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The RBA’s bond splurge has a big sting

The central bank is fixated on creating jobs, but its strategy is not enough to do that, and there could be a nasty end.

Andrew MohlContributor

We have never seen such a combination of expansionary monetary and fiscal policy as today.

Cash rates are being set by the RBA at 0.1 per cent and the federal budget deficit is in the order of 10 per cent of GDP in 2020-21.

Philip Lowe has made it clear he intends to keep the cash rate at 0.1 per cent until the underlying rate of inflation is back in the target range of 2 to 3 per cent.  Dominic Lorrimer

In car-racing terms, the driver has the foot on the accelerator flat to the floor.

An economic boom is likely to follow through 2021 if the economic textbooks we read at school and university mean anything.

And then what?

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These post-COVID-19 extreme settings of policy are obviously not sustainable.

On the fiscal front, the prospect is for the deficit to fall back towards about 3 to 4 per cent of GDP over the next three years, providing the government lets the automatic stabilisers work and resists the temptation to keep pump-priming.

Cash rates at 0.1 per cent and asset price bubbles indeed look like two peas in a pod.

This may be enough to keep our AAA credit rating, but we are clearly on notice from the ratings agencies.

Beyond 2021, though, this fiscal tightening will be a drag on growth in economic activity.

On the monetary policy front, RBA governor Philip Lowe has spoken clearly that he intends to keep the cash rate at 0.1 per cent until the underlying rate of inflation is back in the target range of 2 to 3 per cent.

Wages are now growing by 1.5 per cent and he wants to see them rise by 3 to 4 per cent, which would be consistent with inflation back in the 2 to 3 per cent range.

He believes this will not be the case until at least 2024.

In effect, he is saying he has no intention of changing the lowest cash rate in history for the next three years.

Unlike fiscal policy, which will progressively revert towards more normal settings, the RBA intends to keep its cash rate policy unchanged.

Today’s RBA has a fixation on employment and wages like no RBA before it.

Yet, the transmission mechanism from ultra-low interest rates set by the Reserve Bank to higher employment and wages remains opaque.

In the same speech in which he promised low cash rates for years, the RBA governor lamented the low and falling level of private non-mining business investment as a percentage of GDP.

Investment is the long-term key to higher productivity and growth in real wages; yet, so far, lower and lower cash rates have done nothing to turn on the business animal spirits.

Underlying growth

It would seem that underlying growth in markets, government approval processes, taxation, industrial relations, regulations, long-term confidence, et cetera, are a lot more relevant to investment decision-makers than interest rates.

None of these, by the way, have anything to do with monetary policy.

Nevertheless, the RBA is really putting its balance sheet on the line in its pursuit of record low bond rates.

It is buying hundreds of billions of dollars of government bonds to drive bond prices up and yields down.

The other side of this coin is bank deposits are flooding into the private banking system as the federal government racks up its huge deficit and the cash is not being removed from the financial system by sales of bonds to the private sector as would traditionally have occurred.

Many people independently observe these two events and fail to realise they are inter-related.

The RBA has, of course, used its balance sheet in the past to intervene in markets.

Its intervention in the foreign exchange market over two decades to 2004 was proven to be timely, limited and profitable.

The RBA would buy the Australian dollar only when it was heavily sold down and sell it later when it was overbought. In the process, it smoothed the volatility of the Australian dollar and made more than $5 billion in profits, which were transferred to the federal government through higher dividend payments.

Today’s intervention in the bond market is very different.

Principal player

The RBA has moved from a fringe player to the principal player in the bond market to drive prices up, and yields down, when the prices were already historically high.

The three-year bond at the 0.1 per cent targeted by the RBA equates to an asset trading at 1000 times annual earnings.

Like its central banking peers overseas, its intervention is virtually unlimited and continuing.

By artificially lowering the bond yield or risk-free rate, the RBA is also affecting the pricing of other assets, particularly shares and property.

Cash rates at 0.1 per cent and asset price bubbles indeed look like two peas in a pod.

The RBA has the firepower to do this bond market intervention for years as taxpayers, in effect, fully underwrite its activity.

Unlike the past foreign exchange intervention, though, there is little prospect of all those bonds it is buying being later sold back to the private sector and the RBA, in effect, clearing its position.

Inter alia, we should prepare for the prospect of multibillion-dollar losses in the RBA’s balance sheet as those bonds it is buying eventually fall in price and yields start to rise back towards more normal levels.

Those losses will reflect in lower dividends from the RBA to the federal government and, in the worst case, the need for recapitalisation of the central bank. The consequent increase in federal government debt will then be a drag on spending in key priority areas.

King Canute couldn’t hold back the tide and nor can the RBA, the US Federal Reserve, or any other central bank.

Measure
Measure
Summary | 15 Annotations
order of 10 per cent of GDP in 2020-21
2021/03/15 06:45
r AAA credit rating,
2021/03/15 06:46
et range of 2 to 3 per cent.
2021/03/15 06:46
growing by 1.5 per cent and h
2021/03/15 06:46
by 3 to 4 per cent,
2021/03/15 06:47
e case until at least 2024.
2021/03/15 06:47
Unlike fiscal policy, which will progressively revert towards more normal settings, the RBA intends to keep its cash rate policy unchanged.
2021/03/15 06:47
Investment is the long-term key to higher productivity and growth in real wages;
2021/03/15 06:48
lower cash rates have done nothing to turn on the business animal spirits
2021/03/15 06:48
cash is not being removed from the financial system by sales of bonds to the private sector as would traditionally have occurred.
2021/03/15 06:49
it smoothed the volatility of the Australian dollar and made more than $5 billion in profits,
2021/03/15 06:50
Like its central banking peers overseas, its intervention is virtually unlimited and continuing.
2021/03/15 06:51
artificially lowering the bond yield or risk-free rate
2021/03/15 06:51
, particularly shares and property.
2021/03/15 06:51
the need for recapitalisation of the central bank.
2021/03/15 06:52