Economists again calling on RBA to adjust QE taper in light of recession

Christopher Joye

Coolabah Capital

Interesting thoughts here from UBS on the RBA's QE program (see below), which reflects the emerging consensus, although I would personally like to secure some more data and information before reaching the conclusion that the RBA will indeed harness its much-mooted "flexibility" apropos QE! After all, there is still a lot of time until 7 September...

Ever since the RBA took the decision to shift away from nowcasting and data-dependence, and sought to rely on its very uncertain forecasts of the future, its decision-making has become correspondingly more capricious/unpredictable. 

In July it said it was appropriate to taper its QE program in September, which it revealed was a "line-ball" call given the advent of lockdowns and their uncertain economic consequences. At that time, it assumed the lockdowns would be short and sharp.

By the time August came around, the lockdowns were far worse than the RBA had banked on, and yet it oddly published a new set of forecasts that were even more optimistic than those it had relied on in July, which it said made its September taper more confident and certain. This puzzled virtually all economists.

It seems the RBA has used the recovery experienced after the lockdowns in early 2020 to generate forecasts for the rebound after the current recession. 

Yet we know the reaction this time will be much more sombre: there is no more Commonwealth housing stimulus or generous JobKeeper to flood the economy with cash. 

The RBA's term funding facility, which lent banks $188 billion at an incredibly low cost of 0.1% pa, has also expired, which means mortgage rates have started increasing, not decreasing. 

And then there is just the sustained increase in risk aversion and caution following never-ending lockdowns compared to the expectation last year that the big lockdowns would be our last.

Finally, there is the concern that vaccines will not be a silver bullet given highly impaired efficacy against Delta (see more below). 

The RBA did, however, attach the big caveat in August that if the health situation worsened, and its forecasts were materially downgraded, it will consider deferring its QE taper...It amplified this caveat in its August Board Minutes. After the sentence, "the bond purchase program will continue to be reviewed in light of economic conditions and the health situation, and their implications for the expected progress towards full employment and the inflation target", the RBA added the highlighted words below:

The Board would be prepared to act in response to further bad news on the health front should that lead to a more significant setback for the economic recovery.

The media and the market took this to mean that a QE taper deferral was on the cards, smashing down the Aussie dollar and bond yields on the expectation that the RBA would not reduce QE in the face of major downgrades to its forecasts, and the stock of bonds held by the RBA would be bigger than the market had previously supposed.

August has seen almost 60% of the national economy in deep recession with NSW and Melbourne in open-ended lockdowns. Both the severity of these lockdowns and the COVID transmissions have been much worse than the RBA expected (the RBA assumed only Sydney was in lockdown until the end of September, whereas now we have all of NSW and Melbourne wilting under the spectre of never-ending lockdowns).

This means that GDP growth in both Q3 and Q4---given the extension of the NSW lockdowns into October and possibly November, and the likelihood of other States going into lockdown (cf. NT this week)---will be way below the RBA's forecasts. In fact, many economists are saying that Q3 GDP will be more than 2 times worse than the RBA's own downside scenario.

Combined with awful wages data yesterday for the June quarter, notably before the lockdowns, which suggest that the jobless rate is miles away from NAIRU, it is hard to imagine a bigger set of downgrades to the RBA's assumptions. Former RBA economist Peter Tulip wrote on Twitter:

The Wage Price Index is one of the best indicators of the tightness of the labour market. With 0.4% growth in the quarter and 1.7% in the year to Q2, the 4.9% unemployment rate is well above the NAIRU. Anecdotal reports of skill shortages and wage pressures are never reliable.

Add in the news that Pfizer is only 42% effective against symptomatic infection against Delta, which means vaccines are not a panacea to normality, as the RBA had hoped, it is clear there is a credible case the central bank should use the "flexibility" it has promoted in its QE program to increase or decrease purchases to do something more.

Yesterday we saw this flexibility in NZ, with the RBNZ deferring a hike in interest rates, which was otherwise 100% priced by the market, simply because the nation is in a short lockdown due to a tiny number of infections.

While UBS is now confident the RBA's QE taper will be deferred, I will delay my own judgement until we get more data and information coming into the September board meeting. The excerpt below is a quote from UBS's research:

UBS: RBA wants >3% y/y wages; UBSe: COVID lockdown to see RBA delay QE taper

Overall, the previously stronger than expected labour market saw us revise up our outlook for wages to pick up solidly to ~2¾% y/y by end-22. However, the escalating outbreak of COVID, & resulting lockdown in NSW, and now large parts of Australia, now means less pressure in the labour market. The risks around our base case of a lockdown in NSW for all of Q3 now appear to be for a longer and broader lockdown. Hence, we revert back to a more moderate increase in WPI to ~2½% y/y by end-22 & see softer wages than the RBA’s Aug-SOMP baseline in 2H-21. That said, the supply disruptions – which are also reflecting global issues – still suggest that TM CPI will pick-up to ~2% y/y. Meanwhile, the RBA has been generally been on the dovish side of expectations for wages and inflation, and today’s data supports their view. They have made very clear the required ‘condition’ for rate hikes is actual wages of >3% y/y, to be consistent with CPI sustainably within the 2-3% target band. The RBA has seen this as still ‘some time’ away, and we note it just got ‘further away’. Just how far away is unclear, given the uncertainty of the current lockdown, but tomorrow’s labour force survey will give an early read of the initial impact. More broadly, the RBA’s August SOMP was (strangely) optimistic on the impact of COVID on the economy. However, the minutes specified they “would be prepared to act in response to further bad news on the health front should that lead to a more significant setback for the economic recovery”. Hence, we now shift our view from a risk scenario to a base case, & expect them to delay July’s decision of a planned taper of QE scheduled for early September. Specifically, at the RBA’s September 7 meeting we expect they will announce a decision to keep the current QE purchase pace of $5bn/week, rather than reducing it to $4bn/ week. The risk now appears to be for an increase in QE ahead, rather than a decrease.

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Christopher Joye
Portfolio Manager & Chief Investment Officer
Coolabah Capital

Chris co-founded Coolabah in 2011, which today runs over $8 billion with a team of 26 executives focussed on generating credit alpha from mispricings across fixed-income markets. In 2019, Chris was selected as one of FE fundinfo’s Top 10 “Alpha...

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