately higher unemployment. As such, the Board judged that, at that time, the costs outweighed the gains from restoring inflation to target quicker. At the same time, the Board has been clear that it has a low tolerance for allowing inflation to return to target more slowly than currently expected. Accepting this would risk eroding public credibility in our commitment to low and stable inflation. And as I have discussed, the long-term costs to the economy if that were to happen would be considerable. Financial stability and the dual mandate A second potential trade-off in monetary policy frameworks is between financial stability and the inflation and full employment objectives. My main observation here is, again, that these objectives are often more complementary than assumed. R E S E R V E B A N K O F AU S T R A L I A The RBA has long had a mandate to contribute to financial stability. Over the past quarter century, this has included working closely with the Australian Prudential Regulation Authority (APRA) and other members of the Council of Financial Regulators to promote stability in the financial system. It is pleasing that the Review recommended this mandate be made more explicit. Most of the time, the RBA’s financial stability objective is intrinsically linked and complementary to its objectives for inflation and employment. Monetary policy cannot achieve low inflation and full employment without a stable financial system. For example, financial instability can result in the supply of credit being unduly constrained, which disrupts economic activity and results in rising unemployment. Unemployment is, in turn, the most common reason why households and firms are unable to repay debt owed to banks. High inflation can also trigger financial difficulties for households and businesses, and hence financial institutions. However, there are times when what is needed to achieve full employment and low inflation may not be ideal for maintaining financial stability. For example, an extended period of accommodative monetary policy to lift employment and inflation can contribute to the build-up of leverage and imprudent risk-taking in parts of the financial system.[7] A sharp tightening in monetary policy at a later point to control inflation can then expose these vulnerabilities. This was one contributor to what happened in the United States earlier this year with the failure of Silicon Valley Bank. In general, the Board balances its objectives by considering financial stability in its policy settings, without using monetary policy to influence financial stability directly. Financial stability considerations will influence monetary policy when it affects the outlook for employment and inflation. For example, if financial instability results in tighter credit conditions, this is relevant for meeting the Bank’s objectives. But if there seems to be tension between these objectives, the Board will usually prioritise its inflation and full employment objectives. This approach is widely accepted as best practice and is consistent with the recommendations of the Review.[9] It reflects the principle that other agencies and their tools – most notably APRA – are better placed to prevent the build-up of financial vulnerabilities than monetary policy. And it recognises that consistently achieving multiple objectives requires multiple tools. To make this discussion more tangible, it may be instructive to consider the Board’s most recent reflections on financial stability at the October meeting. The Board concluded that while risks to financial stability are currently high, given the challenging economic environment, most Australian households and businesses have been resilient and our financial system remains strong. At the same time, we assessed that these risks did not currently have a major bearing on monetary policy. One aspect of this assessment involved considering how different household groups are faring in response to high inflation and interest rates. One way of illustrating this is through the lens of changes in spare cash flow over the prior two years. Inflation (excluding housing costs) has weighed twice as heavily on the spare cash flows of lower income households compared with those on higher incomes (Graph 2).[10] However, this differential impact from inflation has, on average, been offset by stronger growth in labour income for those with lower incomes. Graph 2 The financial pressures that households are facing can also vary depending on whether they own their home outright, have a mortgage or rent. On average, households with a mortgage have experienced a significant decline in spare cash flows, unlike other households (Graph 3). For these households, higher interest costs have reduced their cash flow by more than the rise in inflation has. By contrast, the spare cash flow of renters has, on average, risen a little as high inflation and rising rents have been more than offset by growth in income. There will, of course, be diverse outcomes for individuals within these groups. R E S E R V E B A N K O F AU S T R A L I A Graph 3 An alternative way of assessing the pressure on households with a mortgage is to look at the income of households with variable-rate loans, relative to their mortgage costs and benchmark estimates of essential living expenses. The main insight from this approach was that the pressure facing indebted households is much greater for a small group of highly leveraged borrowers than for those with more modest levels of debt. About 5 per cent of all variable-rate borrowers are estimated to be paying more for essential expenses and housing than they receive in income (Graph 4). But this rises to about 25 per cent for highly leveraged borrowers – those with loans amounting to at least four times their income.[11] These borrowers may be finding ways to make ends meet, but this can involve some difficult financial decisions. This could include drawing on past savings, working extra hours if they are able, or forgoing some expenditure that would in normal times be considered non-discretionary. At the extreme, it could involve negotiating a hardship program with their lender or selling their property. Graph 4 Estimates of Borrowers with Cost of Living Exceeding Income* Share of variable-rate owner-occupiers by group % % Higher LTI** High LVR*** All loans M J S D M J * S D Estimates of borrowers with mortgage payments and basic expenses (HEM) exceeding their income. Latest observation July 2023. ** Borrowers with loan-to-income ratio exceeding 4. *** Borrowers with loan-to-valuation ratio exceeding 80. Sources: ABS; Melbourne Institute; RBA; Securitisation System. It is important to acknowledge that all of these findings are based on average outcomes for various groups of households. Within each group, there will be individual households that are better off and some that are worse off than average. Indeed, we speak directly to organisations that provide debt advice and mental health services and are hearing that many households are under significant financial stress. We discuss this regularly in Board meetings. At the same time, the Bank’s statutory objectives are economy-wide outcomes, and our key tool – the interest rate – is a blunt one. The Board recognises the effects of monetary policy on the welfare of different individuals, but it must set its policy to serve the welfare of Australians collectively. Monetary policy and the Australian dollar Before I conclude, I want to note that this year marks the 40th anniversary of the float of the Australian dollar. It is therefore an opportune time to remind ourselves of the benefits that floating the dollar created for the monetary framework in Australia (Graph 5). R E S E R V E B A N K O F AU S T R A L I A Graph 5 Australian Dollar* US$ index US$ peg (LHS) 1.4 US$ per A$ 1.2 (LHS) 1.0 TWI** peg 0.8 (RHS) TWI** crawling peg 0.6 (RHS) TWI** (RHS) 0.4 * Grey line separates pre- and post- float periods. ** Indexed to May 1970 = 100. Sources: Bloomberg; Global FInancial Data; RBA; Refinitiv. Floating the exchange rate has given the RBA flexibility to set monetary policy independently of the decisions of other major central banks, though global capital flows mean we still do not set policy in a vacuum. Interest rate volatility declined sharply at the same time as exchange rate volatility picked up, and the exchange rate has worked as a shock absorber to macroeconomic developments (Graph 6). As a result, the Australian economy has mostly been able to absorb external shocks without the large inflationary or deflationary pressures that had previously characterised the economy. Graph 6 Australian Interest Rate and Exchange Rate Volatility* ppt ppt Australian interest rate volatility** % % Australian dollar volatility*** * Grey line separates pre- and post- float periods. ** 90-day bank bill; six-month rolling average of monthly absolute percentage point changes. *** Against US dollar; six-month rolling average of monthly absolute percentage changes. Sources: AFMA; Bloomberg; Global Financial Data; RBA; Refinitiv. The benefits of a floating Australian dollar were especially clear during the mining boom in the early 2000s. At that time, strong global demand for Australia’s resources saw the terms of trade increase by around 75 per cent. This substantially increased demand for the Australian dollar and the exchange rate appreciated significantly. The additional demand for Australian products, and the wealth this created, would have been highly inflationary in prior decades. But we were able to keep inflation around target with only modest increases in interest rates, as the exchange rate appreciation dampened inflation. The reverse was true as the mining boom subsided over the second half of the 2010s. In contrast to these periods, the exchange rate has been reasonably stable over the past two years in tradeweighted terms. While the exchange rate remains an important channel of monetary policy transmission, recent stability in the trade-weighted exchange rate has meant it has not played a large role in recent monetary policy decisions. Conclusion In making decisions on monetary policy, the Board’s focus is on delivering low and stable inflation while maintaining full employment. It also considers whether financial stability might have implications for monetary policy settings. In many cases, these objectives are complementary. But there may sometimes be a need to balance the various objectives and this requires careful judgement. It is incumbent upon the Board to be transparent about when and how it is doing this. Thank you and I look forward to your questions. R E S E R V E B A N K O F AU S T R A L I A Endnotes [*] I am grateful to Michelle Bergmann, Judy Hitchen, Michelle Lewis, David Norman, Beth Tasker and Jess Young for excellent assistance with this speech. See section 10(2) of the Reserve Bank Act 1959. Bullock M (2023), ‘Achieving Full Employment’, Speech at the Ai Group, Newcastle, 20 June. The nature of the relationship shown in Graph 1 has also been more formally explored, using controls for factors such as supply disruptions, in Bishop J and E Greenland (2021), ‘Is the Phillips Curve Still a Curve? Evidence from the Regions’, RBA Research Discussion Paper No 2001–09. See Treasury (2023), ‘Working Future: The Australian Government’s White Paper on Jobs and Opportunities’, Final Report, September. For further discussion, see Ellis L (2019), ‘Watching the Invisibles’, Speech at the 2019 Freebairn Lecture in Public Policy, University of Melbourne, 12 June; RBA (2023), ‘The Non-Accelerating Inflation Rate of Unemployment (NAIRU)’, Explainer. While it is clearer that inflation and national incomes are complements in the long run, there is growing evidence that the longrun level of employment is also influenced by the credibility of the inflation target and the ability of policymakers to avoid recessions; see Blanchard O (2018), ‘Should We Reject the Natural Rate Hypothesis’, Journal of Economic Perspectives, 32(1), pp 97–120. Basel Committee on the Global Financial System (2018), ‘Financial Stability Implications of a Prolonged Period of Low Interest Rates’, CGFS Paper No 61; Borio C and P Lowe (2005), ‘Asset Prices, Financial and Monetary Stability: Exploring the Nexus’, BIS Working Paper No 114. Board of Governors of the Federal Reserve System (2023), ‘Review of the Federal Reserve’s Supervision and Regulation of Silicon Valley Bank’, Report, 28 April; Basel Committee on Banking Supervision (2023), ‘Report on the 2023 Banking Turmoil’, Report, October. See European Central Bank (2023), ‘The Role of Financial Stability in Monetary Policy and the Interaction with Macroprudential Policy in the Euro Area’, ECB Occasional Paper Series No 272; Schroth J (2021), ‘Optimal Monetary and Macroprudential Policies’, Bank of Canada Staff Working Paper No 2021-21; Goldberg JE, E Klee, ES Prescott and PR Wood (2020), ‘Monetary Policy Strategies and Tools: Financial Stability Considerations’, Board of Governors of the Federal Reserve System Finance and Economics Discussion Series No 074. [10] This is consistent with work presented at the RBA’s recent annual conference; see Wood D, I Chan and B Coates (2023), ‘How High Inflation Is Affecting Different Australian Households’, Presentation at the RBA Annual Conference, Sydney, 25 September. [11] Using a broader measure of essential expenses, these figures rise to about 15 per cent for all borrowers and about 50 per cent for highly leveraged borrowers. [12] For a broader discussion about the decision to float the Australian dollar, see Stevens G (2013), ‘The Australian Dollar: Thirty Years of Floating’, Speech to the Australian Business Economists’ Annual Dinner, Sydney, 21 November. BLADE Disclaimer Notice | reserve bank of australia | 2,023 | 10 |
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Speech by Ms Marion Kohler, Acting Assistant Governor (Economic) of the Reserve Bank of Australia, at the UBS Australasia Conference, Sydney, 13 November 2023. | null | reserve bank of australia | 2,023 | 11 |
Speech by Ms Michele Bullock, Governor of the Reserve Bank of Australia, at the Australian Business Economists Annual Dinner, Sydney, 22 November 2023. | Speech A Monetary Policy Fit for the Future Michele Bullock[*] Governor Australian Business Economists Annual Dinner Sydney – 22 November 2023 Thank you for inviting me to speak at the ABE’s annual dinner. I spoke at it last year as Deputy Governor. Little did I know I would be speaking this year as Governor. I am going to talk about two things tonight. The first is current monetary policy, which I suspect is what many want to hear about. The second is more future focused – the changes that the Reserve Bank is implementing to our monetary policy processes. The nature of our inflation challenge But first to our inflation challenge. As I am sure you are all aware, the Reserve Bank Board raised interest rates by 25 basis points at its November meeting. This followed several months when rates were held steady. An important consideration in the Board’s decision was that both economic activity and inflation have been a bit more resilient over recent months than expected. Inflation is past its peak and heading in the right direction, but it is likely to return to target a bit more slowly than we previously thought (Graph 1). As such, the Board decided that a rate rise this month was appropriate to be more assured that inflation returns to target in a reasonable timeframe and to balance its inflation and full employment objectives. Graph 1 Trimmed Mean Inflation Year-ended % Forecasts % Current Previous Sources: ABS; RBA. The minutes of the November meeting were released yesterday and step through the main considerations in that decision, so I won’t repeat those here. Instead, I would like to focus on one particular consideration for policy: that the remaining inflation challenge we are dealing with is increasingly homegrown and demand driven. This point is important because it has implications for the appropriate policy response. If inflation is simply the product of global supply disruptions or other price rises that monetary policy has little influence over then the appropriate response from interest rates would generally be limited. This is especially the case if inflation is driven by just a few items such as fuel, electricity or rents. However, a more substantial monetary policy tightening is the right response to inflation that results from aggregate demand exceeding the economy’s potential to meet that demand. I discussed this issue in my speech last month. It is true that supply-side disruptions were the most prominent driver of the initial surge in inflation around the world over recent years. Pandemic-related supply chain problems occurred at the same time as demand for goods was strong, resulting in a sharp increase in prices for many goods. Then, as the pandemic’s effects on supply chains were starting to ease, Russia’s invasion of Ukraine led to spikes in energy and some food prices. Headline inflation around the world is now declining as goods price inflation is continuing to ease and the energy price rises have unwound, and this process has a bit further to run. But many countries are observing that core services inflation is declining much more slowly. A similar trajectory in inflation has been seen in Australia, although with a slight delay compared with many of our peer economies. Supply chain effects were certainly evident in goods prices and, like overseas, we are observing an easing of these pressures. The energy price impacts didn’t hit us at the same time as other countries, but we also saw electricity and fuel prices rise sharply. As these supply-side effects wane, headline inflation will come down and we are already observing this. But in the background, there has been a solid demand-driven component to inflation. This shift from mainly supply-driven to mainly demand-driven inflation has been a part of our inflation outlook for some time. There are three pieces of evidence that collectively paint a picture of a sizeable demand-driven element to inflation. The first signal is that inflation is broadly based. This is evident from trimmed mean inflation, which remains too high and, in the most recent quarter, was stronger than had earlier been expected. And if we look across the CPI basket, around two-thirds of items have inflation running above 3 per cent – indeed, often a long way above that R E S E R V E B A N K O F AU S T R A L I A number (Graph 2). Inflation is lower than average for only a few volatile items – such as fresh food and holiday travel – and for some items for which government subsidies have recently been increased (Graph 3). So inflation is much broader than just rising prices for petrol, electricity and rents – prices are rising strongly for the majority of the goods and services we all consume. Graph 2 Inflation by CPI Expenditure Class Item Year-ended, September quarter 2023 % % 3 per cent -5 -5 -10 -10 -15 Cumulative weight (%) -15 Sources: ABS; RBA. Graph 3 Inflation Deviation from Average* Six-month annualised, September quarter 2023 ppt Volatile & administered Selected goods Selected services ppt Telecommunications -10 Household services -10 Dining out & takeaway -5 Insurance & financial -5 Rents Clothing & leisure Motor vehicles Household goods Fuel Electricity Alcohol & tobacco Administered Gas Holiday travel Fruit & vegetables AVC** Groceries New dwellings * Average from 1993 to December quarter of 2019; volatile & administered items are 37 per cent of the CPI basket, selected goods are 32 per cent and selected services are 26 per cent; administered excludes utilities; groceries excludes fruit & vegetables. ** Audio, visual & computing equipment. Sources: ABS; RBA. The second indicator that inflation is being driven by domestic demand is that it is increasingly underpinned by services (Graph 4). Hairdressers and dentists, dining out, sporting and other recreational activities – the prices of all these services are rising strongly. This reflects domestic economic conditions and is an indication that aggregate demand is sufficiently greater than aggregate supply to sustain these price increases. R E S E R V E B A N K O F AU S T R A L I A Graph 4 CPI Inflation Year-ended with contributions % Total Services* Rents % Selected goods** Other -2 * Includes market services and administered items; excludes rents and holiday travel & accommodation. ** Includes groceries, alcohol & tobacco, consumer durables and new dwellings. -2 Sources: ABS; RBA. The cost of these services is also typically driven by the price of domestic inputs, since labour and domestic nonlabour costs comprise most of the inputs used in supplying them. The Bank’s liaison with firms indicates that these domestic cost pressures are proving persistent. Labour costs have risen, especially when we incorporate the effect of weak productivity growth, and the price of domestic non-labour costs such as energy, business rents and insurance has increased noticeably (Graph 5). On the other hand, imported cost pressures are starting to subside. Graph 5 Change in Firms’ Non-labour Costs* Net balance, firms reporting in liaison ppt ppt Domestic costs Imported costs -50 -50 -100 * -100 Share of firms reporting above-average increases less share reporting below-average increases or decreases; average increase indexed to 0; smoothed with a 13-month Henderson trend. Source: RBA. The third signal is the continuation of limited spare capacity, most evident in high rates of labour utilisation. There continues to be a clear link between services inflation and measures of spare capacity, since it is easier to raise prices when firms cannot keep up with customers’ demands (Graph 6). We are also hearing in our liaison with firms that capacity utilisation is very high. And various indicators of activity suggest that demand in the economy has been stronger this year than we had expected. We are therefore getting the signal from both inflation and activity data that the level of aggregate demand continues to exceed aggregate supply. Graph 6 Market Services Inflation and Labour Underutilisation % Market services inflation* Mar 2020 – Sep 2023 Mar 1993 – Dec 2019 * Labour underutilisation rate (hours based) % Year-ended inflation rate. Sources: ABS; RBA. An important implication of this homegrown and demand-driven component to inflation is that getting inflation back to target will take time. It took only three quarters for inflation to fall from 8 per cent to 5½ per cent as the supply-side issues eased, and there is some more to go there. But we expect it to take another two years for inflation to fall that much again and move below 3 per cent. This is because much of the remaining task of bringing inflation back to target will require bringing aggregate demand and aggregate supply into closer alignment. That is what the Board is aiming to do with monetary policy – to slow the growth of demand enough to bring inflation back to target while keeping employment growing. I know that my message tonight will not resonate with some. I receive letters from people who are finding it difficult to make ends meet and I speak with organisations that assist struggling households. Everyone is seeing prices for goods and services rise strongly but this has a particularly severe impact on low-income households. This emphasises the need to get inflation back down. I also know that interest rate rises are squeezing the finances of households with a mortgage. But while the Board recognises there is a wide diversity of experience, the Bank’s statutory objectives are economy-wide outcomes, and our key tool – the interest rate – is a blunt one. The Board must therefore set its policy to serve the welfare of Australians collectively. Change at the RBA Let me now turn to the other focus of my speech – the changes the Reserve Bank is implementing to ensure our monetary policy framework is fit for the future. The inner workings of the RBA are not normally of much interest to the public. But it is important that Australians can trust that we have processes that facilitate the best possible decision-making, given the effect of our decisions on people. And there are some major changes underway to R E S E R V E B A N K O F AU S T R A L I A implement the recommendations from the Review of the Reserve Bank. Some of these require changes to the Reserve Bank Act 1959 that the Government will table in the Parliament shortly. But there is much that we can act on independently of that, and tonight I would like to give you a flavour of what we are working on. I want to begin by making it clear that I am 100 per cent behind the changes. The RBA is a great institution with a long history of serving the Australian people. But as times change, we must change. I think, though, that people forget that we have been through change before. Right at the beginning of my career, the exchange rate was floated and interest rates were deregulated. That was a massive change to the monetary policy framework. In the early 1990s we adopted an inflation target. Then in the late 1990s, bank supervision was removed from the RBA’s responsibilities and at the same time we were given powers to regulate the payments system. Again, these were big changes. The latest review is another incarnation of change and, again, we will embrace it to emerge as a stronger institution. Many of the issues raised in the Review around culture and leadership are ones that I am passionate about. As a leader, I have been working on these issues in my areas of influence. I now have an opportunity to lead this change and to model it. My vision for the Bank is to be an institution of diverse perspectives and inclusive processes. I want our people to share their views, knowing that they will be listened to respectfully. I also want the Bank to be open to fresh ideas from outside, by increasing and diversifying our external engagements and leveraging the experience of our people with external expertise. I want us to be an institution that communicates well with both its people and the Australian public. Tonight I will talk about how I plan to implement that vision as it relates to monetary policy and culture. I will leave discussion of the changes we are making to improve the way the Bank is governed and manages risk for another time. Strengthening the decision-making process One of my strategic priorities is to refresh our monetary policy decision-making process so that it is ‘fit for the future’, to borrow the language of the Review. Former Governor Lowe discussed at a high level in July the changes we are introducing to Board processes. These involve: • a move to eight Board meetings a year, starting from February 2024 • longer Board meetings • an internal staff meeting at the beginning of the Board cycle that Board members would be able to attend • Board oversight of the research agenda • changes to communication, including the post-meeting statement being issued by the Board, rather than the Governor, and media conferences after each meeting. Since that announcement, we have expanded and sharpened our thinking on these issues. In doing so, we have focused on the recommendations of the Review. But we have also engaged with peer central banks and drawn on expertise from outside the Bank. In building out these changes, we have been mindful of two key aims highlighted in the Review – providing more opportunity for deep and informed deliberation, and providing a clearer explanation of monetary policy decisions to our various audiences. Deep and informed deliberation The starting point for deep and informed deliberation is to allow time. The first step will involve Board members attending a ‘policy issues meeting’ around 10 days before each Board meeting. Currently, Board members receive the material for the Board meeting four days prior to the meeting. The new process will therefore engage Board members with the policy issues earlier. This new meeting will assemble a group of staff with the right experience and expertise to give the members insights and diversity of perspectives on the key issues relevant for policy. It will provide analysis of issues that are relevant to a few upcoming meetings, not just the immediate one. For example, staff could provide deeper analysis on issues that members have been grappling with in previous meetings. They could discuss longer run issues that potentially affect monetary policy well into the future. Or they could cover topics that the staff believe will equip the Board to consider the different options for policy – for example, scenario analysis. I envisage that members would be active participants in the meeting, asking questions and requesting follow-up analysis as required. The second step is to hold longer Board meetings. Meetings will start on the Monday afternoon. Discussion in the afternoon will involve presentations from staff on the state of the economy and markets, along with the outlook. This will mean that the Board spends around 3½ hours discussing these issues – about twice as much as now. The idea is not for longer presentations but for members to have more time to discuss, probe and deepen their understanding of the issues. My own experience in the current meetings is that there is never any shortage of questions – just a shortage of time to address them all in the meeting. The Board would then reconvene on the Tuesday morning to consider the policy decision. This will have the benefit of members being able to reflect overnight and raise any further issues or questions before the policy decision is made. We have allocated plenty of time to debate and discuss the merits of different courses of action. Finally, the Tuesday morning will include discussion of the post-meeting communication. As I noted, the postmeeting statement will be from the Board, so members collectively will need to consider how best to explain the decision. I will come back to communication in a moment. In addition to time, deep and informed decision-making requires quality briefings. So the other change we are making is to the material we provide to the Board. Members consistently tell us that the Board papers they receive from Bank staff are among the best they receive for boards they sit on. So we want to keep what we do well, but identify where we can do better. The main change we intend to make here is to provide more strategic focus in the material provided to the Board. While the Board has always had an eye to the future and to different policy options, we want to bring this more to the fore in the papers. We will still discuss how the data have evolved but there will be a little less of ‘what went up and what went down’ over the prior few months. What sort of material am I talking about? I envisage a greater role for scenario analysis to facilitate a discussion of risks to the outlook and the potential implications of different decisions. I also envisage a deeper discussion of trade-offs and a consideration of how the immediate decision fits within the medium-term strategy. This sort of material will require the Board to be engaged with our modelling and forecasting frameworks. And it will require the Bank to enhance its modelling capabilities, which we are doing. We will also be providing the Board with a summary of the views from staff to capture the diversity of their opinion. Currently, the Governor briefs the Board at each meeting on the views of senior staff and highlights where there are differences of opinion. We intend to make this more structured and to draw on the full range of internal policy meetings, not just those of the most senior staff. Material setting out in more detail the arguments raised by staff for and against particular policy options and strategies will help members better understand the full range of views. This summary of the diversity of staff views will complement the policy recommendation I make at each meeting, which the Board says it values and would like to continue. Clearer explanations All that said, deep and informed Board decisions need to be backed up by explanations that the public understand. I will therefore be focused on enhancing our communications. There are several elements to this. First, we are going to incorporate communication expertise throughout the policy development process, from the early stages to the Board’s ultimate decision. Communication is an important tool in the conduct of monetary policy, and we want to embed it more effectively into the policy process. R E S E R V E B A N K O F AU S T R A L I A To achieve this, we are elevating the importance of communication within the Bank with the creation of a new executive position and department. You will have heard that we recently appointed Sally Cray as Chief Communications Officer. We have been moving towards more strategic communication for some time, sharing policy messages through a broader range of channels, more directly engaging with important stakeholders, and making our analysis and decisions easier to understand and access. But there is more we can do and Sally Cray will drive that. In the meantime, we have committed to a few concrete actions. We have committed to a regular media briefing an hour after the monetary policy decision is released. This will provide an opportunity for journalists to clarify and probe issues raised in the post-meeting statement, better equipping them to analyse the decision for the public. We will also release the Statement on Monetary Policy at the same time as the monetary policy decision every second meeting. This will provide a more comprehensive discussion of our reasoning and the outlook underpinning the monetary policy decision. The look and feel of the Statement will also change. In time, you can expect to see a shorter document, but with a clearer explanation of how we assess the economy and the outlook. We will also move towards design features that enable casual readers to see the relevant information quicker. But there is much more to go. And it will be an iterative process. I want the Bank under my leadership to be an institution that continually reflects and evolves. The Board is no different. With longer meetings we will have opportunities to reflect on our processes, on what sort of analysis would be helpful for upcoming meetings and whether our communication is hitting the mark. People and culture So far I have talked a lot about the changes we will be making to our processes and outputs. But the quality of these relies on the quality of our people. The Bank is lucky to have so many talented people and I want to bring out the best in them. But to achieve the vision I set out at the start – an institution that values and encourages diverse and inclusive perspectives – is going to require us to focus on our culture and leadership. We have already taken a few steps here. Building on the recommendations of the Review, we have identified some specific areas where our culture does not yet sufficiently encourage this kind of discussion and idea sharing. These include: the level of comfort our people have in challenging, particularly those more senior than them; the style and nature of our internal debate; and a perception that leaders don’t listen to alternative views. You will see that there is a bit of a theme there – leadership. We won’t change the culture unless we can change our leadership behaviours. So we are investing in training and support for our leaders – including our executives – to help them be more open and inclusive. And this training needs to be put into practice. We will therefore set clear expectations, introducing ways to measure the performance of our leaders, and then holding them accountable for their contribution to the vision. I also need to set an example. I am encouraging more active debate and challenge than we have seen in the past, including of my own views, in a respectful and constructive manner. To make clear my commitment to creating a diverse and inclusive workplace where everyone feels they belong, I have decided to stay on as the Chair of the Bank’s Diversity and Inclusion Council – a role that from its inception was held by the Deputy Governor. Changing culture takes time. But I know our staff are committed to making the Bank as effective as it can be, and I am confident that we will see material change over coming years. I hope that will also be visible to those outside the Bank. Conclusion The coming year is going to be challenging for the Bank on two fronts. We still have to bring inflation back down to target while preserving as much of the gains made in the labour market over the past few years as possible. We are still seeking to tread that narrow path. At the same time, we are changing our monetary policy processes and improving our culture. And while I haven’t talked about it tonight, there is also substantial work underway to change our governance and uplift our risk management. But despite this large workload, I consistently hear from the Bank’s staff that they support these changes. I am confident that we will meet the challenge. Thank you for listening. I look forward to your questions. Endnotes [*] I would like to thank Lynne Cockerell, Judy Hitchen, Callum Hudson and David Norman for assistance with this speech. Bullock M (2023), ‘Monetary Policy in Australia: Complementarities and Trade-offs’, Speech at the Commonwealth Bank Global Markets Conference, Sydney, 24 October. The rate of underutilisation captures both the share of the labour force that is unemployed and the share that is employed but working fewer hours than they desire. R E S E R V E B A N K O F AU S T R A L I A | reserve bank of australia | 2,023 | 11 |
Speech by Ms Michele Bullock, Governor of the Reserve Bank of Australia, at the Australian Payments Network Summit, Sydney, 12 December 2023. | null | reserve bank of australia | 2,023 | 12 |
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Opening statement by Ms Michele Bullock, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Canberra, 9 February 2024. | Michele Bullock: Opening statement - House of Representatives Standing Committee on Economics Opening statement by Ms Michele Bullock, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Canberra, 9 February 2024. *** Chair and members of the Committee. This is my first appearance before the Committee as Governor. I have of course been here before, first as Assistant Governor, Financial System and more recently as Deputy Governor, so I am familiar with the process. These hearings are an important part of the accountability process for the Reserve Bank. Like Governors before me, I welcome the opportunity to answer your questions, as do my colleagues. Quite a bit has changed at the RBA since we last appeared before the Committee in August 2023. My seven-year term as Governor started last September and a new Deputy Governor, who has been appointed from outside the RBA, takes up duties next week. We have a new Statement on the Conduct of Monetary Policy, agreed between the Reserve Bank Board and the Treasurer, which makes explicit our mandate for price stability and full employment and requires us to explain regularly how we are meeting these objectives. We have had the first of our Board meetings under the new format – eight meetings a year, each over an afternoon and the following morning. The media statement following the decision on Tuesday was issued by the Board rather than the Governor and I held my first media conference, which will be a regular occurrence following each Board meeting. The RBA also released its Statement on Monetary Policy at the same time as the monetary policy decision, rather than a few days later as in the past. The Statement on Monetary Policy sets out our assessment of current economic conditions, our forecasts and risks around them, and the key issues featuring in the Board's monetary policy decision. On our previous timetable, the Statement on Monetary Policy would have been released while this hearing was taking place. I hope this change has been valuable in enhancing the transparency of our decision on Tuesday and that it was also of some benefit for you all. Inflation One thing that has not changed since the previous hearing in 2023 is the challenge presented by high inflation. We all remain acutely aware that the cost of living is rising much faster than it has over recent decades. It's been evident over the past couple of years in many of the essential goods and services we all buy but also in a myriad of other goods and services that we might regard as discretionary. At its peak, almost 80 per cent of items in the Consumer Price Index (CPI) were recording price rises of more than 3 per cent per annum. So, the problem has been a broad-based one. This is why the Board is focused on bringing inflation down. The Board understands that the rise in interest rates has put additional pressure on the households that have mortgages. But the alternative of lower interest rates and high inflation for a prolonged 1/5 BIS - Central bankers' speeches period would be even worse for these households, as well as all the households without mortgages. It would also make it more likely that inflation expectations would adjust upwards. And if this were to happen, it would be much more costly to address, involving high inflation for longer and even higher interest rates and a larger rise in unemployment to bring it down. Recent developments in inflation are encouraging. Since peaking at 7.8 per cent in the December quarter of 2022, inflation declined to 4.1 percent at the end of 2023. Nevertheless, inflation is still too high. As you know, since the early 1990s the Board has had a target for annual consumer price inflation of between 2 and 3 per cent on average over time. The new Statement on the Conduct of Monetary Policy endorses this but makes it more explicit that we should be aiming for the middle of the range – 2.5 per cent. So, we have some way to go to meet our target. I should add here that we are not unique in experiencing a period of above-target inflation. Inflation has been a challenge in most economies around the world – particularly those with which we typically compare ourselves. At least initially, this was a result of global supply chain issues coupled with strong demand for goods and rising energy prices. This saw inflation around the world rise to rates not experienced for many years, if not decades. As these influences have subsided, global inflation has eased and there has been encouraging progress towards central banks' targets. But services sector inflation remains high in many countries, partly reflecting demand remaining above supply and the associated tightness in labour markets. On Tuesday, we released our updated forecasts for the economy and inflation. These forecasts have inflation returning to within the top of the target range – 3 per cent – in 2025 and to reach the midpoint of the target range in 2026. Importantly, these forecasts are conditioned on the assumption that inflation expectations remain anchored around the midpoint of the target range. Furthermore, these are our central forecasts and there remains a great deal of uncertainty around inflation outcomes that far out. Even if the economy evolves along the central path, inflation will still have been outside the target range for four years. The longer inflation remains high and outside the target range, the greater is the risk that inflation expectations of households and businesses adjust higher. And if that happens, then the risks of inflation becoming entrenched at a higher level rise. This is the balancing act that the Board is focused on. We are trying to bring inflation back to target without slowing the economy more than necessary on the one hand or risking high inflation for longer on the other hand. This leads me to the Board's thinking and its recent decisions. Recent Board decisions At the time we last met in August, the cash rate target was at 4.1 per cent. The Board had left the cash rate at that level since June and indeed continued to hold until November when it increased the cash rate by a further 25 basis points. The decision to raise the cash rate at that time was based on information that had been coming through on inflation, the labour market and economic activity. The weight of that information, plus the RBA's updated forecasts, suggested that the risk of inflation remaining higher for longer had increased. The Board noted that while the economy was experiencing a period of below-trend growth, it had been stronger than expected over the first half of 2023. Underlying inflation was higher than expected at the time of the August forecasts, 2/5 BIS - Central bankers' speeches particularly in services, and conditions in the labour market had eased but remained tight. In addition, housing prices were continuing to rise across the country. These factors, plus the fact that inflation was projected to remain above 3 per cent for another two years led the Board to increase interest rates to be more assured that inflation would return to target in a reasonable timeframe. Since then, we have received more information on the economy and inflation. First, to the economy. Tighter monetary policy has contributed to a further slowing in demand. Weak household spending growth, particularly in per capita terms, has been only partly offset by strong growth in business investment and public demand. That said, labour market conditions remain tight but have continued to ease over recent months in response to slower economic growth. The unemployment rate and the underemployment rate have both increased by around ½ percentage point since mid2023, albeit from low levels. Wages growth remains strong by the standards of the past few years, although there are signs that it is slowing in some segments of the labour market. Firms now expect wages growth to ease over the year ahead. However, recent very weak productivity outcomes have contributed to a sharp increase in labour costs per unit of output. Putting this together, our overall assessment is that the aggregate level of demand has remained above the economy's supply capacity and that conditions in the labour market are still tight relative to what would be consistent with sustained full employment and inflation at target. This means that the slowing in aggregate demand that we are observing is helping to ease inflationary pressures, but we are not yet where we need to be. Consistent with this, inflation has moderated. Headline and underlying inflation were both lower in the December quarter than had been expected at the time of the November Statement on Monetary Policy. Goods price inflation was softer than expected, a pattern also seen overseas. Services price inflation remains high. Indeed, while inflation was lower than we were expecting in November, this is largely attributable to softer-than-expected goods inflation – services inflation was pretty much where we had forecast it to be. High services inflation is reflecting strong growth in both labour and non-labour input costs. Historically, services inflation typically runs above goods price inflation. In the couple of decades prior to the pandemic, inflation averaged around 2½ per cent. But within that, goods price inflation averaged around 2 per cent, while services inflation averaged around 3 per cent. So, while we don't necessarily need services inflation to be at the midpoint of the 2–3 per cent range to meet our target, we do need it to be quite a bit lower than it currently is. One issue I haven't mentioned yet is the other part of our mandate – full employment. While full employment has always been part of the RBA's mandate, the new Statement on the Conduct of Monetary Policy (and the Reserve Bank Bill) makes it more explicit. It says the RBA will conduct monetary policy in a way that will best contribute to both 3/5 BIS - Central bankers' speeches price stability and full employment. Full employment is the current maximum level of employment that is consistent with low and stable inflation. I have spoken in the past about this, emphasising that our two objectives are mostly complementary – over the longer term, low and stable inflation is necessary to achieve sustainable full employment. This is also front of mind for Board members as we battle inflation. The Board is attempting to bring inflation down while preserving as many of the recent gains in the labour market as possible – what my predecessor called 'the narrow path'. So far, we are observing that labour market conditions are easing, although they remain tighter than we think is consistent with low and stable inflation. Our forecasts are for employment to continue to grow but more slowly than over the past few years. But these outcomes are dependent upon inflation returning to target in a reasonable timeframe and inflation expectations not drifting up. If that were to occur, it will be much more costly in terms of employment to get inflation down. In summary, while there are some encouraging signs, Australia's inflation challenge is not over. An inflation rate with a '4' in front of it is not good enough and still some way from the midpoint of our target. Given this, the Board held the cash rate target at 4.35 per cent at its meeting earlier this week. It noted that the path of interest rates that will best ensure that inflation returns to target in a reasonable timeframe will depend upon the data and the evolving assessment of risks. At this stage, the Board hasn't ruled out a further increase in interest rates but neither has it ruled it in. However, given the substantial costs to the economy and the Australian people of continued high inflation, the Board is committed to bringing inflation back to target in a reasonable timeframe. Before I finish, I briefly want to address three further issues. We spend most of our time in these hearings talking about monetary policy and I understand why given the visible impact it has on the Australian people and the economy. But we have many other responsibilities at the RBA, including oversight and regulation of the payments system and the issuance of Australian banknotes. Payments system First, to the payments system. As you are probably aware, the Reserve Bank has had the power to regulate the payments system since 1998. It does so to promote competition, efficiency and safety in the Australian payments system. But in recent years, the payments system has changed dramatically. It has moved from a system that was predominantly serviced by large established financial institutions and card schemes to a vibrant and innovative ecosystem, with participants ranging from traditional financial institutions to small start-ups to large tech companies. Given this, the legislation that gave the RBA the powers to regulate in this area was no longer fit for purpose. The Government is addressing this issue by modernising the legislation to allow the RBA to regulate the new and diverse set of participants more effectively. Once this legislation is passed, we will be embarking on a wholesale review of our retail payments regulation to identify any areas where competition, efficiency and safety could be improved. There is also legislation in the making that will provide a licencing regime for non-bank payment service providers and will implement common access requirements for payment systems. These changes will also help to promote competition in the payments system. 4/5 BIS - Central bankers' speeches Banknote distribution Another issue that I would like to update the Committee on is the work that is underway to address challenges in the cash distribution system. As the use of cash for transactions has declined, the economics of cash distribution has come under pressure. This was one of the main factors behind the merger of the two largest cash-in-transit providers last year, which the ACCC approved subject to a three-year undertaking regarding pricing and service levels. However, Linfox Armaguard has since indicated that, despite this, its cash distribution business remains unsustainable. The RBA places a high priority on the Australian community continuing to have good access to cash withdrawal and deposit services. Late last year, I convened several discussions with businesses in the industry to consider what more could be done to support access to cash for those who need or want it, and to promote a sustainable model for cash distribution in Australia. These discussions are being conducted in line with an Interim Authorisation from the ACCC enabling relevant parties to develop and evaluate industry responses to support the viability of wholesale cash distribution and access to retail cash services. They are likely to continue for some months. Developing a model for cash distribution that is sustainable in the long term requires addressing complex issues that will take some time to work through. I have encouraged the major participants in the cash distribution system to approach these issues with the public interest in mind. $5 banknote redesign project Finally, I would also like to update the Committee on the work underway to redesign the $5 note. Last year, we announced that we would be taking the opportunity to feature a new design on the $5 note that honours and celebrates the culture and history of First Nations peoples. As a first step in determining the design, we will be asking members of the public, over the course of March and April, to share with us what they think should be on our $5 banknote to represent First Nations culture and history in Australia. In recent weeks, we have also begun visiting First Nations community organisations in key regional and remote locations across Australia and the Torres Strait, to engage with local communities about the theme nomination process. I encourage all Australians to be involved in contributing to this important endeavour. I will finish on that note. My colleagues and I look forward to answering your questions. 5/5 BIS - Central bankers' speeches | reserve bank of australia | 2,024 | 2 |
Speech by Mr Christopher Kent, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, at the Bloomberg Australia Briefing, Sydney, 2 April 2024. | Speech The Future System for Monetary Policy Implementation Christopher Kent[*] Assistant Governor (Financial Markets) Bloomberg Australia Briefing Sydney – 2 April 2024 I’d like to start by thanking Bloomberg for hosting this event. Today, I’ll be speaking about the future system for monetary policy implementation – that is, the method by which the Reserve Bank of Australia (RBA) controls the cash rate. Planning for the future system is important given that the unwinding of unconventional monetary policies is leading to a decline in Exchange Settlement (ES) balances – otherwise known as reserves (Graph 1). Reserves held by banks in their ES accounts at the RBA play a central role in policy implementation. Banks use these funds to settle payments with other banks and with the RBA. They can also lend surplus funds to other banks in the overnight cash market. Those transactions go into the determination of the cash rate. Graph 1 Exchange Settlement Balances* $b $b Projected** Actual * Includes minimum required balances to meet after−hours payments. ** Assumes RBA bond holdings are held to maturity and no net change in RBA liquidity operations. Source: RBA At its March meeting, the Reserve Bank Board considered three options for the future system for the implementation of monetary policy: 1. maintain the current ‘floor’ system with an excess of reserves; 2. return to a ‘corridor’ system with scarce reserves, as used prior to the pandemic; or 3. transition to a new system of ample reserves that lies somewhere between these two. The Board endorsed a plan to move to an ample reserves system with full allotment repurchase agreement (repo) auctions for our Open Market Operations (OMOs). The Bank of England, the European Central Bank and the Swedish Riksbank have announced they will be operating similar systems. I want to emphasise that this decision has no implications for the current or future stance of monetary policy. Rather, it is only relevant to the way in which we will achieve the desired stance of monetary policy through our operations. Nor does it have a bearing on the Board’s current approach to quantitative tightening, which is to allow bonds purchased during the pandemic to run down as they mature and to periodically review the case to actively sell bonds. Today I’ll explain the three options for policy implementation, discuss some of the reasons why the Board has chosen to pursue the ample reserves system, and lay out the next steps as we move to that approach. Three options for policy implementation Option 1: A floor system with excess reserves – Our current approach One option is to stay with the current approach. Namely, an excess supply of reserves that leads the cash rate to be close to a floor. This floor is the rate paid to banks on funds left overnight in their ES accounts – the ES rate. The shift to this approach from the earlier system of scarce reserves began in mid-March 2020, as growing concerns about the economic effects of the pandemic led to stresses in global financial systems, including in Australia. As a first response, the RBA increased the extent of liquidity we were providing to banks (Graph 1; Graph 2; Graph 3).[2] Settlement balances quickly ramped up as the RBA met additional demand at our daily OMOs and bought government bonds in support of the functioning of those markets. Reserves grew further with the advent of the Term Funding Facility (TFF) and bond purchases in support of the yield target, and then later in 2020 through the bond purchase program. Graph 2 Reserve Bank Assets $b $b -100 Open repo & other assets OMO repo Term Funding Facility Source: RBA. R E S E R V E B A N K O F AU S T R A L I A Domestic bonds Gold & foreign exchange -100 Graph 3 Reserve Bank Liabilities $b $b -100 Capital & Reserve Bank Reserve Fund Banknotes Exchange Settlement balances -100 Gov. & other deposits Other Iiabilities Accumulated losses Source: RBA. As ES balances rose to high levels and the initial financial stresses in markets eased, most banks found they had a surplus of funds in their ES accounts. Therefore, the demand from banks to borrow from one another in the cash market to meet their payments and other needs declined. As a result, the cash rate became closely anchored to the ES rate and activity in the cash market fell away markedly. ES balances stabilised at around $460 billion in 2022, following the end of the bond purchase program, and since February 2023 have been declining as some of the bonds held have matured and the first tranche of the TFF was repaid by September 2023. ES balances will decline further when the remaining $96 billion of the TFF is repaid by the middle of this year, and as the RBA’s bond portfolio continues to decline. We are confident that the current high level of ES balances is still well in excess of what the banking system as a whole needs to satisfy underlying demand (to meet banks’ payment and minimum liquidity needs). But as ES balances decline further, there will come a point where reserves are no longer in excess of underlying demand. Some central banks have decided to retain a system of excess reserves.[5] To ensure that reserves remain in excess of underlying demand, at some point these central banks will need to offset the decline in reserves associated with the unwinding of their unconventional monetary policies. They can do this in a number of ways, but in general they will need to buy assets, such as government bonds (either outright or under repurchase agreements) or through foreign exchange transactions (e.g. via FX swaps). These central banks will work to maintain a buffer of reserves over and above the underlying demand for reserves. If the buffer isn’t sufficient, it could lead to volatility in a range of money markets.[6] To avoid that, these central banks will be monitoring conditions in money markets very closely and responding if needed, noting demand can change over time and sometimes quite quickly. The Board has decided not to maintain the current floor system with excess reserves. One reason is that it would require the RBA to hold a sizeable buffer of reserves over underlying demand, necessitating a relatively large balance sheet on an ongoing basis. Compared with the other options, this implies some additional risk to the RBA (such as interest rate risk) and a more sizeable footprint in markets. Option 2: An interest rate corridor with scarce reserves – Our pre-pandemic approach What about the option of returning to our earlier system of scarce reserves to guide the cash rate to the target? This system was in use for many years before March 2020.[7] It entails the central bank supplying just enough reserves to meet the underlying demand of the banking system, and providing standing facilities to ensure that the policy rate trades in a corridor around the target. In Australia, banks with surplus reserves could leave them on deposit with the RBA at the ES rate, which used to be 25 basis points below the cash rate target. Banks with a shortage of reserves could borrow them overnight from the RBA at a rate that was 25 basis points above the target. Banks had no reason to pay a rate above the top of the corridor for borrowed reserves, nor would they lend reserves at a rate below the floor of the corridor. To keep the cash rate near the target, the RBA needed to accurately estimate the demand for reserves, forecast changes in the supply of reserves, and conduct OMOs daily (and sometimes more than once in a day). The system worked well for many years, with the cash rate almost always at the cash rate target. Compared with the other two options, this system has a couple of attractive features. Because it entails a smaller balance sheet than under excess or ample reserves systems, it naturally implies lower interest rate risk for the RBA. Similarly, it implies a smaller footprint of the RBA in financial markets. Indeed, this system supports more cash market activity than the other options because on any given day it is more likely that some banks are facing a shortage of reserves and need to borrow from other banks to meet their needs. Despite these benefits, the Board has decided not to return to a scarce reserves system. Such a system entails the highest risk of the banking system running into liquidity shortages. A scarce reserves system requires the central bank to have accurate estimates of reserve demand and supply on a daily basis and respond actively to shortterm fluctuations as needed. In the past, this appeared to be very successful, with only a few trivial deviations in the cash rate from the target (Graph 4). However, a large part of that may have been because of the convention by cash market participants to almost always conduct trades in the cash market at the target rate set by the Board. Having moved away from that environment, such a convention may not re-emerge. Graph 4 Cash Market By monetary policy implementation system* Daily cash market volume* $b $b 5.0 5.0 Excess reserves 2.5 2.5 Scarce reserves bps bps Spread to the ES rate * Rolling 30−day average. Source: RBA. R E S E R V E B A N K O F AU S T R A L I A Cash rate Cash rate target Moreover, even though the cash rate in the past would trade close to target, there were lengthy periods when liquidity was tight in broader money markets, such as for repo and bank bills. This was evident when market rates traded noticeably above the cash rate or overnight index swaps (which measure expectations for the future cash rate), even though the cash rate was trading at the target (Graph 5). This tightening in financial conditions reflected, in part, the fact that some money market participants did not have access to the cash market and borrowed in other short-term markets. At the same time, banks were often reluctant to lend large volumes of reserves in money markets until late in the day, once they were confident in their capacity to meet their own liquidity needs. Graph 5 Australian Money Market Spreads Spread to OIS; 3 month bps bps FX** BBSW Repo* −50 −100 −50 −100 * RBA OMO repos used prior to 2020, private market HQLA repos used from 2020. ** Implied AUD rate based on covered interest parity. Sources: APRA; ASX; Bloomberg; RBA; Tullett Prebon; US Federal Reserve. Having moved away from scarce reserves after the onset of the pandemic, banks appear to have adapted their operations to an environment of higher reserves, simplifying their liquidity management and facilitating smoother daily payment processes.[9] In other words, the underlying demand for reserves is likely to have increased compared with pre-pandemic days. It is difficult to accurately estimate underlying demand in any system, but small errors of estimation would be more problematic in a system of scarce reserves, since they can lead to considerable volatility in cash and other money markets (without very active responses from the central bank). Another issue is that a scarce reserves system is not resilient in the face of a sharp rise in the demand for liquidity in the banking system during occasions of considerable financial market stress. The RBA may be faced with such a scenario in the future and need to provide a large increase in reserves. This occurred at the onset of the pandemic when the RBA met all reasonable demands for liquidity from participants at our OMOs, much like the way in which our full allotment auctions work currently. Reserves also increased with the RBA’s purchases of bonds to address the dysfunction in government bond markets at the time. In short, scarce reserves systems are ill-suited to environments where demand for reserves is volatile and difficult to estimate accurately and where supply may change substantially depending on the need for the central bank to use balance sheet policies. For all these reasons, no other advanced economy central bank has indicated a return to a scarce reserves system. Option 3: Ample reserves with full allotment OMO – A new approach The third option, which the Board has endorsed, is an ample reserves system in which banks’ demands for reserves are satisfied via open market repo operations at a price near the cash rate target, in what are known as full allotment auctions. Together with the floor provided by the ES rate, these operations should keep the cash rate close to target. Setting the price of reserves in this way is in contrast with the scarce and excess reserve systems, where the central bank sets the quantity of reserves in order to affect the price. Under the ample reserves system, the supply of reserves can rise and fall in line with changes in demand, with minimal effects on the cash rate and other money market rates. The Board sees a number of advantages with this new approach. Since the supply of reserves from the RBA will respond to changes in demand, we do not need to accurately estimate demand nor control the quantity of reserves; in short, it is simpler to operate than a scarce reserves or excess reserves system. An ample reserves system also reduces the risk of unnecessary volatility or disruption to conditions in money markets. Similarly, it is more resilient to any future expansion in the RBA’s balance sheet if, for example, there was a need to address extreme stresses affecting bond markets, such as at the onset of the pandemic. That said, in this system, banks will still need to ensure they manage their liquidity carefully, including by obtaining sufficient liquidity at OMOs. An ample reserves system is likely to lead to more activity in cash and other money markets compared with an excess reserves system, although not as much as under scarce reserves. With the supply of reserves just sufficient to satisfy underlying demand, the RBA’s balance sheet will be no larger than it needs to be in order to implement monetary policy, and our footprint in financial markets will be smaller than in an excess reserves system. The RBA will use repurchase agreements to supply reserves, which as of February this year are based on a floating rate (as a spread to the cash rate target), thereby removing interest rate risk for the RBA. Other operations could also be used to supply reserves, such as purchases of short-dated government bonds and/or FX swaps. We used these types of operations prior to the pandemic and they can also be structured to minimise interest rate risk. This is in contrast with an excess reserves system, for which it may be more difficult to supply sufficient reserves while also limiting the interest rate risk held on the RBA’s balance sheet and avoiding an overly large footprint in some markets. The transition from excess to ample reserves The RBA has been running full allotment OMO repo auctions since shortly after the onset of the pandemic, so from our counterparties’ perspective there will be no immediate changes in our operations. Currently, the supply of reserves is in excess of underlying demand, which means that most banks have no need to obtain liquidity through OMOs. Participation is therefore relatively low compared with pre-pandemic levels (Graph 6). As the level of reserves falls, however, we will at some point transition from an excess of reserves to an environment of ample reserves. As this happens, we expect to see cash market activity increase, perhaps with some rise in the cash rate, and potentially some pressure in other money markets. By design, however, any such pressures should, to a large extent, be tempered as banks naturally respond to higher market interest rates by borrowing more at OMO repo at the price set by the RBA. As always, the RBA will be monitoring market conditons closely, particularly around the upcoming maturity of the TFF. And we have the ability to respond to market stresses if the need arises, including by conducting OMO more frequently than once a week. R E S E R V E B A N K O F AU S T R A L I A Graph 6 OMO Outstanding By auction type* $b Competitive $b Full−allotment * Auction sizes increased in March 2020 in response to the COVID−19 pandemic. Source: RBA. What’s next? The Board has endorsed a plan to move to an ample reserves framework with full allotment OMO repo as the RBA’s future monetary policy implementation system. The next steps are for the RBA to determine the more detailed aspects of the system, including: the pricing, frequency and other aspects of our OMO repos; and what other instruments we might use to supply reserves. In addition to repo via full allotment auctions, the demand for reserves could be accommodated via a mix of FX swaps and purchases of short-dated government bonds. Among other considerations, this will depend on how the RBA wants to structure the composition of its balance sheet over the medium term. Also, a range of instruments would help to avoid an overly large presence in any single market, which might otherwise crowd out private sector activity. Under the earlier system of scarce reserves, all of these means of managing reserves – repo, FX swaps and outright bond holdings – were commonplace, though the outstanding balances for these instruments may well be greater under ample reserves. One issue we will be looking at closely is how banks adjust to the progressive withdrawal of liquidity implied by the run down in reserves. Hence, the accessibility of reserves at OMO, and in particular the price to borrow reserves under repo, will be a point of interest, including because it involves trade-offs. For example, an OMO repo rate with a low spread over the ES rate will provide banks with an incentive to demand more reserves than otherwise, which may facilitate more efficient payments and reduce risks to financial stability. However, this will reduce the incentives for banks to source liquidity from private markets (including the overnight cash market), with the RBA having a larger footprint in markets and a larger balance sheet. Conversely, an OMO rate further above the ES rate will provide banks with an incentive to hold fewer reserves than otherwise and obtain more liquidity from private markets, including in the cash market. But this could leave banks with smaller buffers to deal with sudden and unexpected increases in their need for reserves and result in more volatility in money markets. The Board will consider these issues in due course, aided by the results of a public consultation and liaison with market participants that will commence shortly. In the meantime, our operations in financial markets will continue as they are. Namely, weekly full allotment repo OMO operations at a 28-day term and priced at a floating rate of 5 basis points above the cash rate target. Finally, let me stress again that all of this is about the plumbing underpinning the monetary system. It is not about the stance of monetary policy. Endnotes [*] I thank Sean Dowling, Gian-piero Lovicu and Sam Batchelor for their excellent assistance in helping me to prepare this speech. See Ramsden D (2018), ‘Finding the Right Balance’, Speech at the Society of Professional Economists Annual Conference, London, 28 September; Schnabel I (2024), ‘The Eurosystem’s Operational Framework’, Speech at the Money Market Contact Group, Frankfurt, 14 March; Riksbank (2019), ‘The Riksbank’s New Operational Framework for the Implementation of Monetary Policy’, July. See Kent C (2022), ‘Changes to the Reserve Bank’s Open Market Operations’, Remarks to the Australian Financial Markets Association, Sydney, 22 February. Debelle G (2021), ‘Monetary Policy During COVID’, Shann Memorial Lecture, Online, 6 May. We had reduced the gap between the ES rate and the cash rate target to 10 basis points, from 25 basis points under the earlier corridor system. So by design the cash rate, anchored to the ES rate, was close to the cash rate target. The US Federal Reserve, Bank of Canada and Reserve Bank of New Zealand all intend to operate floor systems with excess reserves. See US Federal Reserve (2022), ‘Principles for Reducing the Size of the Federal Reserve’s Balance Sheet’, Press Release, 26 January; Jefferson PN (2023), ‘Implementation and Transmission of Monetary Policy’, H Parker Willis Lecture, Virginia, 27 March; Bank of Canada (2022), ‘Bank of Canada Provides Operational Details for Quantitative Tightening and Announces that it Will Continue to Implement Monetary Policy Using a Floor System’, Notice, 13 April; Gravelle T (2024), ‘Going Back to Normal: The Bank of Canada’s Balance Sheet After Quantitative Tightening’, Remarks at the CFA Society, Toronto, 21 March; RBNZ (2022), ‘Reserve Bank Optimising New Zealand’s Monetary Policy Implementation Framework’, Media Release, 6 May; Callaghan M, C Haworth and K Poskitt (2023), ‘How the Reserve Bank Implements Monetary Policy’, RBNZ Bulletin, June. As was the case in the United States during September 2019. For a comprehensive account of this episode, see Afonso G et al (2021), ‘The Market Events of Mid-September 2019’, Economic Policy Review, 27(2). Debelle, n 3. For a fuller explanation of the RBA’s pre-pandemic system for implementing monetary policy, see Domestic Markets Department (2019), ‘The Framework for Monetary Policy Implementation in Australia’, RBA Bulletin, June. In principle, they could have lent earlier if borrowing cash overnight from the RBA was treated similarly to leaving cash on deposit with the RBA – after all, the pricing of both was symmetric, at 25 basis points away from the cash rate target. But in reality borrowing from the RBA overnight was discouraged, and banks avoided this when they could. That is, arbitrage between the cash market and other money markets was somewhat limited, which resulted in other money market rates sometimes diverging materially from the cash rate. This is evident in Australia and other advanced economies. For discussions on the increase in banks’ demand for reserves in the Euro Area and United States, respectively, see Schnabel I (2023), ‘Back to Normal? Balance Sheet Size and Interest Rate Control’, Speech at Columbia University and SGH Macro Advisor, New York, 27 March; Acharya VV and R Rajan (2023), ‘Liquidity, Liquidity Everywhere, Not a Drop to Use – Why Flooding Banks with Central Bank Reserves May Not Expand Liquidity’, NBER Working Paper No 29680. For discussion on how changes to US banks’ liquidity management preferences during a period of excess reserves may have increased their underlying demand for liquidity, see Lopez-Salido D and A Vissing-Jorgensen (2023), ‘Reserve Demand, Interest Rate Control, and Quantitative Tightening’, 27 February. There is also evidence that more reserves have led to faster settlement of payments in the United States (see Bech ML and RJ Garratt (2012), ‘Illiquidity in the Interbank Payment System Following Wide-scale Disruptions’, Journal of Money, Credit and Banking, 44(5), pp 903–929). Payments efficiency has also increased in Australia, albeit to a lesser extent than the United States, since operating with a higher level of reserves (see Kopec K and C Rao (2022), ‘The Evolution of Interbank Settlement in Australia’, RBA Bulletin, March). [10] In particular, under an excess reserves system the supply of reserves is greater than the underlying demand of the banks, and so a central bank cannot rely on demand at OMO operations to push the supply into ‘excess’ territory. To do this, the central bank may need to either buy a large share of short-dated bonds (with risks to market functioning) or buy longer dated bonds (with the associated interest rate risk). R E S E R V E B A N K O F AU S T R A L I A | reserve bank of australia | 2,024 | 4 |
Speech by Mr Brad Jones, Assistant Governor (Financial System) of the Reserve Bank of Australia, at the COSBOA National Small Business Summit, Sydney, 4 April 2024. | Speech Financing SME Innovation in Australia – Challenges and Opportunities Brad Jones[*] Assistant Governor (Financial System) COSBOA National Small Business Summit Sydney – 4 April 2024 Introduction Small and medium-sized firms (SMEs) are in many ways the backbone of the Australian economy. At the Reserve Bank, the importance of SMEs has long been reflected in our analytical research agenda and our liaison program. Indeed, last July the RBA hosted its annual small business financing roundtable event for the 31st time, while our liaison program – which includes active year-round engagement with SMEs spanning the breadth of the country – is now into its 24th year. There are different ways through which to view the contribution that SMEs make to our economy and society. The first (and most familiar) is through their central role in the daily life of our communities. Of the 2.6 million businesses in Australia, 97 per cent are characterised by the Australian Bureau of Statistics as ‘small’ firms (comprised of less than 20 employees), with a further 2 per cent of firms classified as ‘medium-sized’ (between 20 and 200 employees).[1] SMEs are widely represented across the sectors of the Australian economy. A particularly notable contribution they make is through the labour market, where SMEs account for two-thirds of private sector employment. They also comprise just under 60 per cent of company profits. More than this, SMEs are integral to the social fabric of our communities – whether it be sponsoring the local kids sporting team, community theatre production or charity event. Nowhere is this more true than in regional Australia, where many SMEs are family-run businesses that provide goods and services in areas where larger firms are less active.[2] And who doesn’t have a favourite weekend ‘local’? Another way in which to view the contribution of SMEs to our collective wellbeing is narrower but no less important – they are potential engines of innovation and dynamism in the Australian economy. SMEs can introduce competitive tension to established markets that are typically dominated by larger incumbents, driving them to be more efficient in the process. And in generating or diffusing new ideas and better ways of doing things, they can create new markets for goods and services and facilitate the reallocation of capital and labour to more productive use. This creative energy can be of sufficient scale to directly impact our living standards. But unleashing this creative energy first requires access to financing on reasonable terms. And for a long time, this has been easier said than done. It is this innovation role for SMEs – one that has historically received less attention – that I will focus on today. More concretely, I will begin by setting out some tangible markers of the ways in which a cohort of SMEs, particularly those seeking to compete in global markets, are helping to fuel innovation in the Australian economy. I will then discuss some of the longstanding financing challenges experienced by SMEs, particularly those seeking funding for innovation-based investments that have a large ‘intangibles’ component and a long and uncertain payoff. I will conclude by casting a light on the evolving role that the Australian financial system is playing in supporting innovation among smaller entrepreneurial firms. The punchline here is two fold. First, SMEs have become increasingly important participants in the innovation ecosystem in Australia, particularly in professional, scientific and technical services. In some respects, they appear to be taking over the ‘innovation baton’ from large firms, including in early-stage investment in research & development and intellectual property rights. Second, while the Australian financial system and policy settings have interacted to lend more support to innovation-focussed SMEs over the past decade, there is more to be done if the next generation of innovative Australian firms are to have the wind at their back. The contribution of SMEs to innovation in Australia Why should we care about innovation, and the role of SMEs in it? One reason is that innovation is a feedstock for productivity, which in turn drives national living standards. But as the Productivity Commission has noted, Australia’s productivity performance in the 2010s was the worst in six decades, and the picture has yet to improve in the current decade. If there is a blessing in disguise here, it is that these outcomes have ignited a renewed sense of urgency about how we turn this around. And as we will come to see, some SMEs have a large and growing role to play. For our purposes today, I will generally refer to innovation as the development and application of ideas and technologies that improve the quality of goods and services, or that make their production more efficient.[3] This encompasses not only the generation of entirely new products and processes, but also the rapid adaptation and diffusion of other cutting-edge ideas and processes across the economy. Innovation is closely tied to the concepts of ‘creative destruction’ and ‘economic dynamism’, which can find expression in the entry of new firms, the downsizing (or exit) of less efficient firms, and workers moving from lower to higher productivity firms where wages are higher. On first impression, a discussion of SMEs in this context might seem a bit out of step with today’s international focus on large, winner-take-all ‘superstar’ firms – think BigTech. Here we see a growing share of sales concentrated in a handful of large dynamic firms, whose high mark-ups allow them to generate abnormal profits. This is no accident. Favourable ‘unit economics’ in parts of the technology and data services industry mean that each additional unit of sales, generated from around the world, costs little to produce and so flows straight through to the bottom line. A related theme is that powerful network effects and high barriers to entry (‘walled gardens’) can further entrench market dominance of large incumbents, where free cash flow is recycled back into ever-growing innovation budgets, supporting the development of even more highly valued goods and services and thus increases in profitability. This is the context for rising concerns from competition regulators around the world. But while the concept of innovation might have become, in the public imagination at least, more closely tied to the largest global firms, part of what I want to discuss today is a less covered story – and that is, the pulse of innovative intent that is running through parts of the Australian SME ecosystem. This pulse might be less visible than the latest edition of the iPhone, but it is happening nonetheless. Consider, for instance, spending on research and development (R&D), which is an integral feature of any economy with innovative aspirations, including where firms seek to compete in global markets.[4] SMEs now spend around 25 per cent more on R&D than large firms in Australia, the largest differential in decades. The SME share of R&D spending in Australia oscillated between 30 and 40 per cent for many years; today that figure stands at 55 per cent (Graph 1). All of the real decline in national R&D spending over the past 10–15 years can be attributed to large firms, which was initially concentrated in the mining industry before broadening in scope to R E S E R V E B A N K O F AU S T R A L I A the non-mining sector. While real R&D spending by large firms has retreated to levels observed in the mid-2000s, for SMEs it has more than doubled over the same period and increased as a share of GDP. Today the biggest contribution to R&D spending in Australia comes from SMEs in professional, scientific and technical (PST) services, comprising 26 per cent of the national total; large firms in this sector comprise 8 per cent of the national total. Graph 1 R&D Expenditure Share of total* % % Large SMEs * SMEs are businesses with less than 200 employees; large businesses are those with 200+. Data are biennial after 2012. Sources: ABS; RBA. While just over half of surveyed Australian SMEs are likely to be innovating at any one time, compared with around 70 per cent of large firms, the intensity of innovation is much higher for the SMEs that are innovating. Put bluntly, these SMEs are more likely to be throwing the kitchen sink at innovation. Beyond R&D, this includes by investing in intangible assets such as intellectual property (IP) rights.[5] Similarly, among firms that are active in innovation, the effects on income tend to be far more consequential for SMEs than larger firms that typically have more diversified revenue sources (Graph 2). Graph 2 Impact of Innovation on Income Share of innovating businesses, by size* % Share of income from innovations: 25–50% >50% 10.0 % 10.0 7.5 7.5 5.0 5.0 2.5 2.5 0.0 SMEs Large 0.0 * SMEs are businesses with less than 200 employees; large businesses are those with 200+. Sources: ABS; RBA. In the United States, recent research has pointed to a trend of declining in-house R&D spending by large established firms. This has occurred alongside the repurposing of innovation budgets to fund buyouts of smaller firms that are better placed to commercialise the best-of-breed ideas from their interactions with the university system.[6] Some preliminary research at the RBA has also identified that Australian firms with IP assets are disproportionately likely to be the focus of the buyout decisions of large established firms, over a period where the direct R&D spending by large Australian firms has contracted.[7] This is not to suggest that large Australian firms no longer have an interest in innovation, only that it may be taking a different (acquisition-based) form to the past. I will return to this later. The Australian economy, like most others, tends to be an importer of ‘new-to-world’ innovations rather than a large-scale producer like the United States. But in the case of firms that are engaged in innovation in Australia, SMEs are almost twice as likely to have introduced new-to-world innovations compared with large firms (Graph 3). These types of innovations are harder to produce and so are typically riskier to finance. But they are also likely to generate large positive externalities for the economy and society. Australian SMEs that sell into global markets and that collaborate on innovation, particularly in the manufacturing and PST sectors, are among the most likely to innovate. R E S E R V E B A N K O F AU S T R A L I A Graph 3 New-to-world Innovations Share of innovation-active businesses, by size, 2019–2021* % % SMEs * Large Novelty of the most significant innovation introduced by a business. SMEs are businesses with less than 200 employees; large businesses are those with 200+. Sources: ABS; RBA. Patents and trademarks can be important markers of innovation, and the IP rights conferred by holding them can be highly valuable intangible assets. As IP Australia has noted, patents and trademarks can provide vital tools for entrepreneurship and the creation of high-growth businesses.[9] Labour productivity in Australia is around 30 per cent higher in the median patent-holding business compared with the median business without patents.[10] SMEs now hold almost all patents and trademarks filed by residents in Australia (Graph 4).[11] Perhaps more interesting is that, as with R&D spending, there has been a significant relative shift in the holding of IP rights between SMEs and large firms: over recent years the number of patent-holding SMEs has increased at a rate five times faster than the increase in the number of SMEs in the economy – a pattern not apparent among large firms.[12] Australian SMEs that file for patents, trade marks and design rights are more than twice as likely to achieve high turnover growth than their peers with no recent filings. This broadly aligns with the experience in the United States where the holding of IP rights has been shown to substantially increase investors’ estimates of the value of a start-up enterprise. Graph 4 Australian Firms Holding Trade Marks and Patents Share of domestic holders, annual average, 2010–2020* Trade marks Patents Small * Medium Large % Small businesses have less than 20 employees, medium 20–199, large 200+. Sources: IP Australia; RBA. It has been well documented internationally, and more recently in Australia, that economic dynamism supports productivity-enhancing resource reallocation in the economy.[14] This can be seen in wage and productivity differences across firms (which promotes job switching) and in business entry and exit patterns. For Australian firms of all sizes, there is a positive wage differential between firms that hold IP rights (such as patents) compared with those that do not. But the differential is especially pronounced for smaller firms (Graph 5). Over the past two decades, firm entry and exit rates have generally declined in Australia, though the entry rate for small firms has tracked sideways over the most recent decade (Graph 6). It is possible that lower transition rates (from smaller to larger firms) and acquisition activity may have contributed to some of the sustained decline in entry rates for medium-sized and large firms, but it is an area our researchers are looking into. R E S E R V E B A N K O F AU S T R A L I A Graph 5 Difference in Median Wages for Firms with and without Patents By firm size* % % Small** Medium Large * Small businesses have less than 20 employees, medium 20–199, large 200+. ** Results for small businesses are an average of the results for businesses with 0–4 employees and 1–19 employees. Sources: IP Australia; RBA. Graph 6 Business Entry and Exit Rates By size, annual* % Small Medium % Large Entry rate Exit rate * Small businesses have 1–19 employees (non-employing entites are excluded), medium 20–199, large 200+. Sources: ABS; RBA. The longstanding challenge of SME innovation financing The investment environment for firms is shaped by a number of factors, with the financial system and policy settings key among them. As internally generated free cash flow is often in short supply for SMEs, particularly younger firms, access to external financing can make all the difference. At the RBA, we’ve consistently heard this message through our liaison program. It also accords with surveys of Australian businesses indicating that a lack of financing is a key barrier to innovation for small firms (Graph 7). Graph 7 Firms Reporting Access to Finance as a Barrier to Innovation Share of innovation-active businesses, by size, 2019–2021* % % Small * Medium Large Small businesses have less than 20 employees, medium 20–199, large 200+. Sources: ABS; RBA. There are a number of factors at work here, some of which apply to SMEs in general, while others relate more specifically to SMEs that are active in innovation-based investment. The highest order problem is that small firms are riskier propositions for suppliers of capital. Survival rates bear this out – whether new or established, small firms are more likely to go out of business in any given year than their larger counterparts (Graph 8). Particularly low survival rates among young small firms are consistent with the ‘up or out’ stage of their development, where they are experimenting and succeeding, or failing and exiting – they either crash through or crash. R E S E R V E B A N K O F AU S T R A L I A Graph 8 Business Survival Rates By firm size % New businesses* % All businesses** Large Medium Small Sole traders and partnerships*** * Firms commencing operation in 2019/20. Small businesses have 1–19 employees (non-employing separate line), medium 20–199, large 200+. ** Firms operating at end-June 2019. *** Non-employing businesses. Sources: ABS; RBA. While bank loans to SMEs comprise half of all business lending in Australia, many SMEs report experiencing tight financial conditions in the form of credit-rationing and/or high borrowing costs. This is partly linked to riskweights that are relatively higher for SME lending, reflecting banks’ risk modelling where SME loans are expected to be around twice as likely to fall into arrears as large firms (Graph 9). And loans to SMEs almost always require collateralisation, unlike those to large firms. Graph 9 Business Lending Default Probabilities and Lending Rates % Default probabilities* SMEs Variable lending rate** % Small business 2.4 1.2 Large business 0.0 * Average estimate from internal ratings-based models. On-balance sheet exposures of major banks. SME is the SME retail and SME corporate categories in APRA’s capital framework; large business is the corporate category. ** Average variable rate on outstanding loans. Business size based on turnover and exposure. Sources: APRA; RBA. Prospective lenders and investors also tend to be more circumspect in financing SMEs for any number of reasons, including that: there is a lack of scale in financing smaller entities; their revenues are often more volatile; and informational asymmetries are more acute compared with larger firms where more information on their finances is publicly available. And if many SMEs feel as though they are kicking into the wind when it comes to access to financing, those winds can blow stronger still for SMEs seeking debt funding to support their innovation priorities. There are at least two reasons for this. One issue is that innovation-based assets are often largely (or exclusively) intangible, and therefore are not of a standardised form that most traditional lenders prefer. Given that almost all SME lending is secured, and residential property has an outsized role in collateralising the loans of small businesses, access to innovationbased debt financing is not straightforward. This is particularly the case for younger entrepreneurs struggling to get onto the housing ladder.[17] We also hear through our liaison program that even if small business owners do hold residential property, some are understandably reluctant to post it as collateral given the stress involved; and, if they do, they are more likely to be more risk averse in their business investment decisions when their family home is on the line. Survey data suggest that banks are much less likely to finance the innovation-based investments of SMEs compared with large firms (Graph 10). SMEs are therefore more likely than large firms to fund innovation-based investments from family and friends, and non-bank institutions like venture capital (VC) and private equity (PE) funds who are better placed to bear such risk. I should note here that this pattern has not been unique to Australia, but rather has been widespread across advanced economies and is one of the factors supporting the growth of technology-focused VC funds and PE funds focused on early-stage funding rounds. Graph 10 Sources of Innovation Financing Share of innovation-active businesses, by size, 2019–2021* % % SMEs Large Existing owners * ** Banks Family & friends** Finance firms VC/PE funds SMEs are businesses with less than 200 employees; large businesses are those with 200+. Large business funding from family and friends not published. Sources: ABS; RBA. Another funding issue that is felt acutely by innovation-focused SMEs is navigating the ‘valley of death’ – the long lead time between converting greenfield research ideas into commercially viable propositions, during which time firms can burn through their initial funding. This valley can appear prohibitively deep and wide for many lenders. R E S E R V E B A N K O F AU S T R A L I A Overcoming the financing impediments to SME innovation While funding challenges will likely remain a fact of life for many SMEs, private and public capital is now being mobilised in Australia in ways that are beginning to ease some longstanding constraints on innovation financing, at least for some firms. One of the most material developments has been the emergence of an institutional-grade domestic VC industry that, over the past decade, has channelled long-term equity capital into some of Australia’s more innovative and scalable businesses. This capital can support small firms that are loss-making during an intensive period of ideation and prototype development. The past decade has marked a ‘third wave’ for the domestic VC industry, after nascent upswings in the late 1990s and just prior to the global financial crisis were followed by industry shakeouts. Investment in the Australian VC industry (as a share of GDP) is now in the range of peer economies, though still considerable distance behind the United States and Israel. Over the past decade, assets under management in Australian VC funds have grown from $2.5 billion to $20 billion; their share of institutionally managed private capital in Australia has doubled; and the number of VC deals written each year has increased significantly (Graph 11). This is despite a challenging period for SME technology valuations over the past two years as interest rates have risen. This capital is in search of the far right tail of the distribution of young small firm returns, where a minority of enterprises can break out with innovations that can be readily scaled into global markets, more than making up for losses incurred on those that don’t make it (Graph 12). Graph 11 Australian Venture Capital Annual Assets under management* ($b, LHS) Share of institutional private capital** (%, LHS) Number of deals*** (RHS) no. * 2023 observation only includes data up to June. ** Institutionally managed private capital. 2023 observation only includes data up to June. *** Data up to December 2022. Sources: Prequin; RBA. Graph 12 Annual Revenue Growth Distribution* Percentile ranking, by firm type** % Far right tail % Young small Old large -25 25th * ** Median 75th 95th -25 Year-ended revenue. Results based on ATO tax data in BLADE from 2004–2023. Only includes companies with revenue greater than $75,000. Small companies have less than 20 employees and are less than 10 years old; large companies have 200+ employees and are older than 10 years. Sources: ABS (BLADE); RBA. At the same time, there are limits to what the private domestic VC industry alone can achieve in supporting innovation in Australia. In any given year only a small fraction of innovating firms that seek VC funding actually obtain it, the average deal size has clustered in the range of $10–20 million over recent years (which may be too large or too small for some firms), and the sectoral focus of VC funding is more narrowly skewed vis-à-vis other traditional SME funders (toward software, information technology applications in financial and health services, and manufacturing). This sectoral skew in investment is broadly consistent with the sectoral skew in R&D spending. Over the past decade or so, government has also had an important role – direct and indirect – in easing constraints on innovation funding through long-term equity and cash flow support. Tax benefits for fund managers and investors have been made available through three different VC programs supported by the Australian Government, and in 2017, CSIRO Australia founded the Main Sequence VC fund to serve as an incubator for scientific entrepreneurial talent (particularly in ‘deep tech’) in Australia. SMEs that are further along the commercialisation journey might be eligible for funding from the Australian Business Growth Fund, which was established just prior to the pandemic to provide both long-term growth capital and strategic advisory services for expanding SMEs. A range of government-backed initiatives have also been introduced over recent years to support SME cash flows more generally, including by shrinking the payment times for SME invoices. Arguably the most valued and direct source of cash flow support for innovating SMEs has been the R&D tax credit, which has been in effect for just over a decade. Indeed, recent analysis has found that the ability of Australian SME firms to compete in export markets is linked to their incentives to innovate through R&D. Debt market financing is available to innovating SMEs, though those that are cash flow positive (through the ‘death valley curve’) typically have more options. VC debt funds have sprung up in recent times, with expertise in valuing intangible assets and extending ‘growth credit’ aimed at lengthening the runways for SMEs so they can get through to the next funding round. More generally, the difference in variable rates between SME loans and large firm loans has compressed in recent years,[22] and it is possible that reductions to bank capital requirements for SME loans, which became effective from January 2023, contribute to slightly more accommodative financing R E S E R V E B A N K O F AU S T R A L I A conditions for SMEs. Similarly, over time, the comprehensive credit reporting and open banking regimes might help in reducing informational asymmetries that can make it difficult for startups to access debt financing. The Australian Business Securitisation Fund, which was established prior to the pandemic and invests in securitisations that are backed by SME loans issued by small banks and non-bank lenders, is also aimed at easing financing constraints for SMEs in general (though only a small number of investments have been made so far). And non-traditional lenders, including technology and payment companies, are using transactions data to rapidly identify and make unsecured credit available to SMEs using their own balance sheets. However, these direct lenders comprise a very small share of the small business financing pie and, like most lenders, don’t target innovating firms per se. It is worth highlighting that it is not just increased access to capital that can support innovation-focused entrepreneurs – access to networks and forums for providing strategic advice are becoming commonplace. There is growing recognition across the community of former company founders, experienced private VC investors and managers of public-private growth funds that strategic advisory support – both formal and informal – also has a key role to play. Conclusion Our national living standards will turn in part on the propensity of firms to generate and rapidly integrate innovative practices into their operations. It has been troubling therefore to observe that our aggregate productivity outcomes have been lagging for a considerable time. We should also be under no illusions that financing constraints for many SMEs remain substantial. And they can be even bigger for SMEs that are trying to innovate aggressively, with little in the way of tangible collateral to pledge as security for financing, and where it can take years to generate positive cash flow on the back of investments in greenfield ideas and untried technologies. These types of investments are not for the faint of heart. But in recent years there have been signs, including in R&D spending and IP rights, to suggest that the contribution of SMEs to the innovation economy has been rising. A cohort of Australian SMEs are innovating intensively, including those with ambitions to compete on the global stage. And, as in the United States, it is possible that a division of labour is beginning to emerge in the Australian innovation ecosystem, where large firms increasingly look to acquire and scale up the innovative ideas and practices first developed by more nimble, IP-rich smaller firms. Time will tell here. But if we do follow the pattern in the United States where many large firms are looking to innovate through acquisitions of dynamic SMEs rather than through in-house R&D, then it will place even further importance on our SME sector as an engine of innovation in Australia. Either way, we also need large firms playing their part in the innovation and productivity challenges facing the country. We need both engines firing. Of course, it is not feasible to expect anything like a majority of SMEs to operate on the global innovation frontier – most understandably have more modest, local ambitions. But given the overwhelming majority of firms in Australia are SMEs, it would only take only a small increase in the share of these businesses to successfully innovate to have a material impact on the Australian economy. It is therefore in our collective interest for the financial system and policy settings to interact in ways that continue to support innovative Australian entrepreneurs. If history is any guide, the positive externalities could entail benefits to the Australian economy and society extending well beyond just the firms producing them. Endnotes [*] Thanks to Sid Roche for his considerable assistance in the preparation of these remarks, and to Angelina Bruno and Jonathan Hambur for acting as invaluable sounding boards. In APRA’s lending data, for the largest reporting entities a business is classified as small or medium if it has an annual turnover of less than $75 million; within this, a business is considered small if it has an exposure to the reporting lending entity of less than $1.5 million. Just over 30 per cent of small businesses are located outside of greater capital city areas, compared with around one-quarter of large businesses. See Chan P, A Chinnery and P Wallis (2023), ‘Recent Developments in Small Business Finance and Economic Conditions,’ RBA Bulletin, September. Alternatively, the OECD’s Oslo Manual refers to innovation as ‘a new or improved product or process (or combination thereof ) that differs significantly from the unit’s previous products or processes and that has been made available to potential users (product) or brought into use by the unit (process)’. R&D is an important input variable for both innovation and exporting in Australia; see Zaman M and G Tanewski (2024), ‘R&D Investment, Innovation, and Export Performance: An Analysis of SME and Large Firms’, Journal of Small Business Management, January. For small firms engaged in innovation, this finds expression in a wider set of investment activities than just R&D. See AlphaBeta (2020), ‘Australian Business Investment in Innovation: Levels, Trends and Drivers’, January. See Arora A, S Belenzon, L Cioaca, L Sheer and H Zhang (2023), ‘The Effect of Public Science on Corporate R&D’, NBER Working Paper No 31899, and the references therein. See Hambur J (2024), ‘IP Mergers in Australia’ (forthcoming); Competition Review Taskforce (2023), ‘Tracking Mergers in Australia Using Working Flows’, Treasury. Majeed O and R Breunig (2021), ‘Determinants of Innovation Novelty: Evidence from Australian Administrative Data’, Tax and Transfer Policy Institute Working Paper No 15/2021, ANY Crawford School of Public Policy, Canberra; Zaman and Tanewski, n 4. IP Australia (2023), ‘Australian Intellectual Property Report 2022’, Australian Government. [10] IP Australia, n 9. [11] It should be noted, however, that the majority of patents in Australia are filed by non-residents. [12] Over the same period, the number of large firms has been increasing, while the number of patent-holding large firms has remained relatively stable. This large relative shift could be partly attributed to a decline in the rate at which patent-holding SMEs scale into large firms, and/or an increasing division of innovative labour within the innovation system. See DobsonKeeffe B and M Falk (2024), ‘The Structural Change in Patenting Behaviour in Australia’, IP Australia Analytical Note (forthcoming). [13] IP Australia (2023), ‘IP and the Economy: Key Impacts’, Australian Government; Hsu DH and RH Ziedonis (2013), ‘Resources as Dual Sources of Advantage’, Strategic Management Journal, January; Block JH, G De Vries, JH Schumann and P Sandner (2014), ‘Trademarks and Venture Capital Valuation’, Journal of Business Venturing, 29 (4), July. [14] See for instance IP Australia, n 13; Hambur J (2023), ‘Did Labour Market Concentration Lower Wages Growth Pre-COVID?’, RBA Research Discussion Paper No 2023-02; Hambur J and D Andrews (2023), ‘Doing Less, with Less: Capital Misallocation, Investment and the Productivity Slowdown in Australia’, RBA Research Discussion Paper No 2023-03; Buckley J (2023), ‘Productivity in Motion: The Role of Job Switching’, e61 micro note, November. [15] See Figure 2.2 in Productivity Commission (2023), ‘5-year Productivity Inquiry: Innovation for the 98 per cent’, Australian Government. [16] Productivity Commission (2021), ‘Small Business Access to Finance: The Evolving Lending Market’, Australian Government. [17] In the United States, housing market conditions have been shown to play an important role in firm entry and young firm employment share by affecting wealth, liquidity and collateral. See Davis SJ and JC Haltiwanger (2021), ‘Dynamism Diminished: The Role of Housing Markets and Credit Conditions’, NBER Working Paper No 25466. [18] See for instance McCowage M and L Nunn (2022), ‘The Current Climate for Small Business Finance’, RBA Bulletin, September. [19] OECD (2019), ‘Productivity Growth and Finance: The Role of Intangible Assets – A Sector Level Analysis’, OECD Economics Department Working Paper No 1547. [20] This is separate from the pandemic period that saw a range of policies introduced to support SMEs more generally. These included incentives for SME lending embedded in the RBA’s Term Funding Facility and a host of government support programs, including the SME loan guarantee scheme, the Jobkeeper program, the Boosting Cash Flow for Employers scheme, and modifications to insolvency requirements. See for instance Kent C (2021), ‘Small Business Finance in the Pandemic’, Speech at the Australian Finance Industry Association, Sydney, 17 March. [21] See Zaman and Tanewski, n 4. [22] Some of this compression likely reflects that since the tightening in monetary policy in 2022, rates on new loans for large firms increased by more than for small firms, as the three-month BBSW rate (the reference for most business lending) increased by more than the cash rate (a key reference for small business loans). [23] See Connolly E and J Bank (2018), ‘Access to Small Business Finance’, RBA Bulletin, September; McCowage and Nunn, n 19. BLADE Disclaimer Notice R E S E R V E B A N K O F AU S T R A L I A | reserve bank of australia | 2,024 | 4 |
Speech by Mr Christopher Kent, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, at the Australian Banking Association (ABA) Conference, Melbourne, 26 June 2024. | Speech Restrictive Financial Conditions in Australia Christopher Kent[*] Assistant Governor (Financial Markets) ABA Banking Conference Melbourne – 26 June 2024 I thank the Australian Banking Association (ABA) for inviting me to this conference. On the occasion of the ABA’s 70th anniversary, it would be tempting to look back over the history of banking in Australia. Instead, I will focus on current financial conditions, which is of interest to those in the banking industry and indeed to Australians more generally. The tightening in monetary policy over the past two years is underpinning restrictive financial conditions in Australia. This is contributing to slower growth of aggregate demand, thereby helping to bring the level of demand into better balance with supply and lower inflation. While recent economic data have been mixed, they have reinforced the need to remain vigilant to upside risks to inflation. Hence, with regards to the path of interest rates, the Reserve Bank Board is not ruling anything in or out. Financial conditions are particularly restrictive for households, but less so for larger businesses. Higher interest rates work through several channels and their effects will vary across different households and businesses according to their circumstances, including their indebtedness and the shape of their balance sheets more broadly. Monetary policy is restrictive Monetary policy is the key determinant of financial conditions for households and businesses. Since May 2022, the RBA has raised the cash rate target by 425 basis points. We know that many are feeling a painful squeeze on their finances because of higher interest rates. High inflation, though, has also reduced people’s purchasing power. It has adversely affected all households, but especially those on lower incomes. One way to gauge the stance of monetary policy is to compare the cash rate with estimates of the nominal neutral interest rate (Graph 1).[1] Definitions of the neutral rate vary, but in essence it is the level of the cash rate that would neither stimulate nor restrain demand; in other words, it would underpin a balance between demand and supply of goods and services and in the labour market, with inflation consistent with the inflation target. Graph 1 Nominal Neutral Rate % % Nominal cash rate Assumption** Model average neutral rate Range of available estimates* * Range of central estimates corresponding to available models. Nominal neutral rates are defined using trend inflation expectation. ** The nominal cash rate assumption is based on market pricing for overnight indexed swaps (OIS) on June 24, 2024. Sources: LSEG; RBA. Currently, the cash rate is above our range of estimates of the nominal neutral rate.[2] This follows a period before and during the pandemic when it was below neutral. The cash rate is also above most estimates of the nominal neutral rate provided by market economists surveyed by the RBA. In May, the median estimate among market economists implied that the cash rate was around 1 percentage point above the nominal neutral rate.[3] In short, these estimates imply that monetary policy is restrictive and so it is continuing to bring aggregate demand into better balance with aggregate supply, as intended. That said, estimates of the neutral rate are subject to considerable uncertainty, so the extent to which monetary policy is restrictive is unclear. Also, the neutral rate can change over time. Indeed, our (model-average) estimates for Australia have increased since the pandemic, as have some estimates for other economies.[4] Factors cited as drivers for the recent increase include: increases in public debt globally; downward pressure on savings due to demographic changes, such as the baby boomer generation moving into retirement; and increases in investment, from both the public and private sectors, including to support the green energy transition. Moreover, there are many methodological and conceptual choices involved in estimating the neutral rate. As my former colleague Luci Ellis put it, estimates of the neutral rate only cast a faint light to guide monetary policy makers. We can also assess financial conditions by examining a broad set of indicators that complement the signals we take from the real economy. The dashboard of indicators presented in the following graph point to financial conditions being restrictive (Graph 2). This is most obvious for the benchmark measures of interest rates and for financial conditions faced by households. Conditions appear to be less tight for larger businesses. R E S E R V E B A N K O F AU S T R A L I A Graph 2 Financial Conditions* 2009-2024 Cash rate target 0.1 Three-year AGS yield 0.1 Outstanding variable mortgage rate 3.0 Housing credit growth*** 8.5 Required mortgage payments** 7.1 Required HH debt payments** 9.2 1.5 Equity risk premium 3.0 Business credit growth*** 15.4 Interest coverage ratio 4.6 5.4 7.2 6.5 2.6 4.9 10.4 10.4 13.4 12.2 BBB three-year corporate bond yield 1.0 Business lending rate 4.8 4.3 3.9 9.6 5.2 5.8 7.1 8.6 4.2 -8.8 7.0 3.1 Loosest 2.0 Tightest * Blue dots show current measures, green dots show the average over the sample and the grey bars show the middle 80 per cent of observations. ** Calculated as a share of household disposable income. *** Six-month annualised. Sources: ABS; APRA; ASX; Bloomberg; CoreLogic; major banks' websites; RBA. There is a lot in this dashboard, so I will step through it carefully. The scale of each row corresponds to the range of these measures since the global financial crisis (GFC).[7] The grey shaded area shows the typical range of outcomes (as indicated by the central 80 per cent of the distribution). The blue dots are the most recent value for each measure. The further a dot is to the right, the tighter are financial conditions along that dimension (relative to the period norms), and the further left, the looser are conditions. The green dots are the average since the GFC. We need to be careful, though, because the neutral level of an indicator can rise or decline over time for various reasons. So, a deviation from the average of the sample may not give a true measure of the degree of tightness right now. For example, the measure of required mortgage payments as a share of household disposable income is at its highest since the GFC, but total household debt payments are not. This difference reflects the downward trend in personal credit over that period. The two measures shown at the top of the dashboard are key benchmark interest rates and are currently higher than their historical averages. As mentioned earlier, the cash rate target has been raised by 425 basis points since May 2022. The three-year government bond (AGS) yield is below the level of the cash rate, but still quite a bit higher than its post-GFC average. The middle four measures relate to financial conditions faced by households. They are quite tight. Finally, the bottom five measures show financial conditions faced by businesses. These are less tight than for households. Overall financial conditions are restrictive for households While higher interest rates affect the decisions of all households, the effects of tighter monetary policy are felt most directly by the roughly 40 per cent of Australian households with a mortgage.[9] The average rate on outstanding mortgages has risen by 335 basis points over the tightening phase to date, to a little over 6 per cent. Pass-through has been a bit less than in the past because of the high share of mortgages fixed at low rates during the pandemic.[10] Increased discounting on mortgages by lenders competing for borrowers has also played a role. Nevertheless, the increase in mortgage rates has been large and rapid (Graph 3). Also, most of the remaining low fixed-rate loans from the pandemic era will expire this year, which will add around 20 basis points to the average outstanding mortgage rate. Graph 3 Housing Lending Rates % % New variable* All outstanding** Cash rate * ** Perpetual data used to 2013; advertised package rates to July 2019; thereafter, data from the EFS collection. Perpetual data used to 2015; data from the Securitisation System to July 2019; thereafter, data from the EFS collection. Sources: APRA; Perpetual; RBA; Securitisation System. While mortgage rates are below the peak in 2007, households hold a bit more mortgage debt (as a share of household disposable income) than in previous tightening phases. As a result, scheduled mortgage payments – which include mortgage principal and interest – have increased to a record 10 per cent of household disposable income (shown by the blue bars in Graph 4). Our estimates suggest that total scheduled debt payments (which include payments on consumer credit) have also increased sharply (these are shown by the top of the green bars). However, total scheduled debt payments by households remain below earlier peaks because the stock of consumer credit has declined significantly since 2008. Meanwhile, extra payments into mortgage offset and redraw accounts (shown in grey) have held up despite the increase in scheduled debt payments – I will come back to this point soon. R E S E R V E B A N K O F AU S T R A L I A Graph 4 Selected Claims on Household Income Quarterly; share of household disposable income % Projection* % Historical estimate Scheduled mortgage payments Extra mortgage payments Consumer credit payments * Projection for total scheduled payments on household debt at end-2024, based on the current level of the cash rate. Sources: ABS; APRA; RBA. The rise in scheduled debt payments has put additional pressure on the budgets of many households and contributed to weakness in consumption growth. While many indebted households – and particularly those on lower incomes – have felt these budget pressures acutely, nearly all borrowers are servicing their debts on schedule. Much of this reflects the resilience of the labour market; even though conditions there are gradually easing, they remain tight. The share of credit card balances accruing interest remains low, suggesting that most households are responding to cost-of-living pressures via some combination of consuming less or saving less than in the past. Growth in employment has supported some households’ ability to service their debts. Higher interest rates are providing an incentive for all households to save more and borrow less. For households with a mortgage, despite higher debt-servicing costs and other pressures on disposable incomes, payments into offset and redraw accounts have increased as a share of income over recent quarters (Graph 5). Flows of these extra payments are now a bit above their pre-pandemic average. By contrast, the gross savings rate across all households has declined and is now below pre-pandemic levels. Graph 5 Saving Rates Share of household disposable income Total gross savings % % Pre-pandemic average (2014–2019) % Extra mortgage payments % Sources: ABS; APRA; RBA. The different behaviour of these two series reflects a combination of things, including differences in measurement approaches and economic factors. One such factor is that households with a mortgage face a strong incentive to keep their savings in offset and redraw accounts because these accounts earn a high taxadjusted rate of return when interest rates are high. High interest rates also provide an incentive for households without debt to save more than they would otherwise. And while the savings rate of the household sector has declined, higher interest rates are still likely to be influencing savings decisions. Indeed, households facing a range of pressures on their disposable incomes are responding by restraining their consumption of discretionary items and saving less. However, households overall are still saving. Moreover, both households with a mortgage overall, and the broader household sector still have substantial stocks of additional savings that were built up during the pandemic. That’s not true, though, for all households, with many having run down any savings to support consumption in the face of significant budgetary pressures. As expected, higher interest rates have weighed on household credit growth (Graph 6). While household credit growth has picked up a little since early 2023 – alongside rising housing prices – it remains a bit below average. And after deducting offset balances, household credit growth has been flat for the past year or so. Moreover, the level of household credit (net of offset accounts) has declined as a share of household disposable income. The decline in this measure of household indebtedness is apparent in several other indicators. For example, average loan-to-value ratios for new loans have declined over this phase of monetary policy tightening. Also, loan discharges from property sales have increased, and by more than the rise in new lending (which is shown as commitments in Graph 7). These trends are likely to reflect incentives to reduce or limit indebtedness in response to higher interest rates. R E S E R V E B A N K O F AU S T R A L I A Graph 6 Household Credit % % Growth* Household Household net of offsets % % Per cent of annual HHDY** Housing net of offsets Personal * Six-month-ended annualised; dashed average post-2008 calculated gross of offsets. ** Household disposable income. Sources: ABS; APRA; RBA. Graph 7 Housing Loan Discharges* Quarterly; seasonally adjusted $b $b Value Commitments Discharges % Ratio of discharges to loan commitments % * Discharges and commitments are net of external refinancing. Sources: ABS; APRA; RBA. Increases in the cash rate have led to tighter financial conditions for businesses Increases in the cash rate have also flowed through to higher business lending rates and higher corporate bond yields, although pass-through has varied across different markets (Graph 8). Average rates on large business loans have increased by more than 425 basis points over the tightening phase, compared with around 310 basis points for small businesses. However, small businesses continue to face substantially higher interest rates than their medium and large counterparts. Large businesses with access to wholesale funding markets have benefited from favourable conditions in those markets. In particular, corporate bond yields have risen by less than the rise in riskfree yields over the tightening phase because credit spreads have narrowed noticeably. Graph 8 Cost of Business Debt % % Business lending rates* Small business Medium business Large business % % Corporate bond yields** 5-year yields 3-year yields * Average variable interest rate on credit outstanding. ** For BBB-rated non-financial corporations. Sources: APRA; Bloomberg; RBA. Despite the rise in the cost of new business debt, the growth of business debt remains above its post-GFC average (Graph 9). This reflects business credit growth remaining above average as well as strong issuance of corporate bonds over the past year or so. Above-average growth of business debt has been supported by relatively strong growth in business investment, although business investment growth has slowed recently. Some businesses have curtailed their investment plans a little in response to cost pressures and the weakness in aggregate demand, and businesses expect the pace of investment growth to slow further in the year ahead. As has been the case for many years, small business lending has not grown over the past year and small businesses report that accessing funding through banks with terms that suit their needs remains a significant challenge. R E S E R V E B A N K O F AU S T R A L I A Graph 9 Business Debt Six-month-ended annualised growth, seasonally adjusted % % Business credit Other lending* Non-intermediated debt Business debt -10 * -10 Lending to large businesses by institutions that do not report to APRA. Sources: APRA; Bloomberg; LSEG; RBA. For many medium and large businesses, the effect of higher interest rates has been partly offset by strong nominal earnings, relatively low leverage and, in some cases, debt that was issued at earlier low fixed rates. Indeed, the median interest coverage ratio of listed companies has declined over the tightening phase but is around its post-GFC average – partly reflecting a long-term decline in gearing (Graph 10). Aggregate leverage of non-financial businesses remains relatively low, at a little over 20 per cent, which is below the pre-pandemic average of nearly 30 per cent. All else equal, this decline in leverage would suggest that monetary policy is having less effect on the average business (than if they were more highly leveraged). Most listed companies also hold cash buffers that are slightly higher than pre-pandemic levels, and many businesses have been in a strong financial position throughout the tightening phase. These trends are likely to have contributed to businesses continuing to borrow at an above-average pace despite higher interest rates. Among smaller businesses, aggregate cash buffers remain above historical average levels. But they have declined over the past year, and information from the RBA’s liaison program suggests liquidity buffers are unevenly distributed. Graph 10 Interest Coverage of Listed Companies* Median interest coverage ratio ratio ratio * Leveraged ASX-listed non-financial corporates. Interest coverage ratio calculated as EBITDA/interest expenses. Sources: Morningstar; RBA. Tighter financial conditions are likely to have had a stronger effect on businesses with higher pre-existing leverage and generally weaker balance sheets, as well as smaller businesses which do not have access to wholesale funding markets. Indicators of business financial stress generally remain low, although many businesses are experiencing challenging conditions and the share of businesses entering insolvency has increased since early 2022 (Graph 11). This is particularly so for businesses in the construction and hospitality sectors, although this follows a period of very low insolvencies owing to pandemic-related support measures. Most of these firms entering insolvency are small businesses with little debt.[12] Rates of non-performing loans have also increased slightly but remain low by historical standards. Graph 11 Company Insolvencies Share of total businesses operating, quarterly % % 0.15 0.15 0.10 0.10 0.05 0.05 0.00 Sources: ABS; ASIC; RBA. R E S E R V E B A N K O F AU S T R A L I A 0.00 Conclusion Looking across a range of measures shows that monetary policy tightening has led to restrictive financial conditions. However, the extent of this varies across different sectors and also within sectors. Households have been responding to higher interest rates. While households with mortgages are significantly affected, and quite directly, consumption growth is weak for most people. Smaller businesses, and businesses with higher leverage, are also facing financial pressures, much more so than many larger businesses. Notwithstanding these differences, restrictive financial conditions are helping to slow the growth of demand, thereby bringing the level of demand into better balance with supply. This is contributing to the decline in inflation, which is to the benefit of all Australian households and businesses. Endnotes [*] I thank Sue Black, Shan Jayawardhana, Dmitry Titkov, Peter Wallis, Charlie Wenk and Ada Zhou for their great assistance in helping to prepare this speech. I say ‘one way to gauge’ because the stance of monetary policy is somewhat broader than the current level of the cash rate and incorporates expectations for future cash rates as well as the size and composition of the RBA’s balance sheet. However, in normal times, the level of the cash rate relative to the neutral rate is a reasonable summary statistic for the stance of monetary policy. We use three main types of models for estimating the neutral rate. The first type is a semi-structural model that infers the neutral rate as the cash rate that would prevail in the economy if output was at potential, inflation was at target and employment was full. The second type infers the neutral rate from financial market pricing for government bonds. The third type infers it from a statistical model that attempts to forecast the future level of the cash rate once all cyclical influences have dissipated. See Ellis L (2022), ‘The Neutral Rate: The Pole-star Casts Faint Light’, Keynote Address to Citi Australia & New Zealand Investment Conference, Sydney, 12 October. See the J1 statistical table for summary statistics from the RBA’s survey of market economists: RBA, ‘Statistical Tables’. Benigno G, B Hofmann, G Nuño Barrau and D Sandri (2024), ‘Quo Vadis, r*? The Natural Rate of Interest after the Pandemic’, BIS Quarterly Review, March. Benigno et al, n 4. Possible causes for the earlier multi-decade decline in the neutral rate include a decline in productivity growth and an increase in risk aversion: see Ellis, n 2. Ellis, n 2. We also look at other measures in addition those on the dashboard, including measures adjusted for inflation. Note that I have not included the exchange rate on the dashboard. It is an important channel of monetary policy transmission, but not the focus of my speech today. The level of the Australian dollar (in real trade-weighted terms) is broadly consistent with the range of model estimates implied by historical relationships with the forecast terms of trade and real yield differentials versus major economies. For details, see Hambur J, L Cockerell, C Potter, P Smith and M Wright (2015), ‘Modelling the Australian Dollar’, RBA Research Discussion Paper No 2015-12; Chapman B, J Jääskelä and E Smith (2018), ‘A Forward-looking Model of the Australian Dollar’, RBA Bulletin, December. While net-saver households benefit from higher interest rates, the overall effect on households’ net interest income is negative because aggregate household debt is larger than aggregate household holdings of interest-earning assets: see Beckers B, A Clarke, A Gao, M James and R Morgan (2024), ‘Developments in Income and Consumption Across Household Groups’, RBA Bulletin, January. [10] See Ung, B (2024), ‘Cash Rate Pass-through to Outstanding Mortgage Rates’, RBA Bulletin, April. [11] See Chan P, A Chinnery and P Wallis (2023), ‘Recent Developments in Small Business Finance and Economic Conditions’, RBA Bulletin, September. [12] See RBA (2024), ‘Chapter 2: Resilience of Australian Households and Businesses’, Financial Stability Review, March. | reserve bank of australia | 2,024 | 6 |
Speech by Mr Andrew Hauser, Deputy Governor of the Reserve Bank of Australia, at the Opening Dinner for the Citi A50 Australian Economic Forum 2024, Sydney, 27 June 2024. | null | reserve bank of australia | 2,024 | 6 |
Remarks by Ms Michele Bullock, Governor of the Reserve Bank of Australia, at the Pacific Banking Forum 2024 Dinner, Brisbane, 8 July 2024. | Michele Bullock: Remarks - Pacific Banking Forum Remarks by Ms Michele Bullock, Governor of the Reserve Bank of Australia, at the Pacific Banking Forum 2024 Dinner, Brisbane, 8 July 2024. *** Good evening, everyone. It's an absolute pleasure to be here. I actually want to just acknowledge that it is NAIDOC Week, National NAIDOC Week, this week. NAIDOC Week, for our visitors, is about recognising the history, culture and achievements of Aboriginal and Torres Strait Islander Peoples, and the theme this year is: 'Keep the Fire Burning! Blak, Loud and Proud.' In that vein, I too would like to begin my remarks by acknowledging the Jagera people and the Turrbal people. They are the traditional custodians of the land on which we gather today. They've cared for it for millennia and I want to pay my respects to their elders past and present, and I extend that respect to Aboriginal and Torres Strait Islander Peoples who are here today. I also want to say thanks to the Wagga Torres Strait Islander Dance performers. That was absolutely wonderful. I really enjoyed that, so well done to them. Finally, I'd like to echo Assistant Treasurer Jones' comments and warm welcome, and I'd especially like to welcome my fellow central bank governors, deputy governors and assistant governors who are here tonight. At the Bank, we have a longstanding relationship with our Pacific partners. Many Pacific Islanders, in fact, call Australia home as you know – a lot of them are in the rugby team – and we have a deep interest in promoting their welfare and the interests of our Pacific neighbours more generally. So over the past four decades, we at the Bank have met annually with central banks from the Pacific Island countries, Timor-Leste and New Zealand, and, in those meetings, we discuss the challenges that the region is facing and work together to try to implement solutions. The decline in correspondent banking relationships is one of the biggest challenges currently facing the Pacific region, and the situation, I think, as you've heard today in your meetings, has deteriorated in recent years. It's progressed from a looming threat to an acute issue that some Pacific Island countries have actively faced in recent years. So it's not out there on the horizon; it's here. From the data that we've seen, the decline in the relationships is widespread and the trend appears set to continue, unless we collectively take action to address it. Now, we know that the situation in the challenge is complex. The decline isn't driven by one issue or one cause; it's a combination of factors. One important driver is that the volume of correspondent banking flows is relatively small in this region. It's a combination of small populations dispersed over far-reaching and diverse geographical areas, and it often encompasses very remote locations, and that makes it difficult for correspondent banks, or even potential correspondent banks, to achieve economies of scale. So that's one driver. A second important issue is that some countries have found it challenging to meet international regulatory requirements because they're small, they've got lots of competing demands on their resources, and that's challenging. And the regulations, we know that the bar is going up, so it's not easy. But we do need to find a solution to this issue. 1/3 BIS - Central bankers' speeches The withdrawal of correspondent banking relationships poses large risks to economic and financial stability in the Pacific region at the household, the business and the government level. Remittances, as we know, can be an important source of incomes for households. Businesses rely on the ability to receive payments for exports, including tourism flows, which for many countries is very important. And governments also need to be able to import key supplies for their people and their nations. So maintaining the ability to send and receive these flows internationally is essential. I'd have to say, pleasingly, there are some green shoots. We at the Bank welcome the initiatives by the Pacific Islands Forum secretariat and the World Bank, including the correspondent Banking Relationships' Road Map and the Strengthening Correspondent Banking Relationships Project. We at the Bank have met with the World Bank's team several times to provide comments on the proposal and we're really pleased to hear of the progress that they've made to date. It's also encouraging to hear of the wideranging commitment from the Pacific Island countries to participate in the project – that's really important – and we look forward to future conversations with all of our Pacific Island counterparts and the World Bank as this project progresses. Now, in conjunction with development partners, there's also a lot of technical assistance and capacity-building initiatives underway, and some are planned in the region. At times, in the past, these projects have tended to be run in isolation and that's led to duplication of effort. So I think it's really good to have everyone here in the room because better coordination is going to be essential if we're going to more efficiently deliver these projects going forward. I think, tomorrow, you're all going to discuss what sorts of commitments we can make on coordination; I think that's really important. So this Pacific Banking Forum is a key milestone in addressing the decline of correspondent banking relationships and facilitating this coordination, so I'd personally like to thank the governments of Australia and the United States for convening this forum because it brings together the largest number of stakeholders to date to address this issue. We've got stakeholders from public and private sectors from over 20 nations, which is absolutely marvellous. I've been struck tonight meeting regulators, central banks, governments and private sector; it's been astounding, the buy-in that we've got here. I think it's very clear that making progress in arresting the decline of correspondent banking relationships does require collective action of this wide variety of people that we've got here today, and we all need to step up to the plate here. This includes continuing to improve and enforce AML/CFT standards. We need to ensure that Pacific Island countries are well supported in implementing those standards, and that's going to require effective collaboration from all of the development partners in this room. Over and above the AML/CFT standards, the private and the public sectors need to work collaboratively to stop the full withdrawal of correspondent banking relationships from any country; that's really important. For our part, the Reserve Bank, the RBA, we will continue to support development partners and Pacific Island central banks and banking authorities by providing technical expertise, and we'll be drawing on our long-standing relationships to try to facilitate coordination and advocate for positive outcomes in this region. 2/3 BIS - Central bankers' speeches Finally, I'd just like to highlight something that all of you know: it's a difficult challenge and it's going to require all of us to be flexible. We need to be ready to change as initiatives develop, and we need to consider how we can overcome domestic challenges to move forward towards solutions. I want to thank you all for being here and for your participation, and I want to encourage you to use this opportunity to agree on what's required to move forward and to commit to prioritising the changes because we need to do this to ensure long-term, sustainable correspondent banking relationships in the Pacific region. So thank you and enjoy the rest of your evening. 3/3 BIS - Central bankers' speeches | reserve bank of australia | 2,024 | 7 |
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Speech by Mr Andrew Hauser, Deputy Governor of the Reserve Bank of Australia, to the Economic Society of Australia (Queensland), Brisbane, 12 August 2024. | Speech Beware False Prophets Andrew Hauser[*] Deputy Governor Speech to the Economic Society of Australia (Queensland) Brisbane – 12 August 2024 Introduction My theme today is learning and the role it plays in monetary policymaking. So it is fitting that I am speaking with you, on my first visit to Brisbane, just a stone’s throw from two great seats of learning – the Queensland University of Technology (QUT) and the University of Queensland (UQ). QUT’s Gardens Point campus sits on a stunning peninsula in the Brisbane River that is full of history. The Botanic Gardens started life in 1828 as a means of feeding the penal colony. And Old Government House was built in the 1860s for the first Governor of Queensland, Irishman Sir George Bowen and his wife, the tremendously-titled Contessa Diamantina di Roma (after whom the Diamantina River is named). But the history of this area, and its connection with learning, is much older than that. The river – or Maiwar as it was long known – has been a source of life for the Jagera and Turrbal Peoples for thousands of years. And the area around Gardens Point was a sacred site, where Aboriginal women received ceremonial teaching – and men were forbidden. Today QUT is establishing a new Faculty of Indigenous Knowledges and Culture to recognise and foster Indigenous Australian excellence and innovation.[3] Against that rich backdrop, I want to acknowledge the traditional owners of this land, pay my respects to their Elders past and present – and extend that respect to any Aboriginal or Torres Strait Islander peoples here today. Head south-west down the river to St Lucia and UQ’s Great Court and look upwards, and you may see a carving of a jovial man in a hat carrying an apple. The gargoyle is said to be Dr Colin Clark – a prominent British disciple of John Maynard Keynes. Clark was recruited in the late 1930s by Queensland Premier Bill Forgan Smith to help make the case in Canberra for more expansionist state spending, and establish one of the earliest systems of national accounts. When Keynes heard that Clark intended to settle in Australia, he tried to dissuade him, arguing that he would be more influential back in England. But Clark was having none of it: Australia, he wrote, was ‘too remarkable an opportunity to be missed’; its people had ‘minds which are not closed to new truths’, and the country would ‘show the world, in economics, politics, education and technology in the next twenty years’. In what seems to have been the clincher, he noted that ‘economics ranks next after cricket as a topic of public interest’. Nearly 100 years later, I’d change little in describing my own early impressions of Australia, with one notable exception: sport quite often plays second fiddle to economics (and the RBA) on the front pages! A vibrant public economic debate, with diverse views, is healthy. But one feature of the landscape is less desirable – and that is the extraordinary certainty with which individual views about the outlook for the economy and the path of monetary policy can sometimes be expressed. ‘The economy is falling off a cliff’; ‘No – the economy is red-hot.’ ‘Rates up now – we’re way behind the curve’; ‘Rates are clearly far too high – slash them’; ‘It’s vital rates stay where they are’. Those seeing things differently are castigated as incompetent, biased or on the make. And changes in view are presented as disastrous or humiliating failures. In short, it’s a world of winners and losers, gurus and charlatans, geniuses and buffoons. This isn’t unique to Australia of course – everywhere is prone to it in some way (witness the extraordinary calls for emergency intra-meeting rate cuts in the United States during the recent market turbulence, for example). Of course, eye-catching language sells newspapers, secures clients and draws crowds to the soapbox. But when the stakes are so high, claiming supreme confidence or certainty over what is an intrinsically uncertain and ambiguous outlook is a dangerous game. At best, it needlessly weaponises an important but difficult process of discovery. At worst, it risks driving poor analysis and decision-making that could harm the welfare of all Australians. It is right to want to be confident that the central bank will bring inflation back to target and maintain full employment: that is the RBA’s mandate, and we should be held to account for it. But the policy strategy required to deliver that outcome, and the economic judgements that inform it, simply cannot be stated with anything like the same degree of certainty. Those pretending otherwise are false prophets. Overconfidence is not unique to economic commentary: it’s a universal human failing.[5] In my remarks today, I want first to illustrate some real-world examples, before turning to ways in which central banks can avoid falling prey to it in our own deliberations. By forming contingent hypotheses about the future – rather than overly precise point forecasts. By learning continuously – from our own forecast errors, from diverse quantitative models, from corporate liaison and other qualitative intelligence-gathering, from experience in other countries, and from internal and external challenge, including scenarios and ‘what-ifs’. By communicating clearly and openly about what we don’t know, as well as what we do. And by adopting policy strategies that reflect risks to the outlook, as well as the central case. I will describe how some of these tools were applied in our most recent monetary policy round, and how we hope to develop them further. Overconfidence in everyday life To illustrate how commonly overconfidence arises in everyday life, let me pose four questions, most with a Queensland flavour. I’m keen to know both your answers, and also your confidence in those answers: 1. How many paving stones cover QUT’s Gardens Point campus? 2. Will it rain in Brisbane tomorrow? 3. Who will win the 2025 State of Origin rugby league series? 4. What will Elon Musk do next? Question 1 provides scope for the greatest certainty, because there is a precise, knowable answer. At the same time, it’s not an easy question – few of us have intimate knowledge of the campus; fewer still are quantity surveyors or have the time to go and count them! So while we can make more or less informed guesses, we are likely to cite wide ranges of uncertainty around those guesses. What’s striking, however, is that, while we may think the ranges we give are wide, they are actually almost always too narrow. Table 1 reports the results of an exercise in which professionals across a range of industries were asked a set of hard but factual questions like the one I’ve just posed. The column on the right shows how often people’s ranges of uncertainty are too narrow to include the true answer. So, for example, only 10 per cent of those asked to give 90 per cent confidence intervals should miss the true answer. In fact, miss rates lie between 42 and 64 per cent. People are vastly too confident about what they truly know. R E S E R V E B A N K O F AU S T R A L I A Table 1: Overconfidence across Industries* Percentage of misses Ideal (%)** Actual (%) Industry tested Kinds of questions used in test Advertising Industry Computers Firm Data processing Industry General business Money management Industry Petroleum Industry & firm Pharmaceutical Firm Security analysis Industry Source: Russo JE and Schoemaker PJH (2016), ‘Overconfidence’, in M Augier and D Teece (eds), The Palgrave Encyclopedia of Strategic Management, Palgrave Macmillan, London, p 1238. * There is also a good discussion of this issue in Part III of Kahneman D (2011), Thinking, Fast and Slow, Farrar, Straus and Giroux, New York. ** The ideal percentage of misses is 100 per cent minus the size of the confidence interval. Thus, a 10 per cent ideal means that managers were asked for 90 per cent confidence intervals. In case you are curious, by the way, the Gardens Point campus is covered by 9,546 Urbanstone Juperana granite pavers. I know this, not because I am a paving nerd, but because the company that provided the materials is part of the RBA’s liaison program, through which we keep a close eye on real-world economic developments – and a key plank of our continuous learning process that I will elaborate on later. Question 2 asked ‘Will it rain in Brisbane tomorrow?’. Unlike the previous question, there’s no certain answer. But we can put quite well-defined probabilities on it. History suggests that it rains on just under 20 per cent of August days (Graph 1). Graph 1 Share of Rainy Days in Brisbane 1999–2024* % % J * F M A M J J A S O N D Data as at 24 July 2024. Source: Bureau of Meteorology. But we can do better than that: the Bureau of Meteorology (BOM) uses much richer data and modelling to put the probability of rain tomorrow at a rather alarming 95 per cent (Figure 1)! Figure 1: BOM Forecast for Weather in Brisbane Tomorrow Source: BOM, ‘Brisbane Forecast’, Brisbane Forecast (bom.gov.au), as of Sunday 11 August 2024. Unlike most of us, weather forecasters are actually quite good at estimating their uncertainty about their shortterm forecasts. Even as far back as the 1970s, if they told us there was a 95 per cent chance of rain tomorrow, they were usually pretty close (Graph 2). And meteorological models have evolved enormously in sophistication and accuracy since then. Graph 2 At first sight, Question 3 – ‘Who will win the State of Origin rugby league series in 2025?’ – seems similar to Question 2. There are only two possible answers[7] – and probabilities seem readily available, for instance from betting markets (Graph 3). But the similarities are illusory. Today’s short-term weather forecasts are the product of advanced stochastic modelling that yields well-defined risk measures. But no model can fully capture the huge range of time-varying, ambiguous and judgemental factors that go into determining the winner of a sports series a year out. Such processes are said to be subject to ‘Knightian’ or ‘radical’ uncertainty. R E S E R V E B A N K O F AU S T R A L I A Graph 3 Probabilities of State of Origin Winners Implied from betting odds % % Favourites NSW Queensland Underdogs Game 1 * Game 2 Game 3 Series Probabilities for the 2024 games are calculated using odds prevailing shortly before each game. Probabilities for the 2025 series are as of late July 2024. Sources: EliteBet; TAB. Even in the short gaps between this year’s games, the quoted odds bounced around like a yo-yo in response to a stream of unpredictable developments – Joseph Sua’ali’i being sent off in game 1; Latrell Mitchell’s triumphant return for NSW in game 2; and the pitched battle of game 3. Who knows on what, as-yet unimagined, events next year’s series will turn. But it seems likely that the current 60/40 odds quoted in favour of NSW reflect excessive confidence that whoever won in 2024 will win in 2025 too, rather than any clear-eyed assessment – a variant of the certainty bias. My final question – ‘What will Elon Musk do next?’ – is a more extreme form of radical uncertainty. Key drivers of the true answer – goals, beliefs and motivations – are partly or wholly unobservable (so-called ‘latent’ variables). And the range of possible answers is unbounded. Anyone claiming to have identified a small number of welldefined outcomes, each with a clean probability, is at best ambitious – and, at worst, at risk of seriously overestimating their true confidence levels. Tackling uncertainty and overconfidence in central banking So what, then, for monetary policymaking? When we set interest rates, we have to look ahead – that is, make forecasts.[9] That’s one source of uncertainty. Monetary policy works with long and variable lags – so our forecasts have to be medium-term, not short-term. That’s a second source of uncertainty. And most importantly of all, the things we are forecasting – inflation and unemployment – are the complex, time-varying outcomes of the decisions and interactions between many millions of people, companies and other organisations. That puts us squarely in the world of Knightian uncertainty – of the State of Origin or Elon Musk. Unfortunately, most of the models used for economic analysis come from the worlds of paving stones and tomorrow’s weather! Estimate the average historical relationship between individual economic variables, run those relationships forward in time – and you get a set of deterministic point-estimate forecasts. Such model-based forecasts help show how the economy might respond if relationships remained exactly as they were in the past. But overreliance on them has two key drawbacks: • First, the probability of such paths being precisely correct is essentially zero. That makes them a poor basis for decision-making when used in isolation – because the absence of alternatives or fallbacks makes it harder to conceptualise other possible outcomes and weigh up the likelihood of those alternatives becoming reality. And that, in turn, can force forecasters either to underreact to news (forcing the data into their existing narrative, rather than learning) or to overreact (jettisoning one point-forecast for another demonstrably different path, which will also prove to be wrong). • Second, although it is possible to estimate confidence intervals around point forecasts using the models themselves, they are likely to be substantially too narrow (that is, overconfident) because they fail to account for the fact that the model may simply not be the right representation of reality. So just as overconfidence can easily affect our everyday lives, it can affect monetary policymakers too. How do we guard against that? The starting point is to avoid placing too much reliance on point forecasts in the first place, and instead frame our policy decisions in terms of contingent hypotheses or judgements. Some judgements may be strongly held, and hence given a high weight in the decision; others may be very tentative and given only a low weight. Both the hypotheses, and the weights attached to them, are continuously updated through a process of learning. To bring this to life, consider a key question in the run-up to the RBA’s most recent policy decision: why has CPI inflation been so unexpectedly persistent? A good place to start is to ask how unexpectedly persistent inflation has actually been – that is, to learn from our own forecast errors. Such learning can be difficult for those who treat forecast ‘misses’ as failures. A more mature approach – and one long adopted by the RBA and other central banks – seeks instead to recognise that where forecasts are carefully constructed to make the best use of current data, ‘misses’ contain vital information about an intrinsically complex and stochastic world. This idea is also embedded in the ‘fancharts’ shown around the RBA’s outlook for inflation and other variables, which are calibrated using past forecast errors, not mechanical model outputs. Three key facts emerge when we look at the recent path of forecast errors for inflation. First, although underlying inflation for the June 2024 quarter was broadly in line with our May forecast, inflation in earlier periods in 2023-24 proved somewhat stickier than we had expected (Graph 4). Graph 4 Trimmed Mean Inflation Year-ended, seasonally adjusted % % Actual Historical forecasts Sources: ABS; RBA. R E S E R V E B A N K O F AU S T R A L I A Second, the pattern for market expectations (derived from inflation swaps) has been somewhat similar, suggesting the upside surprises have not been limited to the RBA (Graph 5). Graph 5 Headline CPI Inflation Year−ended, non−seasonally adjusted % % Actual Forecasts implied by inflation swap pricing* −2 −2 * Forward rates for inflation calculated quarterly immediately prior to RBA SMPs using prices for inflation swaps at terms of 1–3 years. Sources: ABS; Bloomberg; RBA. Third, some other jurisdictions have seen a rather greater incidence of inflation undershoots in recent quarters, raising the possibility that something slightly different might be underway in Australia. Graph 6, for example, shows the picture for the euro zone. Graph 6 ECB Headline Inflation Forecasts Year-ended % % Actual ECB inflation target -3 Latest forecast -3 Sources: ECB; RBA. To understand why past inflation outcomes may have been stronger than expected requires a hypothesis. In such circumstances, the economist’s reflex is to reach for a model: often some variant of a Phillips Curve, in which higher inflation reflects some combination of (a) higher expected inflation, (b) higher demand, and (c) lower supply capacity. There is no evidence that longer term inflation expectations rose over this period in Australia. And GDP came in at or below forecast – which we tentatively assume is informative about demand conditions. We have therefore placed some weight on the possibility that past upside inflation surprises may have reflected somewhat weaker supply than previously thought. Now, it is one thing to hypothesise weaker supply, it is another to quantify it. And that’s because supply is not directly observable: it is a classic latent variable.[14] So any estimate is subject to huge uncertainty. In the most recent monetary policy round, RBA staff approached this challenge in two ways. The first was to use a range of alternative models that posit different assumptions about the structure of the economy to estimate supply.[15] It is common practice to transform the results of such models into estimates of ‘spare capacity’ in either the labour or product markets. Graph 7 shows the range of spare capacity estimates for unemployment implied by the range of models.[16] Choosing a single path within this range is subject to the very objections to point estimates that I just rehearsed. But to rationalise recent above-forecast inflation outcomes, the August 2024 Statement on Monetary Policy (SMP) assumes that supply was somewhat weaker, and hence the labour market was somewhat tighter, than previously thought.[17] And that extra weakness is assumed to persist, pushing up a little on the outlook for inflation. It must be said, however, that these changes in assumptions are tiny relative to the huge true range of uncertainty over these measures. So we have to be humble about our confidence in this judgement: spare capacity could easily be much higher, or much lower. Graph 7 Labour Market and Spare Capacity % % Unemployment rate ppt ppt Unemployment gap* -1 -1 -2 -2 * Blue-shaded region shows illustrative range of central gap estimates from a selection of models; June quarter 2024 values are partial estimates; estimates are subject to substantial uncertainty, as well as revision due to data and model refinements. Sources: ABS; RBA; Ruberl et al (2021). As a second cross-check, staff also compared their estimates to qualitative real-world indicators of capacity pressures from company surveys and the RBA’s liaison program.[19] Graph 8 shows that such measures lie at or above the upper end of our model-based estimates. That is also consistent with the messages of persistently elevated cost pressures I have personally heard from liaison visits to Townsville, Perth, Adelaide, Melbourne, Western and central Sydney in recent months. R E S E R V E B A N K O F AU S T R A L I A Graph 8 Estimates of Capacity Utilisation %, ppt Share of firms reporting labour availability as a constraint** Model estimates of output gap* (RHS) (LHS, %) ppt -3 -20 -6 -40 NAB capacity utilisation** (LHS, ppt) -9 -60 * Violet-shaded region shows illustrative range of central output gap estimates (as a per cent of potential output) from a selection of models encompassing different measures and definitions of the output gap; estimates are subject to substantial uncertainty, as well as revision due to data and model refinements. ** Deviation from post-2000 average. Sources: ABS; NAB; OECD; RBA. Future inflation also depends on the outlook for demand – and here too we must guard against the risk of overconfidence. In the latest SMP, we do so in part by considering alternative scenarios, drawing on lessons from overseas (particularly important for open economies such as Australia) and the potential for, potentially sharp, changes in behaviour. One scenario asks whether the unemployment rate may be about to pick up more rapidly than assumed, pulling down on demand and reducing inflationary pressure.[20] In the central projection, employment growth only falls modestly, with total hours worked in the economy continuing to rise as the population and participation in the labour market grow. That is consistent with past downturns in activity of similar magnitude (Graph 9). Graph 9 Labour Market Downturns and Current Outlook* Cumulative change in total hours worked % 1980s 1990s GFC Early 2000s Current outlook** % -2 -2 -4 Total hours Employment rate Participation rate -4 Average hours Working age population * Change relative to quarter coinciding with peak in total hours (that is, 1981:Q3, 1990:Q2, 2000:Q3, 2008:Q3 and 2023:Q2). ** Bars with transparency, and the lighter line represent August 2024 SMP forecasts. Sources: ABS; RBA. But those assumptions could be wrong. What if unemployment rises more rapidly, as it has for example in Canada, Sweden and New Zealand (Graph 10)? Concerns that something similar might be about to happen in the United States caused last week’s sharp repricing in US rate expectations. Graph 10 Unemployment Rates* Quarterly deviation around post-pandemic trough ppt ppt Canada Sweden 1.0 1.0 United States Australia 0.5 0.5 New Zealand 0.0 0.0 Germany -0.5 -2 -2 Quarters from trough * Data is to June quarter 2024, except for the United States which includes a September quarter 2024 estimate (based on July’s figure). Sources: Eurostat; LSEG; RBA. R E S E R V E B A N K O F AU S T R A L I A -0.5 Graph 11 illustrates that a higher unemployment path would bring inflation back to the midpoint of the target range more rapidly, more than offsetting the higher inflation persistence assumed in the central case. Graph 11 Unemployment Risks Scenario* % Unemployment rate Trimmed mean inflation 4.8 % 4.5 Higher unemployment 4.6 4.0 Aug SMP 4.4 3.5 May SMP 4.2 3.0 Lower unemployment 4.0 3.8 * 2.5 2.0 Scenario assumes exchange rate and policy path are fixed to August SMP assumptions. Sources: ABS; RBA. We also conducted a scenario exercise for household consumption.[21] Judgements about consumption are particularly important for the inflation forecast, because consumption accounts for roughly half of total Australian demand. Assuming that unemployment rises only gradually, the central projection is for consumption growth to pick up in line with an expected recovery in household real incomes (Graph 12). Graph 12 Household Disposable Income Growth Real, year-ended with contributions % Forecasts % -5 -5 -10 -10 -15 Total Labour income Other net income Net interest payable -15 Tax payable Prices Sources: ABS; RBA. The drivers of the pick-up in incomes are relatively clear, barring further shocks. But consumption also depends on the extent to which households choose to spend or save these higher incomes – and we are much less confident in that judgement. It is possible, for example, that households fortunate enough to have accumulated assets in recent years may choose to spend rather more than past relationships suggest. Aggregate net wealth in the household sector has increased by 58 per cent in the past five years (Graph 13) – much more than incomes. That could pose upside risks to consumption. Graph 13 Household Net Wealth Nominal, quarterly $tr $tr Total Consumer durables Financial assets Housing Liabilities -5 -5 Sources: ABS; RBA. At the same time, other households, particularly the young, have been forced to cut their spending back sharply as real incomes have fallen (Graph 14). Higher future real incomes may relax some of those constraints, allowing such households to increase their spending by more than historical relationships would suggest. But it is also possible that persistent uncertainty about the future may cause them to rebuild savings or pay down debt, posing downside risks to consumption. R E S E R V E B A N K O F AU S T R A L I A Graph 14 Card Spending Growth by Age Group Nominal, year-ended in four-week rolling average % % Total population >60 years 20–34 years -5 M J S D M J S D M -5 Source: CBA. These two-sided uncertainties about future saving behaviour are captured in two stylised profiles. One assumes that the saving ratio remains close to its relatively low current level; the other assumes it picks up to around its longer term historical average (Graph 15). Graph 15 Consumption Risks Scenario* index index Consumption per capita** December quarter 2019 = 100 May SMP Aug SMP Lower consumption % Household gross saving ratio*** % Higher consumption * Scenario assumes exchange rate and policy path are fixed to August SMP assumptions. ** Population denominator adjusted to exclude international students. *** Outliers during the COVID-19 pandemic were truncated. Sources: ABS; Department of Home Affairs; RBA. As with the other judgements, it is notable that quite small differences in this assumption – well within historical ranges – produce materially different outcomes for inflation and unemployment (Graph 16). Graph 16 Consumption Risks Scenario* % Unemployment rate 4.8 Trimmed mean inflation % 4.5 Lower consumption 4.6 4.0 Aug SMP 4.4 Higher consumption 4.2 3.5 3.0 May SMP 4.0 2.5 3.8 * 2.0 Scenario assumes exchange rate and policy path are fixed to August SMP assumptions. Sources: ABS; RBA. Policy implications and conclusions Let me conclude. As humans, we are all prone to overconfidence, particularly when forecasting the future. In many cases, the answer we ought to give is that we simply do not know. But it can be hard to say that, particularly if your job is to give a view, and particularly where even small changes in judgement can have first-order effects on people’s lives. Central bankers, and those who comment on us, are no exception to this universal human trait. In my remarks today, I have set out some of the ways in which we can try to lean against overconfidence without falling into the opposite trap of saying nothing at all. By avoiding over-reliance on point estimates and instead framing our assessments in terms of contingent hypotheses. By continually adjusting the weights we place on those hypotheses through a process of learning – from our own forecast errors, from a wide range of analytical models, from qualitative data and intelligence, from other countries, and through what-ifs and scenarios. And by communicating openly and honestly about where we are relatively confident about the outlook (and where we are not), where we are seeking to learn, and the balance of risks. Many of these tools are already in use at the Reserve Bank – and we will move further in that direction as we complete the implementation of the RBA Review recommendations. Of course the billion dollar question is how to map essentially uncertain judgements into policy decisions. That is really the subject for another speech – but the short answer is one should seek to choose strategies that are responsive to, and also robust to, your evaluation of the risks to the outlook as much as to the central projection. In some cases, uncertainty may induce you to be less activist – as you wait for more data, or try to avoid triggering tail risks through your own actions. In others, it can induce you to be more activist: for example, the asymmetry of potential outcomes underpinned the policy response in many countries during the COVID-19 pandemic. But beware anyone who claims it is obvious what to do – for they are false prophets! R E S E R V E B A N K O F AU S T R A L I A Endnotes [*] I am very grateful to Alex Baker, Alex Ballantyne, Michelle Bergmann, Michele Bullock, Natasha Cassidy, Selwyn Cornish, Ryan Couston, Stephen Cupper, Tom Cusbert, Amelia Dakin, Iris Day, Anthony Dickman, Boston Dobie, Jacqui Dwyer, Rachael Fitzpatrick, Bowen Hao, James Holloway, Jessica Hua, Callum Hudson, Sarah Hunter, Ben Jackman, Brad Jones, Chris Kent, Liam La, Kevin Lane, Jeremy Lawson, Virginia MacDonald, Kieran MacGibbon, Martin McCarthy, Alexandra Michielsen, Marcus Miller, Patrick Parrish, Mick Plumb, Max Prakoso, Avinash Rajan, Ravi Ratnayake, Penny Smith, Hamish Sullivan, Joyce Tan, Megan Thomas, Jake Thomson, Dmitry Titkov, Greg Tyler, Tom Williams, Michelle Wright, Joan Zhang, Zhan Zhang and Min Zhou for their assistance with, or comments on, this speech. Many of the themes in this speech have been covered by RBA colleagues in the past. See, for instance, Stevens G (2011), ‘On the Use of Forecasts’, Address to the Australian Business Economists Annual Dinner, Sydney, 24 November; Debelle G (2017), ‘Uncertainty’, 7th Warren Hogan Memorial Lecture, Sydney, 26 October; Ellis L (2019), ‘Watching the Invisibles’, The 2019 Freebairn Lecture in Public Policy, University of Melbourne, 12 June; Ellis L (2022), ‘The Neutral Rate: The Pole-star Casts Faint Light’, Keynote Address to Citi Australia & New Zealand Investment Conference, Sydney, 12 October; Cagliarini A and A Heath (2000), ‘Monetary Policy-making in the Presence of Knightian Uncertainty’, RBA Research Discussion Paper No 2000–10. Bowen had an extraordinarily varied career. After his time in Queensland, he served as Governor of each of New Zealand, Victoria, Mauritius and Hong Kong; and led a Royal Commission to draft the Maltese Constitution. I am grateful to QUT Deputy Vice-Chancellor (Indigenous Australians) Angela Leitch for this information. For further detail on the history of the site and the goals of the new faculty, see respectively: QUT, ‘Campus to Country’, available at <https://www.qut.edu.au/about/campus-to-country>; QUT, ‘Faculty of Indigenous Knowledges and Culture’, available at <https://www.qut.edu.au/about/faculty-of-indigenous-knowledges-and-culture>. Millmow A (2021), The Gypsy Economist: The Life and Times of Colin Clark, Palgrave Macmillan, Singapore, pp 73–83; Markwell DJ (2000), ‘Keynes and Australia’, RBA Research Discussion Paper No 2000-04. A fascinating question for another speech is whether economics may be particularly affected by overconfidence: Kozlowski AC and TS Van Gunten (2023), ‘Are Economists Overconfident? Ideology and Uncertainty in Expert Opinion’, British Journal of Sociology, 74(3), pp 476–500; Fox J (2012), ‘Economists Are Overconfident. So Are You’, Harvard Business Review (online), 27 June. And also, confidence amplified perhaps by its gender bias: Sarsons H and G Xu (2015), ‘Confidence Men? Gender and Confidence: Evidence among Top Economists’, 14 July. A good read on these topics is Silver, N (2013), The Signal and the Noise: The Art and Science of Prediction, Penguin. It includes a discussion of so-called ‘wet bias’, which describes the incentives that may bear on some less honourable weather forecasters to lean towards under rather than over confidence, deliberately over-predicting the chances of rain, on the grounds that people would rather go prepared for rain and be pleasantly surprised than the reverse! I am reliably informed that this was not always the case, because series draws were previously possible – and indeed occurred in 1999 and 2002 (in both cases Queensland retained the Shield because they won the previous series). The rules were subsequently changed to introduce’golden point’, so now there has to be a series winner. See Knight FH (1933), Risk, Uncertainty and Profit, 1st reprint edition, Houghton Mifflin Co, Boston; Kay J and M King (2020), Radical Uncertainty: Decision-Making Beyond the Numbers, WW Norton & Co, New York. In truth, we are usually uncertain even about where we are today: macroeconomic data are typically released only with a lag, and are themselves only estimates of the underlying concept, usually obtained by sampling or surveys and in some cases prone to substantial revision. [10] There is empirical evidence that confidence intervals formed by first choosing a central case and then overlaying two-sided intervals around it are more vulnerable to overconfidence bias than confidence intervals chosen without such prior ‘anchoring’ to a central estimate: see, for instance, Kahneman D (2011), Thinking, Fast and Slow, Farrar, Straus and Giroux, New York. [11] For further examples of the RBA’s work in this area, see: Tulip P and S Wallace (2012), ‘Estimates of Uncertainty around the RBA’s Forecasts’, RBA Research Discussion Paper No 2012-07; RBA (2022), ‘Box C: What Explains Recent Inflation Forecast Errors?’, Statement on Monetary Policy, November; RBA (2023), ‘Box B: Has the Economic Outlook Evolved as Forecast a Year Ago?’, Statement on Monetary Policy, November. The importance of building such learning into monetary policy deliberations in a systematic way was underscored in the recent Bernanke Review of forecasting at the Bank of England: see Bank of England (2024), ’Forecasting for Monetary Policy Making and Communication at the Bank of England: A Review’, 12 April; Kanngiesser D and T Willems (2024), ‘Forecast Accuracy and Efficiency at the Bank of England – And How Errors Can Be Leveraged To Do Better’, Bank of England Staff Working Paper No 1078. [12] This obviously assumes that the market projections are not simply copied from the RBA’s! [13] Experience in other countries is discussed by Chris Giles in his recent Financial Times piece: Giles C (2024), ‘Learning to trust the forecasts’, Financial Times (online), 30 July. [14] Of course, demand is a latent variable too. And there are many other ways in which the supply judgment could be wrong – most obviously if the Phillips Curve is a poor model of reality. That is why it is important for policymakers to be explicit about the judgments they are making, so the sensitivities of their projections to those judgments can be understood and critiqued. [15] Most take signal directly from inflation or wage out-turns, but many also incorporate other indicators that provide a read on supply, such as labour productivity. For further information see Ballantyne A, A Sharma and T Taylor (2024), ‘Assessing Full Employment in Australia’, RBA Bulletin, April. [16] The staff track a wide range of labour market indicators to inform their judgement of capacity, see RBA (2024), ‘2.5 Assessment of Spare Capacity’, Statement on Monetary Policy, August. [17] RBA (2024), Statement on Monetary Policy, August. It is important to emphasise that the August assumption retains the view that the labour market’s supply capacity has improved over the past decade – just at a slightly slower rate than previously assumed. [18] The uncertainty surrounding model estimates of the economy’s capacity are explored in Bishop J, J Hua, S Omidi, X Zhou and A Ballantyne (2024), ‘Assessing Potential Output and the Output Gap in Australia’, RBA Bulletin, July. [19] For further information on the liaison program, see Bullock M (2024), ‘Economic Conditions in Post-Pandemic Australia with a Regional Lens’, Rotary Club of Armidale Annual Lecture, Armidale, 8 August. [20] RBA (2024), ‘Chapter 3.4: Key Risks to the Outlook’, Statement on Monetary Policy, August. [21] See RBA (2024), n 20, ‘Key risk #2’. R E S E R V E B A N K O F AU S T R A L I A | reserve bank of australia | 2,024 | 8 |
Opening statement by Ms Michele Bullock, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Canberra, 16 August 2024. | Michele Bullock: Opening statement - House of Representatives Standing Committee on Economics Opening statement by Ms Michele Bullock, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Canberra, 16 August 2024. *** Good morning chair and members of the Committee. These hearings are an important part of the accountability process for the Reserve Bank and my colleagues and I are pleased to be here to answer your questions. I will start with a discussion of the inflation situation and the economic outlook. I will finish with an update on our priorities in the payments space and the cash distribution issues that the industry is dealing with. Inflation The Reserve Bank Board's mandate is to contribute to the welfare of the Australian people by delivering price stability and full employment. This mandate is set out in the Reserve Bank Act 1959. The Statement on the Conduct of Monetary Policy, agreed between the Australian Government and the Board, sets out how this works in practice. Specifically, we have agreed with the government that the best way of achieving low and stable inflation is to aim for annual consumer price inflation of between 2 and 3 per cent. While all outcomes within that range are consistent with our price stability objective, the Board sets policy to return inflation to the midpoint of the target. But the agreement with the government provides flexibility around the timeframe in which we meet our inflation objective. This is because we need to balance meeting our inflation objective with our full employment objective – achieving the maximum level of employment that is consistent with low and stable inflation. The reason I set this out is to give context to the Board's current strategy for monetary policy. The Board is trying to bring inflation back to target in a reasonable timeframe while preserving as many of the gains in the labour market that we have seen in the past few years. This is the so-called narrow path. So how are we doing? Since our previous appearance before this Committee, there has been further progress on inflation, but it has been very slow. Inflation peaked at 7.8 per cent in the December quarter 2022. It came down to 4.1 per cent at the end of 2023 but since then has only declined a further 0.3 percentage points to 3.8 per cent in the June quarter 2024. Underlying inflation, which abstracts from volatile components of the index, is also still elevated at 3.9 per cent in June 2024. This remains too high. Our current forecasts have underlying inflation by the end of this year still sitting around 3.5 per cent. What is driving this persistent inflation? A lot of it reflects inflation in services. Most of the disinflation we have seen since the peak in December 2022 has been driven by a 1/4 BIS - Central bankers' speeches decline in goods price inflation. Through 2022, there was very high inflation in goods prices, reflecting supply chain issues at a time of strong aggregate demand. Prices of groceries and consumer durables and new dwelling construction costs all surged. Inflation in many of these goods has since eased substantially, except for new dwelling costs, which are still increasing by around 5 per cent on an annual basis. Inflation in services prices, on the other hand, has remained high, running at around 5 per cent. There has been broad-based inflation in market services, reflecting continued demand and the ability for some businesses to pass through costs. Other contributors to high inflation have been rents and insurance, reflecting conditions specific to those industries. All of this has meant that while goods price inflation has declined substantially, it has not been enough to offset continued high services price inflation. This situation is not unique to Australia. Most advanced economies have experienced a similar pattern of inflation – a spike in inflation owing to goods and energy prices, followed by a sharp disinflation in goods prices but continued high services price inflation. As a result, other central banks are remaining cautious about the future path of interest rates. Some have decreased their policy rates a little but they have been emphasising that the job is still not done and policy remains restrictive. Likewise here in Australia. We did not increase interest rates as much as some other central banks. And we have received some criticism for that. Indeed, some commentators continue to call for further tightening in monetary policy. But as I noted earlier, we have been trying to balance bringing inflation back down over a reasonable timeframe, without inflicting unnecessary damage on the labour market. And the Board's judgement to date has been that policy is currently sufficiently restrictive to do that. The Board's recent decision Which brings me to the Board's most recent decision. At its meeting on 5 and 6 August, the Board decided to leave the cash rate unchanged at 4.35 per cent. It recognised that while inflation had fallen substantially since its peak, it is still some way above the midpoint of the 2–3 per cent target range. And as I noted earlier, inflation is proving persistent. But the Board remains vigilant to upside risks to inflation and noted that policy will need to remain sufficiently restrictive until it is confident that inflation is moving sustainably towards the target range. Prior to our decision, markets had brought forward their expectations of a rate cut following inflation outcomes in the United States and the June quarter CPI in Australia coming in a bit lower than expected. Then volatility in international financial markets resulted in further declines in interest rate expectations. Financial markets are still pricing in a rate cut by the end of the year. The Board's message, though, was that it is premature to be thinking about rate cuts. Inflation is still too high and, in underlying terms, is not expected to be back in the top of the band until the end of next year. Circumstances may change, of course, and the outlook is uncertain. But based on what the Board knows at present, it does not expect that it will be in a position to cut rates in the near term. I understand that this is not what many households want to hear. Those with mortgages are feeling the squeeze on their cash flows from the increase in interest rates over the 2/4 BIS - Central bankers' speeches past couple of years. Businesses too are facing higher borrowing costs. But the alternative of higher inflation for longer is much worse. Inflation has not been this high for a few decades and I think many people have forgotten how bad it is – some younger people will not have experienced high inflation at all. There is a reason why there is so much talk about the cost of living – high inflation hurts everyone. It reduces what people can buy with their wages, erodes the value of savings, and it disproportionately hurts those on low or fixed incomes. This is why it is imperative that we do what we need to ensure inflation returns to levels at which it is in the background again. Economic outlook That said, the economic outlook remains highly uncertain. The RBA published its most recent forecasts at the same time as we announced the monetary policy decision. As I noted earlier, the central forecasts are for inflation to return to the target range late in 2025. It is forecast to approach the midpoint of the target band in 2026. This is a slightly slower return to target than we were forecasting in May. It reflects a judgement that the gap between aggregate demand and supply in the economy is larger than previously thought. That is, even though growth in the economy has been weak, the level of demand for goods and services is still higher than the ability of the economy to produce those goods and services. These are our central forecasts and there is substantial uncertainty around them, more so the further out the forecasts are. Recognising this, we highlighted three key risks in the Statement on Monetary Policy: more excess demand in the economy at present than currently assessed; consumption growth in the future stronger or weaker than expected; and the labour market deteriorating by more than expected. The Statement provided some scenarios to demonstrate how different paths for the economy might affect the outcomes for inflation and employment. The scenarios show that if consumption or the labour market are weaker than expected, inflation could return to the target band more quickly and the unemployment rate could rise more sharply. And the reverse could occur if consumption and the labour market are stronger than expected. These scenarios are important because we know that economic activity and inflation could be much stronger or weaker than implied by our central forecasts. So we need to understand the implications for the economy and how monetary policy will have to respond if things turn out differently. My colleague Andrew Hauser gave a considered speech on the issue of uncertainty on Monday. The key point was that we know the future is uncertain and that we therefore need to be humble in our forecasts, be willing to learn from our errors, and use a diverse range of models and qualitative intelligence, as well as internal and external challenge. And we need to respond as the economy evolves. The Board is conscious of this, hence its commitment to be driven by the data and to adjust its assessment as necessary. The Board is of the view that it currently has the balance right between reducing inflation in a reasonable timeframe and maintaining the gains in the labour market. Ultimately, our full employment goal is not served by letting inflation stay above target indefinitely. So the Board remains focused on the potential upside risks to inflation. Before I finish, I want to say a few words on the payments system and issues in the cash distribution system. 3/4 BIS - Central bankers' speeches Payments system The Parliament is currently considering some important amendments to the Payment Systems (Regulation) Act 1998 (PSRA) that will enable us to promote safety, efficiency and competition across all players in the payments ecosystem. Once the reforms are passed, we will undertake a comprehensive review of our retail payments regulation. This review will consider the appropriateness of our regulatory settings and principles, and how to apply them to emerging players and business models. Many stakeholders would like to see progress on a range of issues, including the high cost of card payments for small businesses, surcharging of consumers and competition issues related to mobile wallets. The timely passage of the PSRA reforms will allow us to consider these issues in the broader context of the RBA's expanded regulatory arrangements. The Payments System Board discussed these issues at its quarterly meeting yesterday. It also discussed a number of other issues that are important for the future of the payments system in Australia. This included a paper that has been written jointly with the Australian Treasury, providing a stocktake and roadmap on domestic research priorities relating to the concept of central bank digital currency. The paper will be published in September. The Board also discussed developments in least-cost routing, challenges in wholesale cash distribution and opportunities relating to improved access and functionality for the New Payments Platform. Banknote distribution Another issue I would like to update the Committee on is recent developments in the cash distribution system. While the use of cash for everyday payments has declined in recent decades, it remains an important means of payment for many Australians. Cash is used as a store of wealth, particularly during periods of economic uncertainty, and can be a useful backup for electronic methods of payment. As you know, the cash distribution system came under considerable stress earlier in the year when the financial viability of the largest firm providing cash-in-transit services, Linfox Armaguard, came under question. Since then, the RBA, the Australian Treasury and key participants in the cash distribution industry have been working together to strengthen business continuity arrangements, increasing the ability of the industry to respond to a significant disruption to the supply of cash. In late June, an industry support package of approximately $50 million over 12 months was agreed between Linfox Armaguard and its major banking and retail customers, reducing the near-term risk of a major disruption. The funding deal should provide time for the industry participants, the RBA and government to focus on formulating a longer term model for cash distribution, so that cash is available for those who need and want to use it. Developing a more durable future cash distribution system will require broad consultation and require participants in the system to approach these issues in the public interest. Thank you for listening. My colleagues and I look forward to answering your questions. 4/4 BIS - Central bankers' speeches | reserve bank of australia | 2,024 | 8 |
Keynote address by Ms Michele Bullock, Governor of the Reserve Bank of Australia, to the Anika Foundation Fundraising Lunch, Sydney, 5 September 2024. | Speech The Costs of High Inflation Michele Bullock[*] Governor Keynote Address to the Anika Foundation Fundraising Lunch Sydney – 5 September 2024 I am very pleased to be here at the Anika Foundation fundraising luncheon. It is a tradition for the Governor of the Reserve Bank to give this annual address and I am very happy to continue it. As you know, the Foundation supports research into adolescent depression and suicide, a widespread issue and I suspect one that many of us in this room have been touched by. I am therefore very pleased to be speaking at an event in support of such an important cause. The monetary policy environment I want to start by explaining the Board’s most recent policy decision and summarising our central outlook for the Australian economy as set out in our August Statement on Monetary Policy. To a large extent, I will be reinforcing many of the points I made following the August Board meeting. As I’m sure you know, at its meeting in early August, the Board decided to leave the cash rate unchanged at 4.35 per cent. While inflation has fallen substantially since its peak, it is still some way above the midpoint of the 2–3 per cent target range, with underlying inflation – as measured by the trimmed mean – at 3.9 per cent in June. The Board is trying to bring inflation back to target in a reasonable timeframe while preserving as many of the gains in the labour market that we have seen in the past few years as possible. This is the so-called narrow path. In our central August forecast, underlying inflation is expected to be back in the target range by the end of next year, and to approach the midpoint in 2026 (Graph 1). That is a slightly slower return to target than our forecast in May. Meanwhile, the labour market remains relatively tight but is expected to continue to ease gradually over the next couple of years. Graph 1 Trimmed Mean Inflation Forecast* Year-ended % % -1 * -1 Confidence intervals reflect RBA forecast errors since 1993, with the 70 per cent interval shown in dark blue and the 90 per cent interval shown in light blue. Sources: ABS; RBA. There is substantial uncertainty around this central outlook, however, with risks on both sides. One way to think about this is to consider the historical errors around our central forecasts – represented as fan charts in the Statement on Monetary Policy. There are many things that could happen that could result in inflation being above or below the central forecast. The Statement also provided some specific scenarios under which consumption and employment could be stronger or weaker than implied by our central forecasts. These illustrate that outcomes for inflation could be quite different if the economy follows an alternative path. The Board needs to be alert to these possibilities in thinking about the future path of interest rates. In setting policy, the Board is looking to strike an appropriate balance between the RBA’s inflation and full employment objectives. Given the starting point of high inflation and a relatively tight labour market, and that low and stable inflation ultimately supports our full employment objective, our highest priority has been and remains to bring inflation down – I will come back to say a bit more about why later. The Board remains vigilant to upside risks to inflation and has noted that monetary policy will need to remain sufficiently restrictive until it is confident that inflation is moving sustainably towards the target range. Moreover, the forecasts I’ve described were predicated – as usual – on the technical assumption that the cash rate follows the path implied by the market. This meant that the central forecast for inflation was based on cuts in the cash rate starting early next year. Accordingly, the Board’s message following its meeting only a few weeks ago was that it is premature to be thinking about rate cuts. Circumstances may change, of course, and if economic conditions don’t evolve as expected, the Board will respond accordingly. But if the economy evolves broadly as anticipated, the Board does not expect that it will be in a position to cut rates in the near term. I now want to talk through recent developments in inflation in a bit more detail; explain why it is so important to complete the job of getting inflation down; and say a bit about the resilience of household finances to high inflation and the tightening in monetary policy that has occurred in response. R E S E R V E B A N K O F AU S T R A L I A Recent developments in inflation So, what is driving inflation now? The chart below shows the contributions of various parts of the consumer price inflation (CPI) basket compared to their average contribution over the entire inflation targeting period (Graph 2). This helps identify which parts of the CPI basket drove the rise in inflation in 2022 and the subsequent easing. Graph 2 CPI Inflation – Deviation from Average* Year-ended with contributions ppt CPI Housing Market services ppt Administered Retail goods Other -2 -2 -4 * -4 Deviation from inflation targeting average; market services excludes holiday travel and telecommunications; retail goods is consumer durables and groceries excluding fruit & vegetables. Sources: ABS; RBA. You can see that through 2022 and 2023, most components of the CPI basket were growing faster than usual. Inflation in housing and goods prices was particularly high over that period. But over the past 18 months, goods price inflation has declined substantially as supply disruptions associated with the COVID-19 pandemic and war in Ukraine have subsided and global demand for goods has eased. Inflation for retail goods – consumer durables and groceries – is now close to its historical average. Inflation for administered prices – which are at least partly regulated or relate to items for which the public sector is a significant provider – is only a little above its long-run average. The key drivers of elevated inflation at the moment are housing costs and market services inflation, which remain above their average levels and have been easing only gradually. On the housing side, this reflects both construction cost growth and strong increases in rents. Year-ended growth in advertised rents is still high, reflecting pressure from a rebound in housing demand and limited supply response.[1] Rents on new leases take time to impact overall CPI rents because only a small share of the stock of rental properties update leases in a given month and so CPI rents inflation is likely to be high for some time (Graph 3). New dwelling inflation has declined from its earlier peak as materials costs have eased, but it remains elevated. There is still a large pipeline of work and ongoing labour shortages for certain trades. Graph 3 Rent Prices Capital cities, 2019 = 100 index index Advertised rents CPI rents Sources: ABS; CoreLogic; RBA. Market services is making the largest contribution to above-target inflation. While year-ended inflation has been moderating across most market services – particularly those that are more discretionary, such as eating out and recreational activities – inflation in this category remains high at 5.3 per cent over the year to the June quarter. We typically think of market services inflation as reflecting overall domestic inflationary pressures – a combination of costs and margins. Domestic non-labour costs (including, for example, electricity, insurance and warehousing and logistics rents) continue to increase strongly, and labour cost growth is also strong, reflecting both wage increases and weak productivity growth (Graph 4). Graph 4 Change in Firms’ Costs ppt ppt Non-labour costs* Net balance, RBA liaison Imported -50 Domestic % -50 % Unit labour costs Non-farm, year-ended growth -10 * R E S E R V E B A N K O F AU S T R A L I A -10 Share of firms reporting above-average increases less share reporting decreases, no change or below-average increases; average increase indexed to 0; smoothed with a 13-month Henderson trend. Sources: ABS; RBA. Survey measures, including in the RBA’s liaison program, suggest that firms are continuing to pass through some of this cost growth to prices, although softer consumer demand has made pass-through more difficult in some industries. The key takeaway here is that domestic capacity pressures, in both housing and market services, are contributing to above-target inflation. Despite a gradual easing over the past 18 months, the labour market remains relatively tight, with labour availability still a constraint for some businesses and job vacancies elevated. We also continue to observe tightness across product markets, and firms report high capacity utilisation. Restrictive monetary policy has been working to bring demand and supply more into balance and this has contributed to the easing in aggregate CPI inflation. It is true that inflation in some components of the CPI has eased more than others. But it is not unusual for different components of inflation to behave differently at any point in time. And at an aggregate level, there is further to go. With underlying inflation having fallen very little over the past year in quarterly terms, the Board is vigilant to upside risks. That is why, as the Board has said, policy will need to be sufficiently restrictive until we are confident that inflation is moving sustainably towards the target range. Why is bringing inflation down so important? We know the restrictive monetary policy settings that are necessary to bring inflation down are causing hardship to some households and businesses. We are very conscious of that. In fact, we spend a lot of time trying to understand how interest rates settings are affecting households and businesses – and I will say more about that later. But inflation causes hardship too, for all Australians and particularly for the more vulnerable in our community. Our experience of how costly inflation can be is the reason that getting inflation back to the target range is our priority. There are two ways to come at this. The first, taking a longer view, is to remind ourselves why we have a flexible inflation targeting framework, which goes back to the experience with high inflation in the 1970s and 1980s. Inflation – as measured by the year-ended change in the CPI – reached 17.7 per cent in March 1975 and it remained around 10 per cent on average for the rest of the 1970s and early 1980s (Graph 5). Graph 5 CPI Inflation* Year-ended % % Inflation targeting Period averages -5 * -5 Excludes interest charges prior to the September quarter of 1998; adjusted for the tax changes of 1999–2000. Sources: ABS; RBA. For those who experienced it, memories of that period may have faded – and for many younger people it probably seems like ancient history. But institutions can preserve the lessons of the past. The move to flexible inflation targeting by many central banks in the 1990s embodied the strong consensus at the time that inflation was harmful and that the way monetary policy had operated in the 1980s had not been sufficient for many central banks to bring inflation down. High and variable inflation is harmful because it raises uncertainty and makes it harder to plan for the future. It can distort economic activity, affecting decisions about investment and employment and ultimately hurting productivity and household incomes. For example, it might be hard for a firm to lock in a supply contract if it doesn’t know what prices are going to be over the next year. In turn, this might make it harder to make expansion plans. High and variable inflation can also cause shifts in people’s wealth and spending power. Agreeing to a new contract, or making saving plans, is harder if you don’t know how expensive things will be in the future. Moreover, high inflation eventually requires disinflation, which can have long-lasting costs for households through higher unemployment. Setting a clear and transparent inflation target helped guide the Reserve Bank Board’s decision-making. But it also provided a clear anchor for inflation expectations, resulting in lower and more stable inflation. Over the inflation targeting period well-anchored inflation expectations have enabled monetary policy to more effectively respond to the ups and downs of the economic cycle, stabilising the economy and creating the conditions for steady growth and job creation. The anchor has held through the recent inflation episode – but we do not and cannot take that for granted. Over time, inflation expectations will only remain aligned with the target if we continually work to return inflation there when it moves too far up or down. The timeframe over which we do so can (and does) vary as we take account of our full employment objective. But, over the medium term, our full employment goal is best served by achieving the inflation target. The second way to come at the question of why getting inflation down is the Board’s priority is to look at the effects that high inflation has had on people over the past three years. Every Australian feels the effects of inflation, but people have different patterns of spending and incomes, and so their experience of cost-of-living pressures varies. Lower income households tend to allocate more of their spending towards essentials, including food, utility bills and rent. Higher income households tend to spend more on owner-occupied housing as well as discretionary items such as consumer durables. Through most of the recent inflationary period, inflation has been broadly based across most components in the CPI basket. So, most people have experienced similar rates of increase in inflation. However, inflation for nondiscretionary items has eased but remains elevated in recent quarters. This partly reflects housing inflation. Lower income households tend to spend a larger share of their income on rents, and so this is likely to be a greater challenge for this segment of our community (Graph 6). R E S E R V E B A N K O F AU S T R A L I A Graph 6 Discretionary and Non-discretionary Inflation Year-ended % % Non-discretionary Discretionary -3 -3 Source: ABS. The experience of individual households varies widely, but younger households and lower income households have been particularly affected by cost-of-living pressures overall.[4] They are often budget-constrained and have less scope to reduce their spending on discretionary items to balance their budgets (Graph 7). They may also have less scope to reduce spending via trading down to cheaper items within the same category if they were already purchasing lower cost items. Moreover, they typically have smaller savings buffers and so less scope to use savings to maintain their current standard of living. Graph 7 Household Consumption Weekly per household by equivalised income quintile, 2021/22 $ $ Housing and food Enjoyment and luxury Other 3,000 3,000 2,000 2,000 1,000 1,000 e til in qu h 5t 4t h qu in in qu d 3r in qu d 2n til e e til ile nt ui tq 1s til e Sources: ABS; RBA. We know that if high inflation becomes entrenched in the expectations of firms and households it would be more difficult and costly to reduce. If businesses and workers come to expect that prices and wages will continue rising quickly this adds to inflationary pressures, requiring even higher interest rates to bring inflation down. Ultimately, we would need to slow the economy down by more, which would result in a larger rise in unemploy ment and higher risk of recession. The costs of job loss are very high to individual workers and lead to persistent earnings losses. This experience is consistent across groups of workers. But job losses tend to be disproportionately borne by some members of the community – the young, those who are less educated, and people on lower incomes and with less wealth (including renters).[5] A weak labour market also hurts those who keep their jobs, whether through a reduction in hours worked or lower wages growth. So the future costs to not taming inflation would be borne by all Australians, but disproportionately by lower income households. How resilient have household finances been to high inflation and tighter monetary policy? I have noted on a number of occasions that monetary policy needs to be set for aggregate economic conditions. We only have one instrument – the interest rate – to impact demand and it is blunt. But just as inflation is felt differently by various groups in the community, so too are interest rate moves. We therefore need to pay close attention to conditions facing different parts of the community, including the most vulnerable. That is true when thinking about monetary policy and also in thinking about financial stability. The RBA’s forthcoming September Financial Stability Review (FSR) will provide an overall assessment of the health of household and business finances. While I don’t want to steal the FSR’s thunder, I do want to conclude today by previewing a few key messages on how household finances are faring. The first thing to say is that I understand that the Board’s message on interest rates is not what many borrowers want to hear. Those with mortgages are feeling the squeeze on their cash flows not just from high inflation, but also from the increase in interest rates that has occurred in response to it. And as labour market conditions ease, more households will experience a strain on their finances from unemployment or reduced working hours. Information received through the RBA’s liaison program indicates that more people than usual are seeking support from community organisations, and often for the first time. In the FSR we tend to focus on households with mortgages, because debt has the potential to amplify and transmit stress across the financial system. A key point to make here is that despite the pressure on household budgets, only a small share of borrowers is currently at risk of falling behind on their mortgage repayments. Key reasons for this are that the labour market has been strong, people have been able to find and stay in work and many have been making adjustments to their spending, particularly on discretionary items. For owner-occupiers with variable-rate loans (which is a subset of all borrowers), we estimate that around 5 per cent are in a particularly challenging situation, where the combined total of their essential spending and scheduled mortgage repayments is more than their income – that is, they have a ‘cash flow shortfall’ (Graph 8). Although this group is fairly small overall, those in it have had to make quite painful adjustments to avoid falling behind on their mortgage repayments. This includes things like cutting back on their spending to the more essential items, trading down to lower quality goods and services, dipping into their savings or working extra hours. Some may ultimately make the difficult decision to sell their homes. A really important point to note here, is that lower income borrowers are over-represented in the group of people who are really struggling. R E S E R V E B A N K O F AU S T R A L I A Graph 8 Borrowers with Cash Flow Shortfall* Estimated share of variable-rate owner-occupier loans % % Lowest income quartile Other income quartiles * Estimates of borrowers with minimum scheduled mortgage payments and essential expenses (proxied by the Household Expenditure Measure) exceeding their income. Excludes borrowers in arrears, which accounted for around 0.6 per cent of loans in June 2024. Sources: ABS; Melbourne Institute; RBA; Securitisation System. Should inflation remain high for longer than the RBA is forecasting, the share of borrowers most at risk of being unable to service their debts would increase a little further.[6] While the numbers are not large enough to pose a material risk to the stability of the financial system, it would have a material impact on those households who end up in this situation. And we know that lower income borrowers are most at risk of this, because they typically have smaller financial buffers. Conclusion Inflation has not been as high as it has been recently for a few decades and I think many people have forgotten how bad it is – people under the age of 40 will not have experienced high inflation until the last few years. There is a reason why there is so much talk about the cost of living – high inflation hurts everyone, and especially the most vulnerable. It reduces what people can buy with their wages, erodes the value of savings, and it disproportionately hurts those on low or fixed incomes. This is why it is imperative that we return inflation to levels that mean it is in the background again – at which point it will no longer be distorting our economy. We see achieving our inflation target as going hand in hand with our full employment objective, as it lays the foundations for economic growth and jobs creation. The Board is seeking to balance reducing inflation in a reasonable timeframe and maintaining as many of the gains in the labour market that we have seen in the past few years as possible. Ultimately, though, it is crucial to remember that our full employment goal is not served by letting inflation stay above target indefinitely. Endnotes [*] Thank you to Michelle Bergmann, Callum Hudson, Tim Taylor and Michelle Wright for excellent assistance with this speech. See Hunter S (2024), ‘Housing Market Cycles and Fundamentals’, Address to the REIA Centennial Congress, Hobart, 16 May. One of my predecessors as Governor, Bernie Fraser, put it like this in 1990: ‘That inflation is a bad thing and should be eradicated is about as close to a consensus as you are likely to get on any economic or political issue.’ See McTaggart D (1992), ‘The Cost of Inflation in Australia’, Paper delivered at the RBA Annual Conference, 10–11 July. The 1992 RBA Annual Conference, which took place just prior to the introduction of inflation targeting in Australia was dedicated to the costs of high inflation. See Blundell-Wignall A (ed) (1992), ‘Inflation, Disinflation and Monetary Policy’, RBA Annual Conference, 10–11 July. See Wood D, I Chan and B Coates (2023), ‘Inflation and Inequality: How High Inflation Is Affecting Different Australian Households’, Working paper prepared for the RBA Annual Conference, Sydney, 25–26 September 2023; Beckers, A Clarke, A Gao, M James and R Morgan (2024), ‘Developments in Income and Consumption Across Household Groups’, RBA Bulletin, January. See Lancaster D (2021), ‘The Financial Cost of Job Loss in Australia’, RBA Bulletin, September; Coates B and A Ballantyne (2022), ‘No One Left Behind: Why Australia Should Lock in Full Employment’, Grattan Institute; RBA (2023), ‘Box B: Scenario Analysis on Indebted Households’ Spare Cash Flows and Prepayment Buffers’, Financial Stability Review, April. This scenario was illustrated in the March 2024 Financial Stability Review. See RBA (2024), ‘4.1 Focus Topic: Scenario Analysis of the Resilience of Mortgagors and Businesses to Higher Inflation and Interest Rates’, Financial Stability Review, March. R E S E R V E B A N K O F AU S T R A L I A | reserve bank of australia | 2,024 | 9 |
Speech by Mr Brad Jones, Assistant Governor (Financial System) of the Reserve Bank of Australia, at the Intersekt Conference, Melbourne, 18 September 2024. | null | reserve bank of australia | 2,024 | 9 |
Speech by Mr Christopher Kent, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, at the review of the Term Funding Facility (TFF) publication, Sydney, 9 October 2024. | null | reserve bank of australia | 2,024 | 10 |
Speech by Ms Sarah Hunter, Assistant Governor (Economic) of the Reserve Bank of Australia, at the Citi Australia and New Zealand Investment Conference, Sydney, 16 October 2024. | 56789 6ÿ9 6ÿÿÿÿ9 ÿ96 ÿÿÿ !"#"$ÿ&'()*#ÿklm +,,-,./0.ÿ23456036ÿ789303:-9; <=)=ÿ>'?)#"@="ÿ"(AÿB*CÿD*"@"(AÿE(F*?)G*()ÿ<H(I*#*(J* KLM05LÿNÿOPÿQ9.3R56ÿSTSU 56V 6 WÿX3YZMÿ[-6,.ÿZ-\5ÿ.3ÿ]/Lÿ65,]59.ÿ.3ÿ.^5ÿ.6/M-.-30/Zÿ/0Mÿ36-_-0/Zÿ3X056,ÿ3[ÿ.^-,ÿZ/0M`ÿ.^5ÿ2/M-_/Zÿ]53]Z5 3[ÿ.^5ÿ836/ÿa/.-30`ÿ.3ÿ]/Lÿ65,]59.ÿ.3ÿ.^3,5ÿX^3ÿ^/45ÿ]/,,5MÿR5[365ÿY,ÿ/0Mÿ.3ÿ/9\03XZ5M_5ÿ.3M/Lb, 9Y,.3M-/0,ÿ3[ÿ.^-,ÿZ/0McÿWÿ/Z,3ÿ5d.50Mÿ.^/.ÿ65,]59.ÿ.3ÿ/0Lÿe-6,.ÿa/.-30,ÿ]53]Z5ÿf3-0-0_ÿY,ÿ^565ÿ.3M/Lc +ÿZ3Xÿ/0Mÿ,./RZ5ÿ-0[Z/.-30ÿ6/.5ÿ-,ÿ96-.-9/Zÿ.3ÿ]65,564-0_ÿ:/96359303:-9ÿ,./R-Z-.Lcÿg/4-0_ÿ/ÿ_33Mÿ-M5/ÿ3[ X^/.b,ÿ_3-0_ÿ.3ÿ^/]]50ÿ.3ÿ]6-95,ÿ/ZZ3X,ÿRY,-05,,5,ÿ.3ÿ]Z/0ÿ[36ÿ-045,.:50.ÿ/0Mÿ5d]/0,-30cÿW.ÿ/Z,3 :/\5,ÿ.^-0_,ÿZ-\5ÿRYM_5.-0_ÿ/0Mÿ[-0/09-/Zÿ]Z/00-0_ÿ5/,-56ÿ[36ÿ^3Y,5^3ZM,cÿh^-,ÿ-,ÿ]/6.-9YZ/6ZLÿ.6Y5ÿ[36 .^3,5ÿ30ÿZ3Xÿ-093:5,`ÿX^3ÿ.L]-9/ZZLÿ^/45ÿ,:/ZZ56ÿ[-0/09-/ZÿRY[[56,ÿ.^/0ÿ3.^56,ÿ/0Mÿ,]50Mÿ:365ÿ3[ .^5-6ÿ-093:5ÿ30ÿ5,,50.-/Z,cÿknmÿ+0MÿX-.^ÿ:365ÿ,./RZ5ÿ^3Y,5^3ZMÿ/0MÿRY,-05,,ÿR/Z/095ÿ,^55.,`ÿ.^5 [-0/09-/Zÿ,L,.5:ÿ-,ÿ:365ÿ,./RZ5cÿkom h^5ÿ5d]56-5095ÿ3[ÿ.^5ÿZ/,.ÿ[5XÿL5/6,ÿ^/,ÿ9Z5/6ZLÿ^-_^Z-_^.5Mÿ.^-,cÿ8456L305ÿ/963,,ÿ.^5ÿ59303:Lÿ^/, [5Z.ÿ.^5ÿ-0965/,5Mÿ93,.ÿ3[ÿZ-4-0_cÿkpmÿh^-,ÿ-,ÿ456Lÿ9Z5/6ÿ-0ÿ.^5ÿM/./ÿX5ÿ:30-.36̀ÿ,Y9^ÿ/,ÿ^3Y,5^3ZM ,]50M-0_`ÿRY.ÿ-.b,ÿ]56^/],ÿ:365ÿ/]]/650.ÿ-0ÿ,Y645Lÿ:5.6-9,ÿ,Y9^ÿ/,ÿ930,Y:56ÿ930[-M5095`ÿX^-9^ 65:/-0,ÿ:Y9^ÿZ3X56ÿ.^/0ÿ-.,ÿ]65i]/0M5:-9ÿ/456/_5ÿ726/]^ÿO;cÿK3ÿ.^565ÿ/65ÿ/ÿ0Y:R56ÿ3[ÿ_33M 65/,30,ÿ.3ÿR6-0_ÿ-0[Z/.-30ÿM3X0ÿ/0Mÿ\55]ÿ-.ÿ/.ÿ/ÿZ3Xÿ/0Mÿ,./RZ5ÿ6/.5c ?38ÿ@ 01ÿ34456571ÿ67ÿ689ÿ631 59ÿ5 36ÿ7ÿ993694ÿ5136571ÿ6743ÿ9163ÿ319ÿ7691ÿ1769ÿ6836ÿ689 316ÿ67ÿ 39ÿ9ÿ6836ÿ5136571ÿ99636571ÿ9 351ÿ318794ÿ6ÿ8ÿ5ÿ685ÿ689ÿ39ÿ14ÿ836 5 36ÿ47ÿ916ÿ5136571ÿ767 9ÿ839ÿ71ÿ99636571 ÿ"#ÿ$%&'()$#%ÿ*+,*-)()$#%.ÿ/())*01 2379717 56ÿ9193ÿ6851ÿ6836ÿ3ÿ9935569ÿ7ÿ7156916ÿ385951 ÿ7ÿ314ÿ63 9ÿ5136571 79ÿ65 9ÿ5ÿ94318794ÿ5136571ÿ99636571ÿ5836ÿ5ÿ979ÿ37ÿ689ÿ9717 ÿ9599ÿ5136571 5ÿ9193ÿ393 9ÿ3ÿ7ÿ369ÿ651ÿ63537ÿ39ÿ89:ÿ9ÿ916;ÿ314ÿ689ÿ 39ÿ495571ÿ394 71ÿ685ÿ14951 ÿ959ÿ6836ÿ97 9ÿ94951751 ÿ014994ÿ685ÿ5ÿ3ÿ9ÿ971ÿ7 ÿ9717 5 8567<ÿ6899ÿ39ÿ 659ÿ95749ÿ6836ÿ49 716369ÿ689ÿ43 3 9ÿ494318794ÿ99636571ÿ31 39ÿ314ÿ689ÿ75ÿ976ÿ314ÿ939ÿ76ÿ3753694ÿ568ÿ94318751 ÿ689 ÿ5=597ÿ916 995919ÿ5ÿ>6ÿ719ÿ93 9ÿ6?38ÿ8;ÿBCD %94ÿ) 01ÿ345ÿ61ÿ7897 1ÿ 7ÿ ÿÿ347ÿÿ17ÿ1ÿ711 ÿ1 17ÿ7ÿ4ÿ475ÿ 7 7 7ÿ97197ÿ61ÿÿ 7ÿ67 1ÿ 76ÿ1ÿ34 ÿÿ4 997ÿ16 5ÿ475ÿ1ÿ 1ÿÿ34 475ÿ4ÿ3ÿ4 997ÿ1113ÿÿ147ÿ316ÿ 1ÿ7897 1ÿ7ÿ ÿ7ÿ9 5ÿ7 1ÿ7897ÿ1ÿ67 1ÿ1!7ÿ413ÿ4ÿ1ÿ!7ÿ1ÿ7 77ÿ16 5ÿÿ677 76ÿ5ÿ413ÿ4 17ÿ37ÿ4ÿ37ÿ776ÿ17ÿ37ÿ19ÿ31ÿ6ÿ4ÿÿ9 5ÿ776ÿ5ÿ34 ÿ37ÿ4ÿ3 4 997ÿ1ÿ97ÿ7377ÿ13ÿ6ÿ47 ÿ66 1ÿ1ÿ4 ÿ47ÿ74 !1ÿ1ÿ417416ÿ 1ÿ7897 1ÿ1ÿ67 5ÿ776ÿ1ÿ 1ÿ47ÿ67 1ÿÿ 7ÿ"ÿ1ÿ7897ÿ1!7ÿ 9 ÿ!77ÿ9 ÿ6ÿ ÿ#7ÿ3 5ÿ4 1 ÿÿ414ÿ47ÿ3 77 ÿ917ÿ$%94ÿ&'ÿ+,-ÿ(4ÿ16ÿ7ÿ317ÿ1ÿ47ÿ1 7977 !7ÿ ÿ1ÿ447ÿ3 7ÿÿ475ÿ4ÿ 1ÿ3ÿ7ÿ447+ÿ.-ÿ#ÿÿ16ÿ7 ÿ7897 1ÿ1ÿ447ÿ7ÿ97ÿ!ÿ47ÿ47ÿ1677ÿ1ÿ17ÿ447ÿ3 7ÿ16 5ÿ1 ÿ317 9ÿ' 012ÿ45671ÿ89 8ÿ895ÿ5ÿ1ÿ51678 718ÿ17717ÿ2ÿ7ÿ7 5 ÿ18ÿ8ÿ 71851ÿ9ÿ5 818ÿ51851 778851ÿ7ÿ8ÿ897ÿ2 785ÿ12ÿ51871 851 ÿ85ÿ 851ÿ27551ÿ 27ÿÿ51 15 78ÿ 855 18ÿ977ÿ778851ÿ8971ÿ772ÿ518ÿ1487 ÿ518778ÿ87ÿ79 147ÿ87ÿ12 897ÿ57ÿÿ 78ÿ51ÿÿ711 851ÿ12ÿ12ÿÿ897ÿ51678 718ÿ85ÿ1ÿ98ÿ51851 778851ÿ7ÿÿ 8ÿ51ÿ788ÿ 9ÿ767ÿ71 5ÿ27551ÿ89 8ÿ 27ÿ767ÿ2 97ÿ 8ÿ89 8ÿ778851ÿ772ÿ518ÿ 8 ÿ51851ÿ8 7ÿ 71ÿ271972ÿ778851 85 ÿ72ÿ8ÿ4787ÿ51851ÿ68558ÿ9ÿ!"ÿ#8558ÿ772ÿ178518ÿ12ÿ178518 7ÿ27551ÿ9 27ÿÿ76717ÿ0ÿÿ517 ÿ9ÿ2ÿÿ27527ÿ971ÿ58ÿ5498ÿ8ÿ51678ÿ5 7ÿ7 ÿ7ÿÿ897ÿ51 15ÿ781$ÿ012ÿ8ÿ4ÿ ÿ8ÿ897ÿ7 7ÿÿ9792ÿ2752514ÿ9 9ÿ8ÿ 67ÿÿ7857 718ÿÿ8ÿÿÿ9 7ÿÿ8ÿÿ177872ÿ9549ÿ51851ÿ5ÿ67ÿ9 2ÿ8 1ÿÿ%89ÿ897ÿ78ÿ7&572ÿ8ÿ 7ÿ27551ÿ589ÿ178518ÿ12ÿ89 8ÿ 7ÿ89757ÿ42 27551ÿ5ÿ18ÿ7ÿ 27ÿ 7ÿÿÿ7ÿ $ÿ5 01234567ÿ569256ÿ 3256 ÿÿÿ ÿÿ!ÿ"! 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Speech by Mr Brad Jones, Assistant Governor (Financial System) of the Reserve Bank of Australia, at The Regulators 2024 "Navigating Trans-Tasman financial challenges", organised by FINSIA (Financial Services Institute of Australasia), Sydney, 8 November 2024. | Brad Jones: Panel participation at the Regulators 2024 Speech by Mr Brad Jones, Assistant Governor (Financial System) of the Reserve Bank of Australia, at The Regulators 2024 "Navigating Trans-Tasman financial challenges", organised by FINSIA (Financial Services Institute of Australasia), Sydney, 8 November 2024. *** Good afternoon, and thank you to FINSIA for the opportunity to discuss some of the RBA's regulatory and supervisory priorities in our payments policy and financial stability work. Australia has a payments system that we can be proud of. By global standards, it is fast, efficient and reliable. At the same time, the Australian payments landscape is rapidly evolving, and there is always room for improvement. Alongside opportunities for new business models and technologies to emerge, there are also some challenges for the system. Regulators are leaning into these challenges and industry will need to as well. The Payments System Board is focused on fostering competition and innovation in a regulatory environment that promotes the ongoing safety and security of the Australian payments system. In overseeing the activities of clearing and settlement facilities with our colleagues at ASIC, RBA staff and the Payments System Board (PSB) are equally focused on ensuring that these critical operations are run in a way that supports the stability of the Australian financial system. With this in mind, let me share with you the PSB's five strategic priorities that were set out in the recently released Annual Report.1 Priority #1: Promoting the safety and resilience of payments and market infrastructures Australians increasingly depend on the availability of electronic payment systems, and our financial system is reliant on the smooth functioning of market infrastructures. The orderly migration of Bulk Electronic Clearing Service (BECS) payments to more modern payment rails, such as the New Payments Platform (NPP), is of critical importance, recognising that BECS has been Australia's primary system for account-toaccount payments for over 30 years (facilitating most salary, welfare and pension payments). The industry target date of 2030 is ambitious and will require a concerted and coordinated effort by industry to meet. This effort must include close engagement with a wide range of stakeholders. In the meantime, the RBA is conducting a risk assessment to identify and understand how the transition risks are being managed. Beyond BECS, and in light of the worsening cyber and geopolitical risk environment, the operational resilience of Australia's payment systems is a principal focus for the PSB. RBA staff are closely monitoring the ability of market infrastructures to upgrade their technologies and manage these risks, including relating to third-party service providers. 1/3 BIS - Central bankers' speeches Priority #2: Supporting reforms of the regulatory framework for payments and market infrastructures As regulators need to have the powers to address emerging issues in the payments system, the PSB continues to strongly support the Government's ongoing reforms to modernise the regulatory framework. RBA staff are also operationalising our new crisis management and supervisory powers for clearing and settlement facilities that featured in the recent reforms to financial market infrastructure regulation. Priority #3: Lowering the cost of card payments for merchants, especially small businesses The RBA recently launched a review of merchant card payment costs and surcharging. Options under review include those aiming to reduce the level and complexity of wholesale fees in card payments and promoting greater transparency for merchants. The review is also examining whether limits need to be placed on surcharging. Stakeholder submissions on these issues are invited by early December.2 Priority #4: Improving cross-border payments, which remain expensive, slow and opaque The PSB is encouraging the adoption of internationally harmonised messaging capabilities and enhanced functionality for cross-border payments. A recent example was the launch of the NPP's International Payments Service, which will significantly speed up incoming cross-border payments. RBA staff also continue to examine options for linking fast payment systems across countries. Priority #5: Actively shaping the future of digital money This is a clear priority for the PSB and also features in the RBA's Corporate Plan. In September, we published a paper with Treasury that set out our assessment of the case for central bank digital currency (CBDC) in Australia, and for the first time laid out a three-year roadmap for future work.3 At present, we assess the benefits to the economy as more promising, and the challenges less problematic, for a wholesale CBDC compared with a retail version that would be available to the general public. As I recently discussed, the RBA has made a strategic commitment to prioritise our applied research on the role that CBDC could play in lifting the efficiency and resilience of wholesale markets in Australia.4 To that end, we are about to invite responses to a consultation paper on a new research project, Project Acacia. With industry partners, we look forward to exploring how innovations in digital money and infrastructure could increase the efficiency and resilience of wholesale markets where money and assets are tokenised. Broader financial stability risks 2/3 BIS - Central bankers' speeches Before I turn the floor open to questions, it would be remiss not to briefly mention that our focus on financial stability extends beyond the areas of payments and market infrastructure. As I discussed last year, and as set out by recent editions of the Financial Stability Review, we see risks to financial stability as taking two broad forms.5 Traditional cyclical risks generated from within the financial system These include the effects of higher interest rates or an economic downturn on the resilience of households, firms and banks. These types of risks have long featured in our surveillance work and will continue to do so. Non-cyclical risks generated from outside the financial system These have become more prominent in recent times and there is generally little historical precedent to guide us in navigating them. Foremost here are geopolitical risks, operational risks (including but not limited to cyber risks) and the risks associated with climate change. Our assessment is that this second category of risks continue to build in troubling ways. They not only have the potential to be systemic, but could also cut across the financial system, economy and society in complex ways. For these reasons, the RBA and other member agencies comprising the Council of Financial Regulators are stepping up the intensity of work in these areas. At the same time, the worsening threat landscape – which is more structural than cyclical in nature – requires industry to actively prepare for a much more challenging operating environment in the years ahead. Thank you. 1 RBA (2024), 'Payments System Board 2024 Annual Report'. 2 RBA (2024), 'Merchant Card Payment Costs and Surcharging', Issues Paper, 15 October. 3 RBA and Australian Treasury (2024), 'Central Bank Digital Currency and the Future of Digital Money in Australia', September. 4 Jones B (2024), 'Financial Innovation and the Future of CBDC in Australia', Speech at the Intersekt Conference, Melbourne, 18 September. 5 See, for instance, RBA (2024), 'Financial Stability Review', September; Jones B (2023), 'Emerging Threats to Financial Stability – New Challenges for the Next Decade', Sydney, 31 October. 3/3 BIS - Central bankers' speeches | reserve bank of australia | 2,024 | 11 |
Text of the Sir Leslie Melville Lecture by Mr Christopher Kent, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, at the Australian National University, Canberra, 18 November 2024. | Speech The Financial System and Monetary Policy in Australia Christopher Kent* Assistant Governor (Financial Markets) Sir Leslie Melville Lecture Canberra – 18 November 2024 I thank Simon Grant and the Australian National University for the kind invitation to be here today. It is an honour to present the annual Sir Leslie Melville Lecture at my alma mater. Melville was the first economist at the Reserve Bank of Australia. He established the precursor for Economic Group, which is responsible for macroeconomic analysis, forecasting and policy advice. I spent much of my career there, including as the RBA’s chief economist. I also helped set up the Financial Stability Department, and for some years now, I have been overseeing Financial Markets Group. Today I will cover some key issues that have garnered my attention in those roles. I will start with the observation that despite significant structural differences across economies, including some relatively unique features of the Australian financial system, there is no evidence that monetary policy is stronger in Australia than in other advanced economies. This finding may appear to be at odds with the comparatively large stock of variable rate mortgage debt carried by Australian households and thus their exposure to significant interest rate risk. But this apparent conflict can be reconciled when one considers the various ways that interest rate risk is managed in Australia, as well as the effects of the other important channels of the transmission of monetary policy. After stepping through the arguments in more detail, I will finish with some observations on forward guidance and some reasons why it has been used somewhat differently by the RBA than many other central banks. The aggregate transmission of monetary policy in various economies One way to judge the overall potency of monetary policy is to compare its effects across different economies on aggregates like GDP and inflation using macroeconomic models. Doing so for a range of models for several advanced economies suggests that the effect of monetary policy is neither faster nor more potent in Australia than elsewhere. Central estimates from RBA models of how much GDP and inflation decline in response to an unanticipated increase in policy rates sit near estimates generated by models used by central banks in the United States, euro area, United Kingdom, Canada and Sweden (Graph 1).1 While the central estimates of the effect on inflation are lower for some models of the United States compared with estimates from other economies, these modest differences should be considered within the context of the wide confidence intervals around each estimate (not shown). Graph 1 At the same time, however, key structural differences are likely to underpin some variation in the nature and strength of specific channels of transmission across economies. One key structural feature that sets Australia apart is the prominence of variable-rate debt. The prominence of variable-rate debt in the Australian financial system In Australia, most private sector debt is subject to variable interest rates. Even fixed-rate debt tends to be fixed for short periods compared with other economies. At the other extreme, most mortgage debt in the United States is fixed for 30-year terms and large corporations issue a lot of fixed-rate bonds. The share of Australian mortgages at fixed rates has averaged around 20 per cent over the past two decades. Most of this is fixed for two years or less (Graph 2).2 R E S E R V E B A N K O F AU S T R A L I A Graph 2 Similarly, a larger share of business debt in Australia is at variable rates than in the United States. In common with most advanced economies, Australian firms borrow mostly from banks, and around 90 per cent of these loans are at variable rates.3 While this is comparable to the share of variable rate business loans provided by large US banks,4 bank loans are only a small share of US corporate debt. Large US firms obtain much of their debt by issuing bonds, typically at fixed rates and with an average tenor of 11 years (Graph 3).5 In comparison, since 2022 large Australian businesses issued fixed rate bonds with a slightly shorter average tenor, of around nine years. Graph 3 Interest rate risk Households with sizeable variable rate debts face significant interest rate risk compared with other households.6 A rise in interest rates quickly reduces the disposable incomes of such households and their capacity to consume, invest and save. This creates budget pressures and can lead some households into financial distress and, in the extreme, leave them unable to service their debts. The same is true for businesses with sizeable variable rate debts, but in what follows I will focus my attention on household mortgages, which constitute a larger share of total debt than most other economies and set Australia’s financial system apart from many others. The prominence of mortgages at variable rates in Australia suggests that interest rate risk can manifest itself much more quickly than in most other advanced economies. Indeed, over recent years, some of the most rapid increases in average outstanding mortgage rates occurred in Australia and Norway, which also has a high share of variable rate mortgage debt.7 This is despite policy rates rising by less in these economies compared with many other advanced economies (Graph 4). R E S E R V E B A N K O F AU S T R A L I A Graph 4 Debt levels for households are also relatively high in Australia (as a proportion of incomes) (Graph 5). Combined with the significant rise in outstanding mortgage rates, this has led required mortgage payments – interest plus principal – to increase by 2.5 percentage points of total household disposable income since May 2022; the increase as a share of mortgage holders’ incomes is much larger still. These mortgage payments have reached record highs in Australia (Graph 6).8 Graph 5 Graph 6 Despite the substantial increase in mortgage payments, there has been little increase in acute financial distress among borrowers. Mortgage arrears rates have risen, but they remain low and at similar levels in Australia and the United States (Graph 7). This is despite the significant rise in required mortgage payments in Australia.9 The low levels of defaults in both economies partly reflects the large savings buffers many households built up during the pandemic as well as benign labour market conditions, since unemployment tends to be a strong predictor of mortgage arrears.10 R E S E R V E B A N K O F AU S T R A L I A Graph 7 Financial distress has also been contained, in part, by the way that interest rate exposure of Australian mortgage holders is managed by banks (overseen by the regulators) as well as by the borrowers themselves. In short, these contribute to borrowers having buffers that can lessen the burden of adjustment in the face of a rise in interest rates. Banks account for interest rate risk when setting their lending policies and the Australian Prudential Regulation Authority (APRA) ensures that banks maintain prudent lending standards. When a bank determines how much to lend a prospective borrower, they must assess the borrower’s ability to service their mortgage at an interest rate 300 basis points above the current rate while still meeting basic living expenses.11 This buffer recognises the risk associated with rates increasing as well as other risks – such as to income or unexpected spending needs.12 Borrowers play a key role in managing their own interest rate risk. This starts with their decision on how much to borrow. Historically, only a small share of new borrowers took out loans close to the value of the maximums on offer. In 2022, only around 15 per cent of new owner-occupiers borrowed more than 80 per cent of their maximum assessed capacity. This share is likely to have increased since then due to increases in interest rates and housing prices and declines in real incomes. For the same reasons, more borrowers are struggling to get a mortgage. Indeed, the median deposit has increased noticeably for all types of borrowers over recent years, particularly for first home buyers (Graph 8). And while the first home buyer share of new loans has been a bit above average of late, the so-called bank of mum and dad may have increasingly helped many first home buyers. Graph 8 Once Australians have a mortgage, they tend to reduce their interest rate risk by paying down their loans more quickly than required. They do this by accumulating funds in offset and redraw accounts. These accounts, which are readily available in Australia for variable-rate loans, provide a highly liquid form of saving and a favourable rate of return since the interest saved on balances in these accounts is tax free. Currently, these extra payments are a bit above 20 per cent of the total value of outstanding housing credit.13 Existing borrowers can respond to rising interest rates and the associated increases in required mortgage payments in several ways: • Some borrowers may tap into existing savings. Indeed, the share of borrowers making persistent withdrawals from their offset and redraw accounts increased noticeably as interest rates rose (Graph 9).14 Despite this, borrowers overall have continued to add to these accounts at a similar rate to before the pandemic. As a result, the distribution of these savings buffers (expressed as a share of borrowers’ minimum scheduled payments) has not changed much since 2020, despite borrowers’ minimum scheduled payments having increased by 45 per cent (Graph 10). R E S E R V E B A N K O F AU S T R A L I A Graph 9 Graph 10 • Some households may also reduce their savings rates for a time. Consistent with this, the aggregate savings rate for households declined as interest rates increased and broader cost of living pressures ate into households’ real incomes; although, some of this decline reflected a normalisation of savings rates as the effects of the pandemic wore off (Graph 11). Graph 11 • At the same time, however, higher interest rates provide an incentive to save more, so some borrowers may reduce the extent of their discretionary consumption and even increase their rate of saving. Other borrowers may have limited options other than to reduce consumption as required mortgage payments increase. While aggregate household consumption, particularly of discretionary items, has been weak for some time now, there is no timely and comprehensive data available on consumption by different household types. Nevertheless, spending data from some of the large banks provide a rough guide. It shows that the growth of spending (in nominal terms) has declined for all types of borrowers since mid-2022, but it has been weaker still for borrowers and renters compared with those that own their homes outright. • Borrowers may also be able to take on extra work to manage higher mortgage payments. Indeed, borrowers with the highest ratio of mortgage payments to income in 2021 found more work over the past three years than other groups, thereby contributing to the strong rise in labour force participation over recent years.15 Lenders can help borrowers manage temporary periods of financial stress, deferring payments for a time – including by charging interest only – or lengthening the term of a loan. Many lenders have had to improve their hardship arrangements after a review by the Australian Securities and Investments Commission.16 This included identifying stress and setting up hardship arrangements before borrowers fall behind on their mortgages. Borrowers who are experiencing persistent difficulties servicing their mortgages, and with no further options to adjust their finances, may decide to sell their homes. Our liaison with lenders suggests that while more households are making this very difficult decision, it is less costly financially than otherwise given the low share of mortgages currently in negative equity (less than 1 per cent).17 I have focused mainly on households in this discussion because their exposures are quite different in Australia than in many other economies. But businesses also face interest rate risk. Recent increases in interest rates have largely passed through to small business loans.18 Pass-through has been less for listed companies, owing to their use of longer term fixed-rate debt and interest rate hedges. For many Australian businesses, the effect of higher interest rates has been mitigated by strong financial positions as monetary policy was being tightened, including cash buffers that were noticeably above pre-pandemic levels.19 And while company insolvencies have increased over the tightening phase, this largely reflects factors beyond the direct effects of higher interest rates.20 R E S E R V E B A N K O F AU S T R A L I A It is worth emphasising that the Reserve Bank Board is attuned to interest rate risk and the burden of adjustment being experienced by households and businesses with sizeable debts. Australians more broadly have had to constrain their spending during the period of elevated inflation, including those people who rent and those without debts. While the Board is well aware of variation in the circumstances facing different households and businesses, it has only one instrument – the cash rate target – to achieve its inflation and employment objectives. The effect of interest rates on the cash flows and behaviour of indebted households receives extensive attention in Australia. But this is only one side of the cash-flow channel, and that, in turn, is only one of the channels of monetary policy transmission. The cash-flow channel of monetary policy The other side of the cash-flow channel is the effect of interest rates on the incomes of households (and businesses) with net asset positions. When interest rates rise, they receive more interest income on deposits and other interest-bearing assets. As interest rates rose from 2022, deposit rates in Australia responded noticeably, with about 80 per cent of the increase in the cash rate being quickly passed through to deposits. Pass-through was greater here than in many other advanced economies.21 Because Australian households hold more debt than interest-sensitive assets, the net effect of higher interest rates has been to reduce household cash flows. Household net interest income has declined by 1.2 per cent of household disposable income since early 2022 (Graph 12). While this overall cash-flow effect appears modest, it is important to recognise that borrowers’ marginal propensity to consume is generally much larger than it is for savers.22 Hence, even this modest change in household sector cash flows can have a noticeable impact on household consumption. Graph 12 Net Interest Income for Households* Per cent of household disposable income** % % Interest receivable -3 -3 -6 -6 Net interest income Interest payable -9 -9 -12 -12 * ** Nominal, quarterly. Excluding unincorporated enterprises. Disposable income is after tax and before deduction for interest payments. Source: ABS. Other channels of monetary policy transmission While the cash-flow channel may be stronger in Australia than in many other economies, estimates from the RBA’s MARTIN model suggest that the cash-flow channel of monetary policy is not the strongest part of the transmission mechanism in Australia.23 The other channels of transmission include the savings/investment, credit, asset price, and exchange rate channels.24 Again, differences in economic structures, including household and corporate balance sheets, are likely to affect the relative strength of these transmission channels across economies. The savings/investment channel (or intertemporal channel) operates through the opportunity cost of borrowing (or forgoing saving) to finance new investments or fund consumption. Because savings and investment behaviour should be guided by what the average (real) interest rate is likely to be over the life of the relevant asset or liability, the opportunity cost should not vary according to whether the interest rate on loans is fixed or variable. But fixed-rate lending may, in some cases, amplify or dampen the effect of monetary policy on some spending and investment decisions. For example, most existing US mortgage holders (with long-term fixed rates) were protected from the effect of rising interest rates from 2022 (Graph 13). But at the same time, it became unattractive for existing borrowers to move house because that would require them to refinance their loan at a much higher rate.25 This adverse effect on housing turnover and the associated economic activity implies lower investment and consumption than otherwise in the United States. Such a consideration is not relevant to Australian borrowers on variable rate mortgages, though it is important to note that new housing investment is quite sensitive to changes in interest rates in Australia.26 Graph 13 Differences in industrial structures may also matter for the strength of the savings and investment channel. Changes to interest rates can have strong effects on the demand for durable consumption and capital goods (such as cars, furniture, electronics, or plant and equipment used by businesses). This is because households and businesses have considerable discretion about the timing of those purchases.27 In Australia, production of durable goods is lower than in many other advanced economies (Graph 14). Hence, more of any given change in the demand for durable goods in Australia associated with a change in interest rates is reflected in a change in imports, with less of an effect on the demand for factors of production, like labour. Instead, a larger share of Australian production is accounted for by commodities, the demand for which is less sensitive to interest rates. R E S E R V E B A N K O F AU S T R A L I A Graph 14 There are aspects of other channels of monetary policy transmission that are likely to vary across economies. For example, the structure of household and business balance sheets can influence how responsive consumption and investment decisions are to asset prices or the willingness of banks to lend (both of which will change in response to interest rates).28 • Australians have a lot of their savings tied up in compulsory superannuation. Hence, they have a higher share of their financial assets in pension funds than many other advanced economies, and more than twice the US share (Graph 15).29 Consequently, Australians have a lower share of their financial wealth in directly held securities. We would expect the transmission of monetary policy via asset prices to be much stronger for directly held securities, which households can sell (or borrow against) to fund spending, than assets ‘locked up’ until retirement. • The median listed company in Australia has a higher share of assets held in cash and lower leverage than the median firm in many other advanced economies (Graph 16). All else equal, this will reduce the vulnerability of Australian companies to a rise in interest rates. With access to internal funds, they are less likely to cut back on investment if lenders are less willing to extend credit in response to higher rates (weakening the credit channel).30 Time does not allow for a detailed treatment of the exchange rate channel. The strength of this channel depends, among other things, on the nature of the goods and services traded and the level of foreign currency liabilities exposed to exchange rate movements.31 It is an important channel for Australia as implied by estimates from the RBA’s MARTIN model, and it is also an important channel for other small open economies. Graph 15 Graph 16 Forward guidance and the reaction function The first stage of the transmission of monetary policy describes how a change in the overnight policy rate (i.e. the cash rate in Australia) passes through to other interest rates further out along the yield curve. These rates will depend, among other things, on the expectation of future short rates. The yield curve, in turn, influences a R E S E R V E B A N K O F AU S T R A L I A broader range of financial conditions, including yields on corporate debt, other asset prices and the exchange rate. The spending and investment decisions of businesses and households – which influence aggregate demand and inflation – will depend not just on the near-term rates they face, but also on the path of future rates they expect. Hence, the effect of any given change in the overnight rate will depend on the implication of that change for the path of the overnight rate out into the future. This can be influenced by central banks in two ways. First, by providing information about the central bank’s reaction function – how it is likely to respond to changing economic circumstances to best achieve its inflation and employment goals. Second, by providing guidance on what policymakers at the central bank see as the likely path of future interest rates. Information on a central bank’s reaction function, and its forward guidance on the likely path of rates (that policymakers think will best deliver on the central bank’s inflation and employment goals) can also help to anchor inflation expectations. Central banks provide the public and markets with extensive information on the economic outlook and what guides their monetary policy decisions, and some information on the likely path of interest rates. But exactly how they do this varies across central banks. I will step through some of those differences, with a focus on approaches the RBA has used. To preface these remarks, I would note two things. First, the results I presented at the outset – on the similarity in the effect of changes in policy rates on aggregate demand and inflation – implicitly suggest that despite different approaches, including on forward guidance, monetary policy effectiveness has been broadly comparable across advanced central banks. Second, there are two types of forward guidance on interest rates. Under the stronger form, a central bank commits to keep interest rates at or close to the effective lower bound during extremely adverse circumstances. The RBA’s review of its pandemic experience noted the difficulties of overlaying its initial ‘state-based’ commitment with an inflexible and lengthy time-based element and pairing it with the three-year government bond yield target.32 But that pandemic episode has been discussed at length and I will not go over that form of guidance here again. Instead, in what follows I will consider only forward guidance that provides some sort of information about the likely path for the policy rate.33 It is worth clarifying that forward guidance can also shed some light on the central bank’s reaction function. This was the case, for example, following the August 2024 decision of the Reserve Bank Board. The Governor’s media conference and the minutes noted that, in contrast to the market path for the cash rate that had shifted noticeably lower over the days leading into the meeting, the Board thought ‘it was unlikely that the cash rate target would be reduced in the short term’ based on the information to hand.34 This reflected concerns that inflation may not return to the target in a reasonable time, which has remained the Board’s highest priority. As I will note below, there may be other ways to convey the reaction function more directly. Outside of the pandemic episode, the RBA’s guidance has tended to be provided less frequently, in less explicit and more qualitative ways, and covering shorter terms than several other central banks. For example, policymakers from the central banks of the United States, New Zealand, Sweden and Norway have for some time been providing their views on the appropriate path of policy rates going out three years (conditional on the information to hand about the likely outlook for key economic variables). I have heard several arguments for the approach that the Reserve Bank Board has taken over the years:35 1. One is that more specific guidance may be taken by some people to be a commitment on a particular path of rates. If a different path were taken, even in response to unexpected circumstances, it might damage credibility. This may be more likely in Australia given the intense focus on monetary policy that stems from the prominence of variable-rate mortgages.36 And while the RBA’s experience with strong time-based forward guidance during the pandemic provided evidence in support of this argument, other central banks have not found this to be a concern when pursuing more standard forward guidance; the Norges Bank is particularly relevant here given that most mortgages in Norway are also at variable rates.37 2. Market participants are likely to be more forgiving (than households and businesses) when a central bank’s guidance does not come to pass. More importantly for them is understanding the central bank’s reaction function. Indeed, the former Deputy Governor Guy Debelle argued that if the reaction function ‘is sufficiently clear, then forward guidance does not obviously have any large additional benefit and runs the risk of just adding noise or sowing confusion’.38 In other words, efforts to clarify the reaction function can be a substitute for providing forward guidance. This could be achieved by consistently explaining the logic of the Board’s decisions, and what they are looking for to guide future decisions. More generally, laying out expectations for the economy and explaining decisions is important for transparency and accountability that are the cornerstones of credibility. Another approach gaining attention is to use scenarios to convey how monetary policy might respond in different circumstances. While scenarios can help to convey the reaction function, they need to be based on the policymakers’ preferences. Results based solely on models are not sufficient since these are estimated with imprecision and reflect the typical behaviour of policymakers in the past, whereas a board’s preferences (and even mandates) can evolve over time, including as the composition of the board changes. 3. This brings me to an argument about the nature of the Reserve Bank Board. Because six of the nine members are part-time, it may be more difficult for them to provide the sort of guidance provided by full-time policymakers, who typically benefit from macroeconomic training and/or extensive support of staff.39 4. Another argument I have heard against near-term guidance is that if there is a good degree of agreement among the Board members of the need for an imminent policy change, then rather than provide guidance to that effect, why not just change rates now?40 5. A question that may be worth further investigation is whether differences in the channels of monetary policy transmission have implications for forward guidance? In particular, because a large share of funding in the Australian economy is priced off the very short end of the yield curve, it may be that forward guidance beyond the near term may have a more limited role to play than in other economies, particularly the United States, where a lot of funding is priced off the longer end of the yield curve.41 To be clear, this is not an argument against forward guidance in Australia, just that it might be less useful than in an economy like the United States. Differences in two transmission channels of monetary policy support this argument. First, the cash-flow channel of monetary policy in Australia – which drives off the short end of the yield curve – is stronger than it is in the United States (even if it is not a dominant channel for Australia). Second, the credit channel in Australia depends on the very short end of the yield curve – since the assessment of borrowers’ ability to service a loan is based on current interest rates. By contrast, serviceability depends on longer term rates for a much larger share of lending in the United States. However, other channels of transmission depend on longer-run expectations of rates in Australia, implying a potential role for forward guidance. In particular, the savings/investment channel depends on longer-run expectations and should be invariant to the structure of finance in an economy. Similarly, the Australian dollar exchange rate is responsive to interest rates out along the curve, as is the case for exchange rates of other advanced economies.42 Conclusion A key characteristic of the Australian financial system is the prominence of variable-rate mortgage debt. While not unique, it sets Australia apart from financial systems in many other economies. R E S E R V E B A N K O F AU S T R A L I A One consequence of this is that Australian borrowers are exposed to considerable interest rate risk. Indeed, mortgage arrears rates in Australia are trending up following the large rise in required mortgage payments. Even so, arrears rates here remain low and are at similar levels to those in economies with much more fixed-rate lending. This outcome reflects several features of the Australian mortgage market that collectively leave most borrowers with buffers that help them to manage through a period of higher interest rates. That has been the case through the recent episode, although many borrowers have struggled in the face of rising interest rates over the past two years or so, and household spending more broadly has weakened noticeably. This influence of monetary policy on the cash flows and behaviour of variable rate borrowers receives a lot of attention in Australia. However, this is only one of the channels of monetary policy and there is no evidence that monetary policy overall is more potent in Australia than in other advanced economies. Further study on the efficacy of these different channels, particularly cross-country comparisons, is an interesting area for further research. Outside the pandemic episode, the RBA has tended to provide forward guidance that is more infrequent, short-term and qualitative than many other central banks. I have outlined some of the arguments for this, but I think it would be worth reviewing the RBA’s approach to forward guidance from time to time, including to consider other ways that the RBA might clarify the nature of its reaction function. Any such reviews should carefully account for features of Australia’s financial system that set it apart from other economies. Finally, it also bears repeating that all advanced economy central banks provide extensive information about the economic outlook and their reaction functions that guide the public and markets to form views about the future path of monetary policy. Central banks may be more or less explicit about that guidance, but as is the case with the aggregate transmission of monetary policy, while the internal mechanisms might differ, the overall effect can be quite similar. Endnotes * I thank Matt Gibson, Peter Wallis, Dominique D’Netto, David Meredith, Hebe Williams and Sharon Lai for help in preparing this speech, and numerous RBA staff for helpful comments and suggestions. The views are my own and not necessarily those of the RBA. These results are based on semi-structural and DSGE models. Different modelling approaches (e.g. vector autoregression models) tend to yield a wider range of estimates regarding the macroeconomic effects of monetary policy. Even so, these approaches do not suggest that Australia is an outlier in relation to other economies. Note that the estimates presented here almost all come from a one-quarter, unanticipated monetary policy shock that is then unwound. This approach is standard practice in the literature and allows for a relatively consistent comparison of outputs across models. However, the artificial nature of the shocks used means we should not read these estimates as reflecting the real-world strength of monetary policy in an absolute sense. For example, a larger effect would be apparent if a change to the policy rate was held in place for longer than a quarter. During the pandemic, the share of debt fixed for periods longer than one year increased noticeably in response to a decline in fixed rates relative to variable rates following the package of policy measures of the RBA in response to the pandemic. Even so, this share remained lower than in most other countries. It has since declined to historical lows. Presently, 97 per cent of housing credit is either variable rate or fixed for a term of one year or less. See RBA (2022), ‘Review of the Term Funding Facility’. For larger businesses, some of this variable-rate borrowing may be hedged. See RBA (2024), ‘Chapter 2: Resilience of Australian Households and Businesses’, Financial Stability Review, September. See Castro M and S Jordan Wood (2022), ‘How Changing Interest Rates Affect Variable-Rate Loans to U.S. Firms’, On the Economy Blog, 16 August. For the year to date in Australia only around 6 per cent of the value of bonds issued by non-financial corporates had floating rate coupons, while this was even lower in the United States at 2 per cent. For a cross-country overview of household and business exposures to interest rate risk, see Committee on the Global Financial System (2024), ‘Interest rate risk exposures of non-financial corporates and households: Implications for monetary policy transmission and financial stability’, CGFS Papers No 70, November. Average outstanding mortgage rates also rose at a similar rate in New Zealand, where most mortgages have residual terms of less than a year, and the policy rate was increased as much as it was in the United States. Total scheduled debt payments by households (including estimated payments on consumer credit) have also increased but remain below historical peaks because the stock of consumer credit has declined significantly since 2008. See Graph 1.16 in RBA (2024), ‘Chapter 1: Financial Conditions’, Statement on Monetary Policy, November. This recent episode in the United States stands in contrast though to the prelude to the global financial crisis when many sub-prime borrowers faced sizeable jumps in the interest rates on their debt. See ‘Chapter 1: Origins of the Crisis’ in Federal Deposit Insurance Corporation (2017), Crisis and Response: An FDIC History, 2008–2013. See Bergmann M (2020), ‘The Determinants of Mortgage Defaults in Australia – Evidence for the Double-trigger Hypothesis’, RBA Research Discussion Paper No 2020-03. In 2019, APRA notified banks they were expected to use a serviceability buffer of at least 250 basis points. This was increased to 300 basis points in 2021. Under APRA’s prudential framework, banks can use exceptions to policy if these are managed prudently and limited. This approach allows banks to consider additional indicators of repayment capacity beyond those captured in the standard serviceability test. See APRA (2023), ‘Housing Lending Standards: Reinforcing Guidance on Exceptions’, June. See APRA (2023), ‘Update on Macroprudential Settings’, December. See Hughes A (2024), ‘How the RBA Uses the Securitisation Dataset to Assess Financial Stability Risks from Mortgage Lending’, RBA Bulletin, July. High-income borrowers are the only group that, in aggregate, have been drawing down on their offset and redraw balances, although within lower income borrower groups there are likely to be households under more stress that have drawn down on what balances they had to help make ends meet. See RBA (2024), ‘Chapter 2: Resilience of Australian Households and Businesses’, Financial Stability Review, September. Das M, J Hambur, K Hellwig and J Spray (forthcoming), ‘Labor Supply Effects of Monetary Policy: Evidence from Australian Mortgage Holders’, RBA Research Discussion Paper. See ASIC (2024), ‘Hardship, Hard to Get Help: Findings and Actions to Support Customers in Financial Hardship’, May; RBA, n 14. See RBA, n 14. See Bullo G, A Chinnery, S Roche, E Smith and P Wallis (2024), ‘Small Business Economic and Financial Conditions’, RBA Bulletin, October. See RBA, n 14. These factors include the removal of significant support measures put in place during the pandemic, weaker demand, and the Australian Tax Office resuming enforcement actions on unpaid taxes. Most businesses entering insolvency are small businesses with little debt. Despite the rise, insolvencies as a share of businesses remain below pre-pandemic trends. See RBA, n 14. See Kent C (2023), ‘Channels of Transmission’, Address to Bloomberg, Sydney, 11 October. Savers that are liquidity constrained, such as pensioners, have been found to have a relatively high marginal propensity to consume (MPC), but they make up a relatively small proportion of households, see La Cava G, H Hughson and G Kaplan (2016), ’The Household Cash Flow Channel of Monetary Policy’, RBA Research Discussion Paper No 2016-12. For a discussion of differences in the MPC by income, see Berger-Thomson L, E Chung and R McKibbin (2010), ‘Estimating Marginal Propensities to Consume in Australia Using Micro Data’, Economic Record, 15 August. For differences by wealth, see La Cava G, H Hughson and G Kaplan (2016), ‘Housing Wealth Effects: Cross-sectional Evidence from New Vehicle Registrations’, RBA Discussion Paper No 2016-02. See Ballantyne A, T Cusbert, R Evans, R Guttmann, J Hambur, A Hamilton, E Kendall, R McCirick, G Nodari and D Rees (2019), ‘MARTIN Has Its Place: A Macroeconometric Model of the Australian Economy’, RBA Research Discussion Paper No 2019-07; Gross I and A Leigh (2022), ‘Assessing Australian Monetary Policy in the Twenty-First Century’, Economic Record, 13 June. See Kent, n 21. This effect typically operates in reverse as interest rates fall, since most US mortgages allow borrowers to refinance at lower rates with minimal penalties. The current easing of monetary policy by the Fed may be an exception, since long-term rates will need to fall more than in recent cycles for refinancing to become attractive to borrowers who locked in rates in 2020–2021. For a discussion of this effect, see Aidala F, A Haughwout, B Hyman, J Somerville and W van der Klaauw (2024), ‘Mortgage Rate Lock-In and Homeowners’ Moving Plans’, Federal Reserve Bank of New York Liberty Street Economics, 6 May. Going the other way, there is an argument that US monetary policy does have a timely effect on disposable incomes via new loans and refinancing; for evidence of this, see Ringo D (2024), ‘Inframarginal Borrowers and the Mortgage Payment Channel of Monetary Policy’, Board of Governors of the Federal Reserve System Finance and Economics Discussion Series 2024-069. For further discussion, see Black S and T Cusbert (2010) ‘Durable Goods and the Business Cycle’, RBA Bulletin, September; Lawson J and D Rees (2008) ‘A Sectoral Model of the Australian Economy’, RBA Research Discussion Paper No 2008-01. A rise in interest rates contributes to lower asset prices by increasing the discount factor used to value expected future cash flows generated by assets (such as dividends, coupon payments and rental income, for shares, bonds and housing). A rise in interest rates may also reduce the supply of loans to households and the availability of external funding to businesses. Lenders could face greater credit risks from borrowers facing higher debt servicing costs and who may be less able to provide collateral for loans due to lower asset prices. R E S E R V E B A N K O F AU S T R A L I A Bishop J and N Cassidy (2012), ‘Trends in National Saving and Investment’, RBA Bulletin, March, pp 9–18; Connolly E and M Kohler (2004), ‘The Impact of Superannuation on Household Saving’, RBA Research Discussion Paper No 2004–01. Some tentative empirical support for this relationship in Australia is discussed in Nolan G, J Hambur and P Vermeulen (2023), ‘Does Monetary Policy Affect Non-mining Business Investment in Australia? Evidence from BLADE’, RBA Research Discussion Paper No 2023-09. The exchange rate channel is typically associated with the trade channel, in which an exchange rate depreciation increases foreign demand for exports and reduces domestic demand for imports, stimulating the economy. However, an offsetting financial or risk-taking channel can exist if an economy has more foreign currency debt than assets, meaning that an exchange rate depreciation worsens its net foreign liability position (unless this exposure is hedged). This can tighten domestic financial conditions. See Kearns J and N Patel (2016), ‘Does the Financial Channel of Exchange Rates Offset the Trade Channel?’, BIS Quarterly Review, December; Smith P (2023), ‘The Extraordinary Decline in Australia’s Net Foreign Liabilities’, Speech to CFA Societies 2023 Australian Investment Conference, Sydney, 18 October. See RBA (2022), ‘Review of the RBA’s Approach to Forward Guidance’ and ‘Review of the Yield Target’. For further discussion, see RBA (2022), ‘Review of the RBA’s Approach to Forward Guidance’, and references therein. See RBA (2024), ‘Minutes of the Monetary Policy Meeting of the Reserve Bank Board’, Sydney, 5–6 September. It is also worth noting that the cash rate path on 6 August, the day of the Board meeting, had declined noticeably following US data since the market path as of 31 July that was used to condition the forecasts presented in the August 2024 Statement on Monetary Policy. See RBA (2022), ‘Review of the RBA’s Approach to Forward Guidance’; Bowman MW (2022), ‘Forward Guidance as a Monetary Policy Tool: Considerations for the Current Economic Environment’, Speech at the Money Marketeers of New York University, New York, 12 October. Senior RBA leaders have previously discussed the potential limits of being too prescriptive in communication. For example, Debelle noted that ‘if the central bank’s communications suggest it has greater knowledge or greater precision in its inflation control than it does in reality, then when this becomes apparent and the public’s expectations are disappointed, the central bank’s credibility may be damaged’: see Debelle G (2009), ‘The Australian Experience with Inflation Targeting’, Speech at Banco Central do Brasil XI Annual Seminar on Inflation Targeting, Rio de Janeiro, 15 May. Lowe noted that following a communication approach that is too prescriptive could ‘cost the central bank the support and confidence of the broader community’: see Lowe P (2019), ‘Remarks at Jackson Hole Symposium’, Wyoming, 25 August. For example, in a reflection of its experiences publishing its own policy rate forecasts (formerly named repo rate), Sveriges Riksbank noted that many previous concerns had not materialised: see Sveriges Riksbank (2017), ‘The Riksbank’s Experiences of Publishing Repo Rate Forecasts’, Riksbank Studies, June. These concerns included that the forecast would be interpreted as a binding promise or that all members of the Executive Board would fail to agree on a repo rate forecast. See Debelle G (2018), ‘Risk and Return in a Low Rate Environment’, Speech at Financial Risk Day, Sydney, 16 March. Related to this point, while forward guidance will aid households and businesses in making their longer term investment and spending decisions, those could also be informed by the yield curve, or other market rates at longer terms. The question really should be whether the central bank has a strong conviction that the market path of rates is unlikely to be the right one. For a brief discussion of the difficulties of even full-time central bankers on the Federal Open Market Committee agreeing on a reaction function, see Stein JC (2014), ‘Challenges for Monetary Policy Communication’, Speech at the Money Marketeers of New York University, New York, 6 May. Edey and Stone note that a disclosure practice that makes sense for a technically focused monetary policy committee might not be well suited to alternative board structures: see Edey M and A Stone (2004), ‘A Perspective on Monetary Policy Transparency and Communication’, Paper presented at the RBA Annual Conference. Stevens makes a similar point: ‘The nature of the Reserve Bank Board – a majority of whom are part-time members, drawn from various parts of the Australian community, but seeking to make decisions in the national interest as opposed to any industry, geographical or sectional interest – needs to be considered when thinking about disclosure practices’: see Stevens G (2007), ‘Central Bank Communication’, Address to The Sydney Institute, 11 December. In a similar vein, some central banks provide guidance about the upcoming decision in a way that reduces the extent of market surprises at the time of the decision. However, providing such guidance in the lead up to a meeting merely brings forward the date of the surprise to that point. For a discussion of this point in the context of communications by the European Central Bank, see Istrefi K, F Odendahl and G Sestieri (2024), ‘ECB Communication and Its Impact on Financial Markets’, Banco de Espana Document de Trabajo No 2431. Some Fed officials have argued that Treasury (real) yields as far out as 10 years provide a better measure of the stance of monetary policy than the current policy rate, due to their tighter relationship with broader financial conditions and economic activity. See Kashkari N (2024), ‘Why I Supported Cutting Rates Last Week’, Federal Reserve Bank of Minneapolis, 23 September; Kashkari N (2022), ‘Policy has Tightened a Lot. Is It Enough?’, Federal Reserve Bank of Minneapolis, 6 May. See Atkin T, I Hartstein and J Jääskelä (2021), ‘Determinants of the Australian Dollar Over Recent Years’, RBA Bulletin, March. | reserve bank of australia | 2,024 | 11 |
Address by Ms Michele Bullock, Governor of the Reserve Bank of Australia, at the Committee for Economic Development of Australia (CEDA) Annual Dinner, Sydney, 28 November 2024. | Speech Economic Conditions and the RBA’s Transformation Michele Bullock* Governor Address at the Committee for Economic Development of Australia (CEDA) Annual Dinner Sydney – 28 November 2024 I would like to start by acknowledging the Gadigal people of the Eora Nation as the traditional owners and custodians of the land on which we are meeting this evening and pay my respects to Elders, past and present. Thank you to the Committee for Economic Development of Australia (CEDA) for the opportunity to be here tonight. We share an important mission: promoting economic stability and prosperity in Australia. And we also share objectives around economic research and analysis. Groups like CEDA play a crucial role in uniting various sectors of our economy and community to engage in meaningful discussions and debates about the economic challenges facing Australian households and businesses. We live in an increasingly complex world, with cost-of-living pressures persisting, technological change accelerating, ongoing conflicts in several zones around the world, and an ever-changing geopolitical landscape. In the face of these numerous global and domestic uncertainties, both our organisations are confronted with significant challenges. Fundamentally, however, the RBA’s role and focus has not changed, and we are ready to meet these challenges head-on. Tonight, I will present the RBA’s analysis of economic conditions both domestically and internationally. I am often asked, ‘why aren’t we cutting rates yet in Australia?’ and so, I will reflect on our monetary policy strategy and how it compares with some of our global peers. I will also provide an update on changes to our monetary policy processes. While monetary policy is central to the RBA’s mandate, our responsibilities encompass a broader range of activities that support the overall functioning of the Australian economy. I will therefore conclude by highlighting some of the initiatives we are undertaking and the transformation underway at the RBA to ensure we are well placed to meet the challenges of today and tomorrow. Domestic economic conditions First, to economic conditions here in Australia. Headline inflation eased to 2.8 per cent over the year to the September quarter of 2024, down from 5.4 per cent over the year to the September quarter of 2023 (Graph 1). This is welcome relief for people feeling the pinch from the rise in the cost of living over the past two years – which is everyone, but particularly the more vulnerable people in our community. But despite the decline there is still some way to go to return inflation sustainably within our 2–3 per cent target range. The word ‘sustainably’ is important because it recognises that we need to look through temporary factors that influence the headline inflation rate from time to time. Indeed, over the past year, part of the decline in headline inflation has been due to temporary factors such as electricity rebates and declining fuel prices. While these temporary factors have undoubtedly helped many Australians, our approach is to look through them to some extent to better understand where inflation will settle in the medium term. Graph 1 Measures of Inflation* % % Headline (year-ended) Trimmed mean** (year-ended) Trimmed mean** (quarterly) -2 -2 * Adjusted for the tax changes of 1999–2000. ** Excludes deposit & loan facilities prior to the September quarter of 2011. Sources: ABS; RBA. The best way to do this is to look at underlying inflation. The measure we typically look at for this is trimmed mean inflation and by this measure, inflation was still too high at 3½ per cent over the year to the September quarter. While this is a welcome decline from 5.1 per cent a year earlier, it is consistent with a situation in which the overall level of demand for goods and services in the Australian economy has been outstripping its supply capacity for some time. We have maintained the cash rate at its current level of 4.35 per cent for a little over a year now. This is 4.25 percentage points above its emergency low level of 0.1 per cent at the height of the pandemic. At this current level, we are of the view that monetary policy is restrictive. The effect of this is most evident in the household sector, with very weak growth in consumption, a decline in per capita consumption and very low dwelling investment. Monetary policy settings will nevertheless need to remain restrictive until the Reserve Bank Board is confident that inflation is on track to return sustainably within the target range and approach its midpoint of 2.5 per cent. Our forecasts published in the November Statement on Monetary Policy suggest that a sustainable return to target will occur in 2026. Elevated inflation indicates that the level of demand in the economy is above the ability of the economy to supply the goods and services demanded. But the evidence suggests that this gap is narrowing (Graph 2). One reason for this is that the rate of growth in demand has been quite subdued. The subdued rate of GDP growth, in turn, reflects the notable weakness in household consumption mentioned earlier. Looking ahead, we anticipate a slight uptick in both GDP growth and household consumption, over the coming year but there are risks in both directions. R E S E R V E B A N K O F AU S T R A L I A Graph 2 GDP Growth % % Year-ended Quarterly -4 -8 -4 -8 Source: ABS. One important influence on the outlook for household spending is conditions in the labour market. At present, we judge that conditions in the labour market remain tighter than what would be consistent with low and stable inflation. This assessment is informed by a wide range of indicators (Graph 3). As a summary, the unemployment rate is currently hovering around 4.1 per cent, which is notably low by historical standards and compared with many other countries. In addition, the increase in the unemployment rate over the last two years has been significantly smaller than some other countries. While some labour market indicators have shown signs of easing, the demand for workers remains robust, particularly in sectors like health care and education. Graph 3 Labour Underutilisation Heads-based, per cent of labour force % % Underutilisation rate Underemployment rate Unemployment rate Source: ABS. Overall, the earlier period of high inflation has imposed large costs on families and businesses across Australia, and especially the most vulnerable. If we fail to bring inflation down in a sustainable way, cost-of-living pressures will only compound and monetary policy would need to remain restrictive for longer. This is why returning inflation sustainably to the target within a reasonable timeframe remains the Board’s highest priority. Our monetary policy strategy Recently, I have been asked why other central banks are lowering interest rates and the RBA is not. To explain this, I need to describe what the Board is trying to achieve and ways in which we seem to be a little different from some other peer economies. The Board sets monetary policy to achieve domestic policy objectives – that is, for inflation to be about 2.5 per cent and the labour market at sustainable full employment. As it currently stands, underlying inflation is still too high to be considering lowering the cash rate target in the near term. The Board’s strategy over recent years has been to set monetary policy in a way that returns inflation sustainably to target in a reasonable timeframe, alongside a gradual easing in labour market conditions to levels consistent with sustainable full employment. The goal underpinning this strategy has been to preserve as many of the jobs that have been created over recent years as we can. This is what we have previously referred to as the ‘narrow path’. When setting policy, the Board aims to ensure that financial conditions are restrictive enough until it is confident that inflation is moving sustainably back to target. This overarching approach is similar to that used at other central banks in advanced economies, where we all have flexible inflation targeting frameworks.1 All central banks care about inflation and the potential impact of their policies on the economy and the labour market. But there have been some important differences reflecting the different weights that central banks place on the two objectives. In Australia, interest rates did not reach the same levels of restrictiveness as many other countries (see the blue bars in Graph 4), and consistent with this, inflation has been somewhat higher relative to target here than in most of those economies, and the labour market is also tighter. This means that even with a similar approach to setting policy, the time to adjust domestic monetary policy settings can differ from peer central banks. R E S E R V E B A N K O F AU S T R A L I A Graph 4 Estimates of Policy Restrictiveness Policy rate minus estimate of nominal neutral rate* ppts ppts At peak policy rate Current At end-2025** -1 -1 Sw ed lia Au st ra ad an ro C m Eu ng Ki U ni te d d St a do te s nd la U ni te Ze a N ew N or w en a ar ea ay * Estimate of nominal neutral rate from each central bank. ** Using market participants’ policy rate expectations. Sources: Bloomberg; central banks; RBA. Indeed, Australia’s labour market conditions appear unusually tight, relative to those in other peer economies. Conditions in labour markets in those economies have eased significantly and unemployment has increased, such that labour markets are now assessed to be close to balance or have spare capacity. Given the tightness in Australia’s labour market, along with our assessment that the level of demand still exceeds supply in the broader economy, we expect it will take a little longer for inflation to settle at target in Australia. Peer central banks have eased policy settings as they have become more confident that inflation is moving sustainably back towards their respective targets, but so far most have also stated that they are removing only some restrictiveness. That is, central banks globally are still pushing against high inflation despite pulling back on the extent of restrictiveness somewhat. With their inflation rates now close to target and the easing they have seen in their labour market conditions, they are turning their attention to downside risks in their economies and labour markets. Looking ahead for Australia, RBA staff expect inflation to return sustainably to the 2.5 per cent midpoint of the target range by late 2026 as restrictive financial conditions gradually bring the economy and labour market into better balance. We still think we are on the narrow path. This staff forecast was conditioned on a forward path for the cash rate implied by market pricing at the time of the November Statement on Monetary Policy, which had the cash rate remaining at its current level over the near term. I should be explicit here that this is not the Board’s forecast for interest rates. It is a conditioning assumption but, along with other information available at the time, it is consistent with inflation returning sustainably to target within the Board’s preferred timeframe. That said, the central forecast for inflation has substantial bands of error around it so as more information comes to hand, we will be reconsidering those forecasts and hence the appropriate stance of policy (Graph 5). Graph 5 Trimmed Mean Inflation Forecast* Year-ended % % -1 * -1 Confidence intervals reflect RBA forecast errors since 1993, with the 70 per cent interval shown in dark blue and the 90 per cent interval shown in light blue. Sources: ABS; RBA. The monetary policy process The process that supports the Board’s monetary policy decisions is evolving. As many of you will recall, the Board previously met monthly for half a day on the first Tuesday of the month (except for January). This year, however, the Board has met seven times, with the eighth and final meeting for 2024 to be held in December. The length of the meetings has increased to a full day, spread over a Monday afternoon and the following Tuesday morning. This change may seem quite small, but it has had an important impact on the monetary policy decision-making process. Specifically, stepping down to eight longer meetings has allowed for more deliberation and debate among the Board members. More time between meetings has also meant that there is more new information for the Board to reflect on and consider. The change to Board meetings has also allowed the RBA staff to adapt our processes to better support the Board’s decision-making. We have redesigned our staff-level meetings to focus more on the big questions and risks to the outlook and monetary policy. We are actively encouraging a greater range of diverse perspectives and challenge to make sure we are turning over every stone; a summary of those different ways of viewing the economy is provided in the Board papers at each meeting. Also, external Board members now meet regularly with a wider range of staff to discuss topics relevant to their decision-making. This is just one way in which we are bringing to life our cultural vision for being open to ideas and dynamic in how we work. The briefings that Board members receive now regularly include policy alternatives, scenarios, and discussion of the trade-offs between the RBA’s objectives of low and stable inflation and full employment. We have drawn inspiration from peer central banks to enhance our practices, and they will continue to evolve as we learn what works well here and how we can do even better. The RBA has always produced high-quality analysis and our staff are well respected for their expertise. But challenging questions lay ahead, and we are best placed to tackle them by continually reflecting on how we can do things differently and what we can learn from others. In this spirit, we are broadening – and deepening – our capabilities, our models and our engagement with people, ideas, and organisations outside of the RBA. R E S E R V E B A N K O F AU S T R A L I A One example of this is our new Monetary Policy Strategy team, tasked with deepening our policy analysis by encouraging debate and collaboration, and harnessing know-how, from within and outside the RBA. You will also have noticed changes in how we communicate. I have held media conferences after each of the Board’s decisions this year, and these will continue next year. Our publications are evolving too. The Statement on Monetary Policy, which we publish four times a year, has been restyled to be more transparent about our forecasts and assumptions, and to give clearer explanations for our assessment of the economy and the risks around the baseline outlook. The Financial Stability Review has also undergone a change, with a greater focus on clearer messages to explain our analysis. We will continue to develop these publications as we enhance our communications strategy. Our transformation agenda Our transformation goes beyond reshaping how we set monetary policy. In April last year, we launched a four-year transformation program based on the RBA Review findings. We set out to become a more open and dynamic central bank, trusted for our analysis and service delivery. Now in the second year of this initiative, we have made significant progress, but much work remains. We are an organisation with a broad set of responsibilities: we regulate the payments system and run the infrastructure used to settle payments; we provide banking services to the Australian Government, making payments that many Australians rely upon; we issue banknotes that, despite an overall decline in cash transactions, remain an integral part of the Australian economy; and we monitor and contribute to financial stability in cooperation with other authorities. We remain committed to communicating clearly with the public about what we do and why. Because of this breadth of responsibility, our transformation is complex. It involves enhancing leadership capabilities, creating a more open and dynamic culture, streamlining operations for greater efficiency, and building resilience – goals shared by many organisations across Australia. An often-overlooked aspect of our role is our involvement in running the critical infrastructure used to settle payments. We are at the core of this system, ensuring it functions in a way that can be relied upon by the households and businesses that make up our economy. We are also the regulator of the payments system, with a mandate to promote competition, efficiency, and safety of the payments system. In practice, nearly every electronic payment in Australia relies on the infrastructure operated by the RBA – whether it’s tapping a card for public transport, receiving a salary, or transferring money – and many are processed in real-time. Last financial year, the RBA settled approximately three million payments daily, worth almost $260 billion dollars – an amount equivalent to Australia’s GDP roughly every ten days (Graph 6). Graph 6 RITS Interbank Settlement Activity* Daily Averages, Quarterly '000 $b Volume (LHS) Value (RHS) S D M J S D M J S D M J S D M J * Excluding FSS transactions. Source: RBA. Think of the payments system as a train network, with the economy as the train moving vast volumes of transactions. We lay and maintain the tracks that keep money flowing throughout the economy, supporting a strong financial system and efficient payments. As the payments ecosystem evolves, new players like digital wallets and ‘buy now, pay later’ services have emerged, enhancing competition and consumer choice. However, these new entrants also introduce risks that may fall outside our current regulatory scope. Proposed amendments to the Payment Systems (Regulation) Act aim to bring these new players inside our regulatory perimeter. But in the meantime, we are consulting on some issues that we do have oversight of – our regulation of card payment systems and the role of surcharging. We expect the Payments System Board to consider and respond to this consultation in the first half of next year. In addition to consulting on the regulatory settings, we are also investing significantly in our systems and technology to keep pace with rapid technological changes, the growing use of digital payments and challenging security environment. The train tracks now need some maintenance. Ultimately, we need to maintain a modern technological framework that supports our operational and strategic objectives. These initiatives will modernise the infrastructure that powers our nation’s payments and banking systems and allows money to move around the economy in a safe, efficient, and reliable way. Closing remarks The RBA has a pivotal role in promoting the economic stability and prosperity of Australia. We are currently facing significant challenges posed by persistent inflation, shifting geopolitical dynamics and the rapid pace of technological change. Yet, these challenges also present us with opportunities to innovate and adapt. Our transformation agenda is not simply a response to current pressures; it is a proactive approach designed to meet the needs of the Australian economy and people today and well into the future. By enhancing our decision-making processes, embracing transparency, and engaging with diverse perspectives, we are positioning ourselves to navigate the complexities of the modern economy effectively. I look forward to taking your questions. R E S E R V E B A N K O F AU S T R A L I A Endnotes * I am grateful to Meredith Beechey-Osterholm, Samuel Evangelinos, Michelle Lewis, Michelle Wright and Jono Vandenberg for excellent assistance with this speech. The Costs of High Inflation | Speeches | RBA | reserve bank of australia | 2,024 | 11 |
Speech by Mr Andrew Hauser, Deputy Governor of the Reserve Bank of Australia, at the Australian Business Economists' Annual Dinner, Sydney, 11 December 2024. | null | reserve bank of australia | 2,024 | 12 |
Speech by Mr Brad Jones, Assistant Governor (Financial System) of the Reserve Bank of Australia, at the AusPayNet Summit 2024, Sydney, 12 December 2024. | Speech The Future of the Payments System Brad Jones* Assistant Governor (Financial System) AusPayNet Summit 2024 Sydney – 12 December 2024 Thank you for the invitation to open the batting at this year’s AusPayNet Summit. This forum is always a highlight on the calendar − for industry and policymakers alike − and I am sure this year will be no different. Not so long ago, opining on the future of the payments system may have been a somewhat mundane affair. Not a great deal changed from one year to the next, and not too many folks, other than the true payment system diehards, were interested. Not so now. For a start, our payments system is rapidly evolving. New innovations are springing up at a dizzying pace. And the payments system has never been more critical to the functioning of the economy. Almost $300 billion in payments now settle across the RBA’s central infrastructure each day. This is equivalent to Australia’s annual GDP flowing through the payments system every 10 days. Furthermore, debates over the future of money and payments now regularly feature in the public square – and as I am discovering, the public square very much extends to summer barbeque conversations. In some sense, money and technology have always been the subject of popular fascination, but this seems especially true today. In short, to channel a former Prime Minister, it has never been a more exciting time to be in payments. My remarks today will focus on the challenges and opportunities in front of all of us involved in payments. There is no shortage of both. But before diving in, let me briefly set the scene by highlighting where our payments system stands today, and the RBA’s role in it. The current state of Australia’s payments system Australia has a payments system that we can be proud of. By global standards, it is fast, efficient and reliable. This is evident not only in the data, but from the discussions that I and my colleagues at the RBA and on the Payments System Board regularly have with our international counterparts. It is also worth noting that for the better part of a couple of decades, retail merchant card payment costs have trended lower in Australia in response to increased transparency and competitive tension in the market for payments services (Graph 1). Some of this competitive tension has arisen organically, and some of it has come about as a result of intervention by the RBA. Graph 1 This brings me to the mandate of the RBA and the Payments System Board.1 At the broadest level, this mandate is to help shape the payments system so that it works in the best interests of Australian households and businesses. Our north star is promoting the public interest. We strive to achieve this through a combination of suasion, regulation and working with industry participants to help overcome the coordination issues that can bedevil payment systems. In seeking to promote efficiency, competition and safety in the payments system, we also recognise the important role of innovation in serving the public interest. Australia’s productivity growth challenges make this all the more pertinent. One can think of the New Payments Platform (NPP) as a notable example of this focus (Graph 2). More recently, this year the RBA materially raised the activity threshold beyond which securities settlement facilities must comply with the Financial Stability Standards. It was assessed that the higher threshold struck a more appropriate balance between the public interest in the management of financial stability risks, and the public interest in avoiding excessive regulatory burden (particularly on small enterprises). And as I will discuss later, we also recently launched a new project with industry to examine how central bank digital currency, stablecoins and tokenised bank deposits could, along with new infrastructure arrangements, support innovation and resilience in wholesale tokenised asset markets. R E S E R V E B A N K O F AU S T R A L I A Graph 2 Where innovation promises to not only enhance efficiency but also resilience and safety in our financial system, all the better. This recognises that we are entering a new era for operational risk – a result of rising geopolitical tension and other sources of potential disruption that include third-party vendors. For these reasons, strengthening resilience in our payment system and our financial market infrastructure is a key area of focus for the RBA in its work with other member agencies on the Council of Financial Regulators.2 This aside, the RBA is also working with the government to make sure that Australia’s regulatory architecture is fit for purpose in the 21st century. This is a pressing issue given the foundational legislation setting out the RBA’s powers was drafted in another era – one prior to the emergence of the digital economy that will be essential to Australia’s future prosperity. If there is one message to takeaway from my remarks today, it is this – while we should recognise that Australia has a world class payments system today, it would be a mistake to assume the same will be true in five or 10 years’ time without a concerted effort from everyone involved in payments. Of course, the RBA has a key role here and we remain committed to working constructively with industry in promoting the public interest. But ultimately, how industry responds to these challenges and opportunities will determine whether it will be able to deliver the services that Australians will need and should expect in the future. Account-to-account payments In the spirit of facing into challenges, let me begin with account-to-account payments. In her speech to this Summit last year,3 the Governor spoke about industry’s decision to target the decommissioning of the BECS framework by 2030. The setting of a target date by industry has helped to focus attention across the ecosystem. But there is much to do here. BECS is the workhorse of the account-to-account payments system. While the share of account-to-account transfers made through the NPP has increased notably (Graph 3), BECS is still used to process the majority of account-to-account payments. This includes payroll, pension and support payments that are critical to Australians. Graph 3 Given the importance of BECS to our financial system, this year the Payments System Board asked RBA staff to undertake a risk assessment of the intended decommissioning. The risk assessment, which will be reported to the Board in March 2025, is drawing attention to some issues that will need to be addressed to facilitate an orderly decommissioning. In the course of engaging with a wide range of stakeholders – banks, payment service providers, payment schemes, end users and government agencies – RBA staff have heard plenty of support for the migration to more modern payment rails such as the NPP. There are features of the NPP that many stakeholders find beneficial, including 24/7 operation, real-time settlement, richer data and enhanced data exchange capabilities. At the same time, some stakeholders have raised concerns about aspects of the migration. I will set these out in a moment, but my colleagues at the RBA and on the Payments System Board see the central challenge as this – industry is yet to arrive at a shared vision of the desired features of account-to-account payments in Australia. This is a foundational issue. While the point of departure has been announced by industry – transitioning from BECS as we know it – establishing a common vision of the features underpinning a desired end state will be essential if a program of this scale is to succeed. Once a consensus has emerged here, a roadmap with milestones can guide industry progress toward the ultimate objective. Now let me share with you some of the feedback we have heard so far: 1. There has been insufficient industry coordination, planning and certainty regarding the transition. This in turn has had made it difficult for industry participants to press on with their individual plans, including those who will have a key role in ensuring the ongoing competitiveness and safety of the system. 2. There is scope for the needs of end users to be given more prominence in industry discussions on the future of account-to-account payments. BECS is the payment rail used to make the majority of essential payments to millions of Australians, so any replacement must be capable of reliably meeting end user needs. 3. A solution for the processing of bulk payments will be important.4 Key end users need confidence that bulk payments will be supported into the future, recognising that many have integrated systems that manage the initiation and reconciliation of payment instructions. The NPP and the fast settlement service (FSS) will need to have capacity to handle a much higher volume of payments. R E S E R V E B A N K O F AU S T R A L I A 4. The cost of the transition and per transaction costs in the future system are a concern for some stakeholders. End users, including those who do not have advanced functionality requirements, understandably want options that represent value for money. The RBA is working to better understand the pricing of account-to-account payments. 5. Many stakeholders have expressed a desire for resilience to feature prominently in future account-to-account system arrangements. BECS outages have typically been low (Graph 4). Contingency arrangements in the future system will need to ensure that end user needs can continue to be met even when operational issues are experienced.5 This suggests resilience will need to be built into the solution from the outset. As mentioned earlier, the RBA and the Australian Prudential Regulation Authority (APRA) are stepping up their focus on operational resilience in the financial system, including payments.6 6. End users will be unable to move payments from BECS until all customers can receive payments via an alternative channel. Some banks using BECS are yet to connect to the NPP, and even for those that have done so, some of their BECS-reachable accounts are not currently reachable via the NPP. It might be that not all of these unreachable accounts will need transactional capabilities in the future, but this is something institutions need to examine. Graph 4 Let me offer a positive take on this feedback. It has surfaced some issues that, if addressed appropriately, can give industry a solid basis on which to move forward. The focus on resilience, functionality and end user needs is particularly relevant here. The announcement by industry of a target date of 2030 for BECS decommissioning has already sparked some useful dialogue. But all stakeholders need a voice, and a broad consensus on some key issues is now essential if Australia’s account-to-account payment system arrangements are going to be fit-for-purpose in the next decade. Time is now of the essence. Review of Retail Payments Regulation As many of you will be aware, the RBA recently launched a Review of Retail Payments Regulation.7 While we hoped to conduct a broad review, including of issues arising from new types of players and technologies in digital payments, proposed amendments to the Payment Systems (Regulation) Act 1998 (PSRA) that would bring relevant participants into the RBA’s regulatory remit currently remain before the Australian Parliament. Given the limitations of our remit under the current PSRA and the significance of the issues, it is important that these reforms are passed as soon as possible. For now, we are focused on whether there are further actions the RBA could take to put downward pressure on merchant card payment costs and whether the surcharging framework remains fit for purpose. These issues can be dealt with under the PSRA in its current form and are inextricably linked: merchants are less likely to surcharge if their payment costs are low. Given the shift towards electronic payments, card payment costs are an ongoing concern for merchants, as they are for consumers. Keeping downward pressure on merchant fees for card payments, particularly for smaller merchants that tend to be charged higher fees, will keep consumer costs down, and so is an important priority for the RBA. The Issues Paper for the Review outlines a broad suite of issues and possible policy responses for stakeholders to consider. We have asked for feedback on the following: • the current level of interchange fee benchmarks and caps, and whether there is a case for more structural changes to interchange regulation8 • whether further regulatory action could increase competitive pressure on scheme fees and whether further action is required to promote least-cost routing for in-person transactions • options to reduce complexity and improve transparency to facilitate merchants shopping around to get the best value, as this would boost competition in the acquiring market. As the payments landscape has evolved significantly since the surcharging framework was introduced in 2003, it is timely to review whether the current rules are still achieving their intended purpose. There are arguments on both sides of this debate, and we recognise that some views are strongly held. We are open to exploring all possible options to find a position that will best serve the public interest, consistent with our legislative mandate. Some of the arguments for retaining the current surcharging framework include: • it provides a price signal to consumers to use a lower cost payment option – where consumers vote with their feet, this puts competitive pressure on card networks to lower their wholesale fees • merchants value the ability to surcharge to recover the cost of payment choices made by customers • surcharging rules have made a significant contribution to the long-run decline in average fees that merchants pay for card transactions (recall Graph 1). However, the decline in cash usage, increased prevalence of surcharging and changes in the way merchants are charged for card payments have led to reasonable concerns about the current framework. In particular: • Fewer consumers transact with cash today and are therefore unable to avoid card surcharges at the point-of-sale. • Many small merchants are now on blended or single-rate payment plans that charge the same fee to merchants for accepting all types of cards. This dulls the price signal to consumers, and can mean users of cheaper card payments cross-subsidise users of more expensive cards. • Consumers are sometimes unaware of the surcharge amount before paying and/or surcharged for amounts in excess of merchants’ cost of acceptance.9 We received over 70 submissions to our Issues Paper, many from institutions represented here today. Thank you to those who took the time to set out their views. We plan to publish submissions on our website in January, and to take a summary of the feedback you have provided to the Payments System Board in March. Following this, we aim to release a consultation paper with potential policy actions around mid- 2025. Thereafter a conclusions paper would set out the Board’s final decisions, likely by the end of the year. R E S E R V E B A N K O F AU S T R A L I A Cross-border payments I’ll now turn to the topic of cross-border payments. Australian businesses and households that undertake international activities need efficient and safe ways to send and receive money. But cross-border payments services are still more expensive, more opaque and slower than their domestic counterparts. Enhancing cross-border payments is therefore one of the Payments System Board’s strategic priorities and an international commitment for Australia under the G20 Roadmap. A recent review by the Financial Stability Board indicated that much more progress is needed to move toward the G20 Roadmap cost targets.10 Lowering the cost of cross-border payment services has proven challenging almost everywhere. In Australia, we estimate that the average cost of sending A$1,000 to other countries still significantly exceeds the relevant G20 targets (Graph 5).11 Graph 5 International Money Transfer Costs * As a proportion of a A$1000 transfer from Australian accounts % % Advanced economies Developing economies Average** Banks Non-banks Average** Banks Non-banks Retail average cost target Remittance average cost target * Estimates based on quotes from online calculators at September 2024; sample includes 22 currencies, 4 major banks and 10 non-banks. ** Weighted by market share. Sources: ACCC ; Online Calculators; RBA. However, the cost of sending money overseas from Australia can vary significantly across providers. Banks are generally more expensive than non-bank providers, reflecting the size of the mark-ups they typically apply to the wholesale foreign exchange rate. By contrast, there are some non-bank digital providers offering prices that are around, or a bit below, the G20 target levels. These differences highlight the importance of transparency over prices and of customers shopping around.12 The speed of cross-border payments is another area where more progress is required. Bank-intermediated cross-border transactions often take a day or more to reach the recipient. Slow processing reflects a range of factors including differing operating hours, inconsistent payments messaging practices, and complex compliance checks. Making use of the new NPP International Payments Service, which allows the final Australian dollar leg of inbound cross-border payments to be processed on a near real-time 24/7 basis, will help. There are also a range of ISO 20022 messaging initiatives where more progress is needed.13 Achieving international consistency in the data carried in payments messages will reduce the need for manual intervention by providers in the processing of cross-border payments, and therefore increase the speed and lower the costs of transactions. Finally, the RBA continues to participate in initiatives like Project Mandala, a collaboration with the Bank of International Settlements (BIS) Innovation Hub and the central banks of South Korea, Malaysia and Singapore. This project examines a common technical model for automating regulatory compliance processes in cross-border payments, including sanctions and AML/CTF requirements, with a view to increasing the speed of compliance procedures and reducing failed transactions.14 The future of digital money This leads me to another focus area for the RBA and the Payments System Board – shaping the future of money in Australia. A central element of this program is determining whether there is a public policy case to introduce a central bank digital currency (CBDC) in Australia, and if so, in what form. We recently published a report with Treasury that provided an updated assessment of the case for a CBDC in Australia, and outlined, for the first time, a three-year roadmap for future work.15 Our current assessment is that a public interest case to issue a retail CBDC has yet to emerge in Australia. At the present time, we see the potential benefits of a retail CBDC as modest or uncertain, relative to the challenges it would likely introduce. However, as these trade-offs could evolve over time, and as more international experience comes to light, the RBA and the Treasury will continue to examine the issues. Like a number of central banks in advanced economies, we see the potential case for a wholesale CBDC as more promising, though not definitive at this point. A wholesale CBDC could have a key role in facilitating the settlement of transactions in tokenised asset markets, and in enhancing cross-border payments. This recognises the key role of central bank money in serving as the ultimate safe settlement asset, particularly in systemically important markets – a point emphasised in international standards. Implementing a wholesale CBDC is also likely to be less disruptive and pose fewer policy challenges than issuing a retail CBDC. It would represent a more incremental change to existing arrangements where digital central bank money is already issued to eligible financial institutions in the form of Exchange Settlement Account balances. But there are still issues that require closer scrutiny here. In that respect, we have made a strategic commitment to prioritise our applied research agenda on innovations in wholesale digital money – namely, wholesale CBDC, tokenised bank deposits and stablecoins. Our most immediate priority is to launch a new research project with the Digital Finance Cooperative Research Centre (DFCRC), known as Project Acacia. Our focus here is on opportunities to uplift the efficiency, transparency and resilience of wholesale markets through tokenised money, assets and new settlement infrastructure. We recently published a consultation paper seeking industry feedback and inviting expressions of interest to collaborate with the RBA and the DFCRC as part of this project.16 I encourage anyone who is interested to reach out to our project team. In addition to Project Acacia, we have a number of other CBDC initiatives in line over the next year. We are currently exploring options for engaging with the public to better understand their needs, preferences and concerns relating to CBDC. We are also planning to convene industry and academic forums to provide more systematic engagement with external experts on retail and wholesale CBDC issues. In short, we have an ambitious agenda on the future of money. But all our efforts are directed to ensuring that our future monetary arrangements are fit for purpose in the digital age. R E S E R V E B A N K O F AU S T R A L I A The future of cash While cash use has declined in recent decades, it remains an important means of payment for many folks in our community (Graph 6). A significant number of Australians still primarily rely on cash to participate in the economy, including our more vulnerable members of society. Cash remains an important store of value, particularly during periods of economic uncertainty. And in serving as a backup means of payment when electronic payment methods are unavailable, including during system outages or natural disasters, cash helps to promote a more resilient payment system overall. For these reasons, the government and the RBA remain committed to supporting access to cash. Graph 6 However, as cash use has declined, the cost of moving it around the country has increased. A significant effort to put cash-in-transit services on a more solid financial footing is now underway across industry. But there is still considerable work to be done to develop a sustainable long-term model for cash distribution. The challenge now for industry is to deliver more efficient cash distribution services, while meeting the public interest in ensuring cash remains an affordable and viable means of payment for Australians. Conclusion Let me wrap up. Australians expect their payments to be convenient, reliable and represent value for money. At the RBA, we share these expectations. We want to see a payments system that is a hotbed of innovation and competitive tension, driving efficiency up and costs down. And we want to see a payments system that is safe and resilient – one that Australians can rely on. As we contemplate what shape the payments system of the future might take, my colleagues and I at the RBA and on the Payments System Board are committed to working constructively with AusPayNet and the wider industry. We are in this together. There is much to celebrate in the Australian payments system, but as I’ve made clear today, also much to do. On that note, I look forward to taking your questions. Thank you. Endnotes * I would like to thank my colleagues in Payments Policy Department for their valuable assistance in the preparation of these remarks. All errors of omission and commission are my own. More formally, the Payments System Board’s responsibilities and powers are set out in four separate Acts. These are: Reserve Bank Act 1959 ; Payment Systems (Regulation) Act 1998 ; Payment Systems and Netting Act 1998 ; and Cheques Act 1986. The Reserve Bank Act, as amended, gives the Payments System Board responsibility for determining the RBA’s payments system policy. It must exercise this responsibility in a way that will best contribute to: controlling risk in the financial system; promoting the efficiency of the payments system; and promoting competition in the market for payment services, consistent with the overall stability of the financial system. Council of Financial Regulators (2024), ‘Quarterly Statement by the Council of Financial Regulators – December 2024’, Media Release No 2024-05. Bullock M (2023), ‘Modernising Australia’s Payments System’, Speech to the Australian Payments Network Summit, Sydney, 12 December. Bulk payment functionality allows payment instructions to be grouped together and sent as a single payment file, supporting efficient processing of large volumes of payments (compared with sending each payment individually). Bulk payments are widely used by government departments and companies for regular payments such as welfare, salary and dividend payments and the payment of bills. BECS is a technologically simpler solution than modern payment rails. While this simplicity means that it is no longer fit for purpose for many payment use cases, it does have some desirable features. In particular, end users do not expect instant payments processing across BECS. When operational issues affect availability of the service, the payments can be delivered in a subsequent batch settlement without much impact to the end user. This includes through the geopolitical risk program under the Council of Financial Regulators, and in the case of APRA, through CPS 230. RBA (2024), ‘Merchant Card Payment Costs and Surcharging – Issues Paper’, October. This could include having only interchange caps instead of both caps and benchmarks, removing ad valorem interchange caps and benchmarks (so that they are solely cents-based), or limiting the number of interchange categories. This includes the impact of other service costs being bundled into the surcharge that is passed onto consumers. Financial Stability Board (2024), ‘Annual Progress Report on Meeting the Targets for Cross-border Payments: 2024 Report on Key Performance Indicators’, 21 October. The Financial Stability Board has, for the purposes of its targets, defined remittances as low value, high volume payments primarily sent to recipients in emerging market and developing economies. Retail payments are all other payments under US$100,000. This task has been helped by recent updates to the guidance from the Australian Competition and Consumer Commission on how international money providers can improve the transparency of these services. This included guidance around how international money providers should display information to consumers, requiring standardised illustration of costs and other service features, such as the time it will take for the recipient to receive the funds. See ACCC (2024), ‘Best Practice Guidance for Foreign Cash and International Money Transfer Services’, October. For instance, the RBA is working to ensure that the Australian industry adopts the globally harmonised ISO 20022 messaging requirements for cross-border payments. Work is underway to plan the NPP’s adoption of globally harmonised ISO 20022 messaging, and we expect industry to have adopted the globally harmonised ISO 20022 messaging requirements for high-value and fast payments by the end of 2027. See BIS Innovation Hub (2024), ‘Project Mandala: Streamlining Cross-border Transaction Compliance’. For the paper, see here: RBA and Treasury (2024), ‘Central Bank Digital Currency and the Future of Digital Money in Australia’, September. See also Jones B (2024), ‘Financial Innovation and the Future of CBDC in Australia’, Speech at the Intersekt Conference, Melbourne, 18 September. RBA (2024), ‘RBA and DFCRC Joint Consultation Paper Project Acacia – Exploring the Role of Digital Money in Wholesale Tokenised Asset Markets’, Media Release No 2024-25. R E S E R V E B A N K O F AU S T R A L I A | reserve bank of australia | 2,024 | 12 |
Speech by Ms Sarah Hunter, Assistant Governor (Economic) of the Reserve Bank of Australia, at the University of Adelaide South Australian Centre for Economics Studies (SACES) Lunch, Adelaide, 13 December 2024. | Speech Shedding Light on Uncertainty: Using Scenarios in Forecasting and Policy Sarah Hunter* Assistant Governor (Economic) University of Adelaide South Australian Centre for Economics Studies (SACES) Lunch Adelaide – 13 December 2024 I would first like to pay respect to the traditional and original owners of this land, the Kaurna people, to pay respect to those who have passed before us and to acknowledge today’s custodians of this land. I also extend that respect to any First Nations people joining us. Today I am going to talk about how the RBA uses scenarios – that is, alternative possible pathways for the economy to help us think through the outlook for the economy and set monetary policy. Our baseline forecast of how the economy may evolve is a key input to the monetary policy decision. It represents what we think is the most likely single path for the economy. But it’s only one path, and the chance of that precise path being the one that happens is approximately zero. So, acknowledging the uncertainty inherent in our forecasts is core to making good policy decisions. The systematic use of scenario analysis is common in many professions where decisions are made under uncertainty – economists are not alone in not knowing exactly how things will play out. For example, scenario analysis is a fundamental part of financial stress testing exercises that are conducted on a regular basis by prudential regulators. Many central banks use scenarios internally to inform their policy decisions, and some publish them. The value of scenarios has been re-emphasised by the recent Bernanke Review of the Bank of England and our own RBA Review, which recommended greater use of scenarios to inform policy.1 So, why are scenarios useful? As forecasters, they can help us think through and communicate risks around our baseline. For example, by identifying which risks the forecast might be particularly sensitive to, and the balance of risks around the central case. They can also help us keep an open mind about alternative explanations for how the economy is evolving. For policymakers, scenarios can provide a tangible link between risks and policy strategy. They allow policymakers to explore how a given policy option performs depending on how risks play out, or to compare alternatives. They also have the potential to help policymakers communicate how monetary policy may respond as conditions evolve – in economists’ parlance, to better communicate their reaction function. I’ll develop these points in the rest of my remarks, and along the way talk through some examples of recent scenarios we have used. But before I get into scenarios, I want to briefly set the scene by outlining the baseline forecast process, and why the forecasts almost always turn out to be wrong in some way. Forecasts are an important input to monetary policy … The baseline forecast represents our central view of how the economy will unfold, conditional on a series of assumptions including the exchange rate and the market-implied path for the cash rate. The forecasts also embed a set of judgements about how the economy may evolve. We typically call out the judgements we think are most important in the Statement on Monetary Policy (SMP), alongside the forecasts. Recently the key judgements have included assessments of the supply capacity of the economy, the trajectory of the labour market, and the extent to which households will spend their income. The judgements and forecasts are built on a wide range of analysis of the data, models that embody relationships and linkages across the economy, and our assessment of how these relationships may evolve differently to what we’ve seen in the past. As well as resulting in quantitative forecasts, this process helps to refine the staff’s narrative for the economy. Constructing a narrative in parallel with detailed outcomes can help test the forecasts and it helps us to communicate our view of the economy. But we know the future is uncertain, and the forecasts will usually be wrong in various ways. Given the uncertainty in forecasts, why spend so much time and effort on them? The answer is that monetary policy operates with a lag, which means the Board needs to think ahead when setting the cash rate target today. Given the importance of looking ahead in the monetary policy decision and the fact that we know forecasts often do not come to pass, there is significant value in thinking through the ways in which actual outcomes might deviate from the forecast. As we will see, scenarios help us do that. … but all forecasts turn out to be at least partially wrong But first, why do forecasts turn out to be wrong? There are some things about the future we can be relatively confident about. For example, we know people typically spend more money in the last quarter of the year in the lead up to the holiday season. Observations like this are so normal that we always look through them and focus on the underlying picture.2 That said, even the seasonal pattern of household spending is shifting, with the ongoing growth in Australia of Black Friday sales in November displacing some spending from December. That is just the tip of the uncertainty iceberg – there are many reasons why actual outcomes depart from the forecasts: • Most obviously, unpredictable events that will have a meaningful impact on the macroeconomy can happen. Think of the pandemic, an unexpected change in domestic or foreign government policy and one-off weather events that affect prices or economic activity. • Relationships between variables can turn out differently than expected – for example, households might save more (or less) of their income than they usually do. Or, our models and analytical frameworks designed to capture these relationships could be incorrect or incomplete. • Assessments of the current state of the economy could be wrong. That could be due to imprecise data – which are often subject to sizeable revisions – or imprecise assessments of economic concepts like spare capacity that we can only infer from the data. Any errors in the assessment of the current state of the world are likely to translate into forecast errors. • Undetected or uncertain structural changes in the economy can cause unforeseen outcomes. A change in the potential growth rate of the economy – maybe caused by the green energy transition, AI adoption or other technological changes – would have wide-ranging effects on variables we forecast. These examples are specific cases where our baseline outlook for the economy may not come to pass. One way of quantifying and communicating general uncertainty in the forecasts is the ‘fan charts’ that the RBA shows in the SMP. These charts show the historical range of forecast errors around the current central forecasts, in this case R E S E R V E B A N K O F AU S T R A L I A inflation (Graph 1). The dark blue range shows that 70 per cent of two-year ahead inflation forecasts have fallen within ± 1 percentage points of the central forecasts since 1993, and 90 per cent fall within ± 2 percentage points. Graph 1 This picture highlights that we can’t be very confident that our central projections will come to pass! Scenarios help us understand and communicate specific risks and judgements While the fan charts illustrate the typical level of uncertainty around our forecasts, scenarios enable a richer discussion of specific ways in which our baseline forecasts may be wrong. This could be due to any of the sources of uncertainty I talked about earlier – the risk of unpredictable events, economic relationships turning out to be different to what we thought, and so on. Constructing a scenario involves making alternative assumptions to the ones in our baseline forecast about how things we are uncertain about play out, and thinking through what that implies for the economic outlook. We often use economic models to explore how these alternative assumptions affect economic outcomes. Part of the value of producing scenarios is that they help us build our own understanding of which risks are important, because the scenario makes clear how sensitive the outlook is to a given risk. That can help us decide which issues we need to dig into more to understand better. Scenarios also provide a way for us to communicate the risks that we think are most important, and a tangible way of illustrating and quantifying them. By tracing through the impact of a risk onto both inflation and unemployment, they help us to understand how risks around those variables are connected in a way that fan charts cannot. For us as forecasters, there is a further possible philosophical benefit to producing scenarios: I wonder if it might reduce the chance that we become too attached to our central forecast narrative. Constructing scenarios means thinking through alternative narratives, and that should help us keep an open mind when our central forecast turns out to be wrong. And as I said earlier, it almost certainly will be wrong in some way. More concretely, scenarios can help us identify the indicators and outcomes that will tell us when we are deviating from our baseline view. This helps us to identify when things are playing out differently, allowing us to update our baseline forecast accordingly. I’ll return in a minute to talk about the value of scenarios in informing the policy decision. But let me first give two recent examples of scenarios we have used. Household income growth and consumption A key uncertainty we’ve been considering recently is how household income growth will affect consumption in the coming years. Household real income is currently being lifted by the Stage Three tax cuts taking effect. But we cannot be certain how consumers will react to this lift in income. Running different scenarios allows us to see how the different responses might play out and how material this would be for the labour market and inflation. The alternative plausible paths for consumption (Graph 2) and the savings rate led to noticeably different paths for inflation and unemployment that would have consequences for policy setting (Graph 3).3 Graph 2 R E S E R V E B A N K O F AU S T R A L I A Graph 3 We first published these scenarios in our August SMP.4 As the charts show, the different cases have material implications for inflation and the labour market. With this in mind, RBA staff are closely monitoring actual outturns and assessing their implication for the outlook for the labour market and inflation. To relate this to the chart, we’re evolving our assessment of whether we’re on the orange, blue or green lines. And the answer to this question is critical to the Board, as a move to the scenarios depicted in green or orange may require a change in policy strategy – I’ll return to that point later. Higher Chinese fiscal spending External risks to the Australian economy can also be interrogated with scenarios. At any given time, there are many known external risks (as well as unknown unknowns). Deputy Governor Andrew Hauser discussed one of the key unknowns, the global trading environment, in his speech earlier this week.5 Another current example of a material external risk is the path of future Chinese fiscal policy. China is a large economy and Australia’s largest export destination, which means its trajectory is important for Australian monetary policy setting. One way we have explored that is to consider the effects of Chinese fiscal spending being higher than expected. There are several ways this could affect the Australian economy:6 • Stronger demand in China increases prices for commodities that Australia exports as well as the price of Chinese exports to Australia. Higher commodity prices increase Australian corporate profits and government tax receipts, some of which could lead to increased spending. • Stronger Chinese demand also increases demand for other Australian exports. Services export volumes are more responsive to demand so there would likely be a direct activity channel for service exports. This could be offset to some extent, however, through adjustments via the exchange rate. • Similarly, stronger demand in China lifts activity in China’s other trading partners, many of which are important destinations for Australian exports. • Financial channels impact the Australian economy. While direct financial links with China are minimal compared with trade links, Chinese activity influences exchange rates and asset prices. A large Chinese stimulus package would likely be associated with an appreciation of the Australian dollar and potentially boost equity market sentiment. The scenario we consider is a very large stimulus package, beyond what we have assumed in our current baseline forecast profile (Graph 4). It is not an outcome we think is likely to be announced in the near term. Looking at a large, if unlikely, stimulus gives a sense of what it might mean for the Australian economy and also illuminates the channels that would be at play for a smaller stimulus (Graph 5).7 While here we look at the impact of a stimulus package in isolation, in practice a large stimulus would be most likely if growth prospects in China were to deteriorate for some reason. In that case, the impact on the Australian economy would differ from the scenario. Graph 4 Graph 5 R E S E R V E B A N K O F AU S T R A L I A Scenarios and monetary policy The goal of all this work is ultimately to help inform good monetary policymaking. I’ve already explained how scenarios help us understand and communicate the importance of different risks to the outlook8 and the economy’s sensitivity to different channels. For example, the China fiscal stimulus scenario shows how Australian outcomes might be affected by Chinese policy, and how transmission of the stimulus might be sensitive to movements in the exchange rate. I will focus now on how scenarios can inform the policy decision itself. Clearly, central forecasts are important inputs to monetary policy decisions. But the extent of uncertainty means it’s equally important for policymakers to consider alternative scenarios, their likelihood and how their strategies might need to adapt. The key point is that scenarios help to make the link between forecast risks and policy strategy. That helps the Board think through policy options and communicate their thinking. In particular: • Scenarios allow policymakers to consider how to make their strategy more robust to key risks materialising. That might mean choosing a policy strategy that performs well – in terms of inflation and employment outcomes – under a range of possible scenarios, rather than just in the most likely central forecast. • Scenarios can also help the Board communicate how policy settings might need to respond if the economic outlook unfolds differently to our baseline. As flagged earlier, in economist-speak they can help the Board to communicate its reaction function to financial market participants and the public, helping them understand what might happen to interest rates over time. For example, the November Board minutes show examples of the Board considering alternative risks to the outlook for household spending and the labour market, and mapping those through to the potential consequences for policy.9 To make this more concrete, Graphs 6 and 7 provide an illustration of the sort of scenarios we might look at to map from risks to possible policy responses. I should emphasise that these are not actual scenarios the Board has considered – while some central banks publish the alternative policy paths that inform their decisions, the RBA has not yet done so. The graphs show hypothetical policy responses to illustrative scenarios where demand and therefore inflation are stronger or weaker than a base profile. The Board has consistently communicated that it is aiming to return inflation to the midpoint of the target band (2.5 per cent) in a timely manner while retaining as many of the gains in the labour market as possible. The two cases considered here do not achieve these outcomes. That is, they would not bring the economy back into balance in the second half of 2026; in the strong-demand scenario, inflation would remain above 2.5 per cent, while in the weak-demand scenario it would drop below 2.5 per cent by the end of the forecast horizon (see solid black lines in right-hand panels of Graphs 6 and 7). While the policy paths shown in these charts are not necessarily ones the Board would follow, the two scenarios are illustrative of how the strategy may need to be adapted as conditions unfold. In the upside scenario the Board may need to consider a tighter policy stance – this could be a rate hike or a longer period on hold. In the downside scenario, the Board may need to consider a looser stance – for example, by bringing forward rate cuts. Graph 6 Graph 7 Conclusion Where does all this leave us? Each quarter, the RBA staff prepare a forecast for the economy, based on their careful assessment of the data, and past historical relationships, but acknowledging it relies on many judgments and assumptions. We select key judgments and risks to create scenarios that might differ from our central forecast. These scenarios help RBA staff understand the risks and they feed into the policy advice, though they only cover a fraction of the overall uncertainty. The Board evaluates this information when setting policy, focusing on the strategy’s robustness amid inherent risks and the delayed effects of monetary policy on the economy. We hope the scenarios we publish help financial markets and the public better understand the forecasts and policy decisions, encouraging broader debate and discussion. R E S E R V E B A N K O F AU S T R A L I A Endnotes * I would like to thank Tim Taylor, Thomas Cusbert and Nicholas West for their assistance in writing this speech and Andrew Hauser, Chris Kent, Brad Jones, Michael Plumb, Penny Smith, Dave Jacobs and Jeremy Lawson for their helpful comments. See Bernanke BS (2024), ‘Forecasting for Monetary Policy Making and Communication at the Bank of England: A Review’, April; Australian Government (2023), ‘Review of the Reserve Bank of Australia’, Final Report, March. Although scenarios have only recently become a standard part of the policy process at the RBA, the need to consider uncertainty in forecasting and policymaking is well-tilled ground in speeches by RBA officials. For example, Stevens G (2011), ‘On the Use of Forecasts’, Address to the Australian Business Economists Annual Dinner, Sydney, 24 November; Debelle G (2017), ‘Uncertainty’, 7th Warren Hogan Memorial Lecture, Sydney, 26 October. This particular observation is so typical that the ABS is able to take it into account in the data series it publishes. Seasonal adjustment is the process of removing the predictable fluctuations in economic data that the holidays and other regular calendar-based events create in order to more clearly reveal the underlying picture. For this scenario taken from the August SMP we used the RBA’s semi-structural macroeconometric model MARTIN – it captures the main empirical relationships we see in the economy so is useful for this kind of scenario. RBA (2024), Statement on Monetary Policy, August. Hauser A (2024), ‘The Ghost of Christmas Yet to Come’, Address to the Australian Business Economists’ Annual Dinner, Sydney, 11 December. See Guttman R, K Hickie, P Rickards and I Roberts (2019), ‘Spillovers to Australia from the Chinese Economy’, RBA Bulletin, June. For this scenario, we again used MARTIN to consider the domestic implications. But because the focus of MARTIN is the Australian economy, we also leant on the Oxford Economics model of the global economy and literature on the effect of Chinese growth on commodity prices to calibrate some of the international transmission mechanisms. Another dimension is the likelihood of any given scenario materalising. Defining objectively what the probability is of a given scenario materialising is generally not possible. Instead, staff and Board members must use their own subjective assessment. See RBA (2024), ‘Minutes of the Monetary Policy Meeting of the Reserve Bank Board’, Hybrid, 4 and 5 November. | reserve bank of australia | 2,024 | 12 |
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