Reserve Bank open to more QE if required but negative interest rates again ruled out

A cautiously optimistic RBA has again ruled out negative rates but remains open to further quantitative easing measures.

Governor of the Reserve Bank of Australia (RBA) Phillip Lowe.

The Reserve Bank has delivered a cautiously optimistic outlook for the economy, helped by a full-throttled stimulus program but warned it is not expected to return to its pre-pandemic level until the end of next year.

Days after slashing interest rates and unleashing an $100bn quantitative easing program, central bank upgraded its forecasts for growth with the economy now tipped to contract by 4 per cent in the year to December, versus a previously expected fall of 6 per cent.

It is also forecast GDP to expand by 6 per cent in the year to mid-2021, instead of the 4 per cent it was anticipating August. Further out it is targeting growth of 5 per cent through 2021 and 4 per cent through 2022.

“Even after the GDP forecast upgrade, the severity of the downturn in the first half of the year means that GDP is not expected to return to its pre-pandemic level until the end of 2021,” the RBA said on Friday, adding recovery from the coronavirus pandemic will be “extended and bumpy”.

“A recovery in economic activity is underway across the country, but is proceeding at an uneven pace. Some industries remain constrained by mandated and voluntary social distancing, particularly in hospitality and tourism, while some other industries are feeling the effects of the broader economic downturn,” the central bank said.

It also warned that the disruption to how businesses and households operate, work and consume given social distancing and overriding caution around Covid-19 “will lead to some structural change in the economy”.

However the central bank’s latest quarterly assessment of the economy was tinged with optimism, noting the slightly improved outlook for growth stemming from a recovery in consumer spending and labour market conditions outside of Victoria — buttressed by significant further stimulus in the federal budget — the unemployment rate is expected to peak a little below 8 per cent in coming months, well below a peak of 10 per cent expected a few months ago.

Unemployment is then expected to gradually decline over 2021 and 2022 to be just above 6 per cent at the end of the forecast period.

But with the outlook implying a large shortfall in activity and employment from levels that would be consistent with full employment, the Reserve Bank expects core inflation to reach only 1.5 per cent by the end of its forecast period in 2022 – well below the central bank’s 2-3 per cent target – despite the massive package of monetary policy measures announced by the bank this week.

In its quarterly statement on monetary policy, released on Friday, the RBA said the interest rate cuts and bond buying it announced after its monthly board meeting on Tuesday would support economic activity and job creation by lowering borrowing costs and making the Australian dollar lower than it would otherwise would be, while also strengthening balancing sheets by supporting asset prices, and supporting the supply of credit flowing to households and businesses.

Significantly, the RBA stressed that it is prepared to further ease monetary policy by boosting or extending its bond buying program if it feels that’s needed, as it monitors the recovery from the pandemic and the outlook for jobs and inflation.

“With forecast inflation still well below target and a second wave of the virus in the northern hemisphere, markets will ask what else the RBA can do,” said Tapas Strickland, director of market economics at NAB.

“Worryingly on the inflation outlook, the RBA’s Business Liaison notes that around 25 per cent of surveyed firms intend to implement wage freezes in the year ahead, while 30 per cent already have wage freezes in place”.

“There is an obvious risk that the widespread imposition of wage freezes and continued labour market slack as forecast could embed ‘a normal’ for wage increases that is below 2 per cent.”

But after slashing key interest rates — including cutting the official cash rate target to a record low of 0.1 per cent, and also lowering the rate on exchange settlement balances to zero on Tuesday — the RBA says it’s not contemplating a further reduction in interest rates.

“With the cash rate target at 10 basis points and the interest rate on exchange settlement balances at zero, interest rates have been lowered as far as it makes sense to do so in the current environment,” the statement said.

“The board considers that there is little to be gained from short-term interest rates moving into negative territory and continues to view a negative policy rate as extraordinarily unlikely.”

But as outlined in its policy announcement, the RBA noted that it has committed not to increase the cash rate target until actual — rather than forecast — inflation is sustainably within the target range of 2–3 per cent – requiring a period of strong employment growth and a return to a tight labour market – and that the 3-year yield target will be removed prior to an increase in the cash rate.

“The focus over the period ahead will be the government bond purchase program,” the RBA said. “If the circumstances require, the board is prepared to do more and undertake additional purchases.

“At its future meetings, the board will be closely monitoring the impact of bond purchases on the economy and on market functioning, as well as the evolving recovery from the pandemic, including the outlook for jobs and inflation.”

Significantly, the RBA’s latest economic forecasts incorporated the latest monetary policy easing.

With inflation forecast to stay well below its 2-3 per cent target, the bias to ease further will remain.

“Given that the global central banking stance remains towards further easing and amid rising infection rates and increased restrictions in the UK, the EU and the US, the battle of the balance sheets suggests that the RBA’s balance sheet is likely to be expanded further beyond its just announced $100bn program,” RBC chief economist Su-Lin Ong said.