• The economy is running sub-par and looks to be in need of further help;
• Financial markets are pricing in another half percentage point rate cut;
• The RBA has studied the use of other tools;
• Greater use of fiscal policy will likely need to be part of the answer.
‘When all you have got is a hammer
Everything looks like a nail‘
- Abraham Maslow
Over the past decade behavioural economics has become big. It has become increasingly recognized that humans have cognitive biases, the systemic errors of thinking that leads to decision and judgement problems. An example is confirmation bias, where you remember or act on information that confirms your preconceived view. Another is the Law of the Instrument, an overreliance on familiar tools. And that Law can certainly be applied to the use of monetary policy and economic growth.
Start with the current backdrop. The global economy is not yet in recession, but has been disappointing. Certainly, the manufacturing sector is doing it tough (and may well be in recession). China has been losing growth momentum. And the Trade War is not helping (although the news has got a little better recently). Countries that are either heavily reliant upon manufacturing or global trade (Germany) are finding the going hard.
So the global economic sky is getting cloudy. Leading indicators are at their lowest level since the GFC. But the sky is not yet dark. Indeed, despite the economic slowing unemployment rates in most countries are at very low levels. This is helping service sectors that are mostly reporting strong sentiment. Importantly, the US consumer is still feeling pretty good and happy to spend. And equity and credit markets are not shouting of any imminent concern about the global economy. But the risks are growing.
Domestically, the economy is only in second gear. GDP growth is moving at well under a ‘trend’ (or average) pace. Both firms and consumers agree that conditions are sub-par. Wages growth and inflation is too low. Jobs growth has been strong, although the unemployment (and underutilisation) rate has risen.
Reach for the Hammer
So economic growth is not strong enough, the unemployment rate too high, inflation too low and the risks of weaker economic outcomes are rising. Over the past thirty-plus years that combination of events would have looked all the world like a bunch of nails that is need of an interest rate hammer. Indeed, the RBA has been busy thumping away, most recently cutting the cash rate by half of one percentage point in June-July. And at the time of writing investors think the hammer has further work to do. Another quarter percentage point rate cut is fully priced by end-2019, and a second reduction is priced by mid next year. At various times markets had even moved to thinking there was a very good chance of a third reduction by mid 2020!
World Business Surveys
OECD Leading Economic Indicator
But increasingly the hammer is not getting the job done, either in Australia or the rest of the world. Yes, jobs growth has been pretty decent. But neither national income growth nor inflation has risen as much as central banks would have hoped. Using the hammer in a conventional way looks like it has run its course. Global central banks have had to peek into their tool box for other instruments to use. The RBA has indicated that it has been watching their work for lessons. And that they too may have to reach for those instruments in the event the cash rate is reduced below 0.5%. Below is a list of instruments the RBA could potentially use, and a brief description of how they may work.
A. Negative interest rates
One option is to use the monetary policy hammer in an unconventional way: taking interest rates below zero. Practically, a negative rate means a borrower not only doesn’t pay any interest but actually repays less money than they borrowed! Negative rates are obviously a pretty good deal for existing borrowers. But negative interest rates only arise when the economic outlook is not normal, such as now. And that is also an environment that does not encourage a lot of new borrowing. Negative interest rates act to boost asset prices (gold, equities). And a negative rate can result in a weaker exchange rate (although this also depends upon the level of interest rates set by other countries).
Negative interest rates have come to increasingly dominate the global financial landscape since the GFC. Subsequent to the European debt crisis, the central banks of the Euro zone (the ECB), Sweden and Switzerland have all set key policy interest rates below zero. Japan did so in 2016. And if financial market pricing is anything to go by seeing the interest rate hammer being used in an unconventional way will be with us for some time to come. At the time of writing investors’ think that the cash rate could stay negative in Europe for at least the next seven years!
This is not the first time a cash rate has been negative. In the 1970s, the Swiss National Bank charged foreign depositors (investors that bought the Swiss Franc and put their money into a bank account) a negative rate as they became increasingly concerned about how high the Swiss Franc was trading. At one stage the deposit rate hit -41%! Eventually the Swiss National Bank succeeded in its aim to weaken their currency. But that was less down to the wonders of negative rates and more down to a guy with a bigger hammer (US Federal Reserve) deciding that those inflation nails needed to be smacked back into place.
But the financial system is not set up for negative interest rates. And so the ongoing use can have adverse consequences. One is that a negative cash rate may encourage households and firm to hold cash instead of putting money in the bank. And the more money that is held in wallets and not in banks the harder it is for that interest rate hammer to work. Cash holdings have been rising faster than economic growth in many countries over recent years. But it is notable that cash holdings are highest in Japan where extremely low interest rates (and inflation) have been in existence the longest (the cash rate in Japan has been under 1% for almost 25 years!).
But technology means that this might be less of a constraint in the future. In Sweden the use of cash is both relatively low and declining. But even in Sweden there is a debate about whether to completely abandon cash. Some people (older people, the disabled) may not have easy access to electronic payment systems. And sole reliance on electronic payments could potentially increase Sweden’s vulnerability to payment system failure.
Cash Rate For Selected Countries
(as at 19 Sept 2019)
Use Of Cash In Selected Countries
(% o GDP)
Another adverse consequence of negative interest rates is that it reduces banks’ profitability. As interest rates are reduced bank margins narrow. Where interest rates are lowest (Europe and Japan) are where banks are least profitable (although other factors such as being less efficient, lower credit growth and higher bad debts have played a part). And as rates go negative the problem is exacerbated further as banks are reluctant to charge negative deposit rates (but competition leads to lending rates falling).
European banks have started to charge larger firms and wealthier households a negative deposit rate (in effect, large depositors are paying a fee to have their cash stored and protected). Research suggests that the cash rate would need to be cut to somewhere between -0.35% to -0.75% before it becomes worthwhile for firms and individuals to store and protect their cash.
Central banks can mitigate the impact of negative rates on banks. One example is that they can introduce ‘tiering’ (central bank only charge banks a negative rate on part of their deposits). But that mitigates, not eliminates, the problem. Admittedly bank profitability is not something that is high on most people’s worry list. But unprofitable banks make very few loans.
Selected Country Cash Rate & Bank Return On Equity
Financial Market Pricing Of Australia's Cash Rate Outlook
(implied average cash rate by year, pricing 19 Sept)
B. Central banks provide cheap funding to banks
The central bank can also provide cheap funding to banks. This has its biggest impact when markets are closed (such as during the GFC), and banks are unable to get funding from other sources. But the ECB recently reached for this tool despite funding markets being open in order to help banks deal with the impact of negative interest rates.
Depending upon the circumstances, cheaper funding can come with conditions attached (eg, banks guarantee they will boost their lending book by a certain amount in return for the cheaper funding). Of course that assumes that the economy is in a good enough state to create the demand for more lending. And if banks can get cheaper funding from central banks it is likely to mean they may need to pay less to other lenders (eg, depositors).
C. Forward interest rate guidance
This is a tool that central banks have become increasingly adept at wielding. Forward guidance is when the central bank provide an indication on where they think the cash rate will be in the future. Forward guidance can be provided in general terms, date-based (the cash rate will be kept unchanged until a certain date) or be target-specific (the cash rate will only be changed when a certain target is hit). For example, the ECB recently announced that interest rates would stay at their current level (or go lower) until inflation converges to its target of 2%.
The RBA has already taken a step down this path, providing general guidance. In its Statement following their September Board meeting the RBA said, “An extended period of low interest rates will be required..”. An extended period of very low interest rates is consistent with current investor thinking. At the time of writing, financial markets had priced the cash rate declining by 50bp over the next nine months and then essentially remaining at that level for the following 3-4 years. Interestingly this pricing appears inconsistent with investors’ view that domestic inflation will not be over 2% for at least the next 20-30 years!
D. Quantitative Easing
Quantitative Easing (QE) is when central banks buy securities from financial markets (or in extreme cases, does direct lending). Again this tool is most powerful when (such as the GFC) no-one else is doing any buying (or lending). Central banks will typically start by buying government bonds leading to lower long-term interest rates and narrower credit spreads. In countries such as Japan and Switzerland the central bank owns so many government bonds (the Bank of Japan owns about half of the government bond market) they are buying other assets (such as corporate bonds and equities) that leads to lower financing costs for the economy.
The RBA has made it clear that if it did undertake quantitative easing it would initially buy Australian Government bonds. Currently, the RBA owns a relatively small proportion of the Australian Government bond market. The biggest holder of bonds currently are banks (to meet liquidity needs) and foreign buyers. If the RBA bought bonds from foreigners that could result in them selling $A (leading to a lower exchange rate). If the RBA bought Government bonds from banks they would need to replace them with other (higher-yielding) assets (such as State Government bonds), leading to lower credit spreads.
Major Owners Of Australian Government Bonds
(proportion of total)
Proportion Of Japanese Government Bonds Owned By The Bank Of Japan
E. Foreign Exchange Intervention
This is when the central bank buys/sells the $A to influence the level of the exchange rate. The RBA foreign exchange intervention policy has evolved since the floating of the currency in 1983. In recent years RBA intervention has been mainly focussed upon reducing volatility during periods of market dysfunction when there are not enough buyers (or sellers).
Foreign exchange intervention is very important for countries where trade is a significant part of their economy (such as Singapore). It is less clear it is as useful for a country such as Australia where trade plays a smaller role. In any event typically there is less need for the RBA to intervene as during periods of global economic weakness the $A usually declines, providing an economic cushion. Having a freely floating currency has been an important reason why the Australian economy has been able to stay out of recession since the early 1990s.
Also, given the size of currency markets it can be hard for central banks to influence $A pricing unless they are either supported by significant capital controls (rules about when money can flow into and out of a country) or is happy to accept a major problem (very weak economy or high inflation).
Currently the market is pricing that the RBA will only use the interest rate hammer. And hopefully that is the case. But the RBA has made sure it can get its hands on other tools if necessary. Like any good tradesman, when and how they use these other instruments will depend upon the situation (are funding markets open, what is happening with the $A). The RBA has also made it clear that if they have to put the hammer down, at least two other tools are likely to be picked up.
But the bigger picture question is if the hammer doesn’t get the job done, why do we think these other tools will? After all, we have seen the results in Europe and Japan where neither economy is exactly humming. If necessary the RBA will use these other tools. But if they do have to use them it would be good to see other trades (fiscal policy) also on the job.
We live in interesting times!
Peter Munckton - Chief Economist