More stimulus needed before long - Capital Economics
Australia & New Zealand Economics

More stimulus needed before long

RBA Watch
Written by Marcel Thieliant

Given that the economy has coped better with the pandemic than the Reserve Bank of Australia (RBA) had anticipated, the Bank probably won’t provide additional easing over the next few months. However, we still expect inflation to fall more sharply than the Bank currently anticipates. As such, we still expect the Bank to resume its bond purchases before long to bring down long-term interest rates.

  • Activity and labour market exceeding Bank’s expectations
  • But unemployment set to remain far above pre-virus levels, weighing on wage growth
  • Bank may resume bond purchases at some point, perhaps early next year

Given that the economy has coped better with the pandemic than the Reserve Bank of Australia (RBA) had anticipated, the Bank probably won’t provide additional easing over the next few months. However, we still expect inflation to fall more sharply than the Bank currently anticipates. As such, we still expect the Bank to resume its bond purchases before long to bring down long-term interest rates.

Economy faring better than anticipated

The RBA hasn’t bought any government bonds since 6th May as 3-year yields are close its 0.25% target. 10-year yields are much higher at around 1%, but New Zealand’s experience suggests that even aggressive asset purchases may not lower them any further. After all, 10-year yields in New Zealand have rebounded strongly since the RBNZ expanded its QE programme in mid-May and are now once again above those in Australia. (See Chart 1.)

Chart 1: 10-year Government Bond Yields (%)

Source: Refinitiv

What’s more, it’s looking increasingly clear that the economy has coped better with the pandemic than the Bank has been anticipating. For a start, retail sales bounced back strongly in May and were 5.3% higher than a year earlier. The services sector probably fared much worse and we still expect consumption to slump by 12% q/q. But that would be a little smaller than the 15% q/q plunge that the RBA predicted in its May Statement on Monetary Policy. We now expect GDP to drop by 8% during the first half of 2020, a smaller contraction than the 10% decline anticipated by the Bank.

There’s also been positive news from overseas as activity in both the US and China is bouncing back more strongly than we had been anticipating. The rebound in China’s economy has lifted the price of iron ore to a one-year high.

Admittedly, the 3.5% contraction in real GDP that we are forecasting for this year would still mark the deepest slump since WWII. But the labour market is also holding up better than expected. The unemployment rate only rose from 5.2% in March to 7.1% in May, leaving it well short of the RBA’s forecast of 10% by June. And the number of total hours worked is on track for a 9% q/q fall in Q2 instead of the RBA’s forecast of a 20% slump.

The muted rise in the unemployment rate largely reflects the fact that many of those who lost their job during the pandemic weren’t immediately looking for a new one. But the 6.5% fall in employment between March and May wasn’t quite as severe as the RBA’s forecast of an 8% plunge. And timelier data released by the Australian Bureau of Statistics suggest that employment has started to bounce back. Indeed, the RBA noted at its June meeting that “the depth of the downturn will be less than earlier expected“. As such, our previous forecast that the RBA may expand its bond purchases as soon as August is no longer fit for purpose.

Large labour market slack to weigh on inflation

However, we don’t think the Bank’s work is done yet. For one thing, the renewed outbreak of the virus in Victoria will prevent output from returning to pre-virus levels anytime soon. Victoria recorded 75 new cases on Sunday and 64 new cases yesterday, not far below the record 111 in late-March. That outbreak hasn’t spread beyond the state’s border yet, but it will surely delay the reopening of borders between states and slow the easing of restrictions on services activities in Victoria. That will be a headwind to domestic tourism, which accounts for 2% of Australia’s GDP. And with the virus outbreak going from bad to worse outside of Australia, we expect the border to remain closed until mid-2021. That will weigh on tourism and education exports, which account for another 3% of output.

What’s more, it remains to be seen how the economy will cope with the withdrawal of the extraordinary fiscal support that it is currently receiving. Commonwealth spending was twice as large as a year earlier in May. We estimate that the $550 JobSeeker supplement, the $750 stimulus payments and the mortgage repayment holiday are offsetting around half of the 8% slump in labour income in Q2. (See here.) And according to a recent survey, around 17% of employees were receiving the $1500 per fortnight JobKeeper wage subsidy in mid-June. That programme is scheduled to end in September. If we add in those who left the labour force in April and May and those who were working zero hours in May, the unemployment rate would be an astonishing 13.7%. (See Chart 2.) We expect the unemployment rate to remain above pre-virus levels for years to come.

Chart 2: Unemployment Rate (% of Labour Force)

Sources: Refinitiv, ABS, Capital Economics

While the RBA may have been too pessimistic about the outlook for activity, we think it’s too optimistic about the outlook for inflation. (See Chart 3.) One reason why inflation held up recently is that firms were passing on higher import costs arising from the weaker exchange rate. But the Australian dollar has rebounded strongly since March and we expect it to climb to US$0.72 by year-end, from US$0.69 today. That will keep a lid on goods inflation. And a range of survey indicators point to a marked slowdown in price pressures. (See here.)

Chart 3: Consumer Prices (% y/y)

Sources: Refinitiv, ABS, Capital Economics

It’s possible that those surveys will improve as the economy reopens. The bigger picture though is that sizeable spare capacity in the labour market is set to weigh on wage growth. For one thing, the Fair Work Commission decided to lift the minimum wage by just 1.75% this year following a 3% increase in 2019. And in the industries hit hardest by the pandemic, the minimum wage will be frozen until next year.

Union officials will probably show restraint, too. After all, they expect consumer prices to rise by just 1.6% per annum over the next two years, the lowest on record. With living costs rising less rapidly, trade unions are unlikely to demand big pay hikes.

What’s more, there are signs that employers are starting to curb labour costs. A recent survey showed that 5% of firms have cut hourly pay while 4% have applied a wage freeze on any employee. Among firms with more than 20 employees, which account for 60% of employment, 9% have cut hourly pay and 11% have frozen wags.

The Q2 inflation data will only be released by the end of July and the RBA may well downplay any weakness as temporary. But if inflation remains as soft as we anticipate even when the economy has opened up again, the RBA may eventually feel compelled to act. As such, we still expect the Bank to resume its bond purchases in order to lower longer-term yields, but not before early next year.

Table 1: RBA Monetary Policy Background Information

Interest Rate Meetings

The Board meets 11 times a year, at 9.00 am on the first Tuesday of the month. There is no meeting in January. Rate decisions are released in a statement at 2.30 pm.

Release of Minutes

Two weeks after each meeting.

Other Publications

The Statement on Monetary Policy sets out the Bank’s assessment of current economic conditions and the outlook. It is published four times a year, on the Friday after the policy meetings in February, May, August and November.

Disclosure of Voting

No, the votes and views of individual members are not identified in either the policy statements or the minutes of the meetings.

Inflation Target

The Board targets CPI inflation of between 2% and 3% over the medium-term. This is an average rather than a rate to be achieved at all times.

Policy Framework

The Reserve Bank Act gives the Board a duty “to maintain price stability, full employment, and the economic prosperity and welfare of the Australian people.”

Membership of Board

The Board comprises the Governor, Deputy Governor, six other non-executive Bank members and the Secretary to the Treasury. The Governor and Deputy Governor serve terms of up to seven years and are eligible for re-appointment. The non-executive members are appointed for terms of up to five years. There is no limit to the number of terms they may serve.

Governor

Philip Lowe

Deputy Governor

Guy Debelle

Other members of the

Mark Barnaba

Carol Schwartz

Reserve Bank Board

Allan Moss

Catherine Tanna

Ian Harper

Steven Kennedy, (Secretary to the Treasury)

Wendy Craik

Meetings

Date

Outcome/Forecast

Date

Outcome/Forecast

4th Feb 2020*

0.75%

2nd Feb 2021*

0.25%

* Denotes release of The Statement on Monetary Policy later that week

3rd Mar 2020

Cut to 0.50%

2nd Mar 2021

0.25%

19th Mar 2020

Cut to 0.25%

6th Apr 2021

0.25%

7th Apr 2020

0.25%

4th May 2021*

0.25%

5th May 2020*

0.25%

1st June 2021

0.25%

2nd June 2020

0.25%

6th July 2021

0.25%

7th July 2020

0.25%

3rd Aug 2021*

0.25%

4th Aug 2020*

0.25%

7th Sep 2021

0.25%

1st Sep 2020

0.25%

5th Oct 2021

0.25%

6th Oct 2020

0.25%

2nd Nov 2021*

0.25%

3rd Nov 2020*

0.25%

7th Dec 2021

0.25%

1st Dec 2020

0.25%

Sources: RBA, Capital Economics


Marcel Thieliant, Senior Australia & New Zealand Economist, marcel.thieliant@capitaleconomics.com