It was clear the RBA needed to raise rates this year before the inflation data...

The RBA should continue to wind back the policy stimulus delivered during the pandemic when it meets next month. The RBA will stop buying government bonds and there is a strong risk that it signals it could start raising the cash rate this year, with CCI analysis showing that a standard policy reaction function relying on the RBA's existing economic forecasts already pointed to higher rates.

COVID might yet derail economic recovery and the RBA  has said it will be reactive in withdrawing stimulus, but this analysis underscores the risk that the RBA follows its peers in raising interest rates.  (NB: This memo was published internally approximately one month ago, notably in advance of this week's inflation data that strongly reinforce its findings...) 

The RBA meets for the first time this year on 1 February and should continue to withdraw the policy stimulus delivered during the pandemic. The process of withdrawing stimulus began last year when the RBA closed the Term Funding Facility to new applications and later abandoned the 0.1% target for the 3-year government bond yield. In February, the RBA will stop buying bonds when it reviews its quantitative easing programme and there is a strong risk that it changes its “forward guidance” to signal that it could start taking back its emergency rate cuts as soon as this year.

Changing the forward guidance on the cash rate will be an awkward concession by the RBA given that it has long stressed that rate hikes were unlikely before 2024, or 2023 at the earliest. This has contrasted with market pricing, where investors have long expected that the RBA would start raising rates this year.

Speaking last year, Governor Lowe sought to rationalise the gulf between market pricing of hikes in 2022 with its forward guidance that hikes were unlikely before 2024. One explanation was that the market was misreading the RBA’s reaction function; for example, wrongly thinking that the RBA would raise rates to rein in house prices. An alternative reason was that the market expected inflation to pick up “much more quickly” than forecast by the RBA, an outcome that he thought had “a very low probability because it would require wages pick up very substantially and probably above 3%”.

Putting aside Lowe’s emphasis on the wage price index – which will be slow to reflect a tighter labour market because it doesn’t capture compositional shifts in the workforce – CCI's research team explored the outlook for interest rates using a Taylor rule version of the RBA’s reaction function, namely:

Policy interest rate = real neutral rate + inflation rate + 0.5*(inflation rate – inflation target) + 2*(NAIRU – unemployment rate)

where:

• for the real neutral rate we compared market pricing with RBA assumptions;
• inflation rate = RBA’s forecast of the underlying inflation rate;
• inflation target = the 2.5% midpoint of the 2-3% target band;
• NAIRU = Governor Lowe’s judgement-based assumption of a range from the high 3s to the low 4s; and
• unemployment rate = RBA’s forecast of the unemployment rate.

with the RBA’s forecasts for inflation and unemployment taken from the November Statement on Monetary Policy, which will be updated next month.

When the RBA has met its inflation target and the economy is at full employment, the Taylor rule reduces to:

Neutral nominal cash rate = real neutral cash rate + inflation target.

Like other advanced economies, the neutral cash rate in Australia has declined over time, where the market pricing of the neutral cash rate broadly tracked the RBA’s published estimates over the years.  However, the two dramatically parted company during the pandemic. Governor Lowe recently put the neutral rate at 3.5-4%, or 1-1.5% in real terms, similar to the RBA's pre-pandemic estimates. This contrasts with current market pricing of a terminal cash rate of just over 2%, implying a negative neutral real cash rate of about 0.5%.

While the neutral rate could be lower than the RBA’s believes given the difficulty in estimating neutral policy rates, economic theory suggests that it is hard to construct a scenario where the neutral rate is sustainably negative given the influence of productivity and population growth. Similarly, in terms of other possible forces on the neutral cash rate, lending spreads on mortgages have drifted a little lower until recently, while estimates of overseas neutral policy rates are still positive, notwithstanding research that past pandemics have depressed neutral rates.  

However, regardless of who is right about the exact level of the neutral cash rate, the RBA's November forecasts for inflation and unemployment already pointed to a higher cash rate in 2022.  That is, relying on the RBA's existing economic outlook: 

• On the market pricing of the neutral rate, the RBA's assumption that the NAIRU ranges between the high 3s and low 4s points to a cash rate of 0.6-1.6% by the end of 2022; and 
• On the RBA's view that the neutral rate hasn't changed much during the pandemic, the RBA's range for the NAIRU would point to a cash rate of 2.1-3.6% by the end of 2022.  

The RBA might be more than willing to overwrite such simple calculations, signalling that it plans to be reactive in setting policy because it has been burnt by persistently overestimating inflation over Lowe's term as governor, but there are other important factors at play when judging the stance of policy. 

Firstly, the NAIRU might not be as low as the high 3s/low 4s range assumed by the RBA, which would place upward pressure on interest rates. Lowe's view on the NAIRU is heavily influenced by the pre-pandemic experience of the USA, where very low unemployment was required to boost wages.  However, our replication of the RBA's inflation model suggests that the NAIRU is currently higher at about 5¼%. The 95% confidence interval around this estimate is very wide at 4½-6%, but this raises the possibility that there is much less spare capacity in the labour market than thought by the RBA.  

Secondly, the focus of the Taylor rule on the cash rate omits the stimulus provided by the RBA's purchases of government bonds. As Deputy Governor Debelle noted last year, "the stock of central bank bond purchases matters rather than the flow", such that the "stimulus remains in place even when the bond purchase programme finishes the stimulus only begins to unwind as the bonds that the central bank has bought mature.”

Comparing the economic impact of conventional with unconventional policy, recent RBA research suggests that a 100bp rate cut boosts output by 0.8%, while international research suggests that increasing a central bank's balance sheet by 1% of GDP increases output by about 0.2%.  Making the strong assumptions that the international findings apply to Australia and that the loans made under the Term Funding Facility have a similar effect to bond purchases, this suggests that a 4pp increase in the RBA's balance sheet as a share of GDP has the same impact on output as a 100bp rate cut.    

Using this assumed relativity to incorporate the impact of both the RBA's bond purchases and the Term Funding Facility, the effective cash rate that factors in the stimulus from unconventional monetary policy is strongly negative. The Taylor rule prescribed a strongly negative cash rate at the worst point of the pandemic, where the unconventional policy was designed to deliver extra stimulus during the pandemic given the RBA was reluctant to follow the BoJ and ECB in adopting negative interest rates.

However, the rapid economic recovery from the recession of 2020 - which took both the market and the RBA by surprise - suggests that a negative effective cash rate is no longer needed, given that the Taylor rule points to higher interest rates in 2022 regardless of relying  on either market or RBA's view on the neutral cash rate.

This reinforces the view that the policy stimulus delivered at the height of the pandemic is no longer warranted,  where the market pricing of rate hikes in 2022 is actually consistent with a usual policy reaction function and the RBA's own economic forecasts.  COVID could still derail the economic recovery and the RBA clearly wants evidence of a sustainable return of inflation to the 2-3% target band before it takes stronger action in withdrawing policy stimulus, but all this points to a strong risk that the RBA raises rates this year.

Please note this memo was prepared and published internally one month ago. The recent inflation data reinforce its findings and reaffirm the conviction that the RBA will commence raising rates in late 2022.    

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