In the AFR I write that the Reserve Bank of Australia’s Governor Phil Lowe did a sublime job this week of radically recalibrating flawed market perceptions of the central bank’s monetary policy posture while quietly, yet brutally, steam-rolling "short-sellers" that were questioning his commitment to unconventional stimulus. Excerpt only enclosed:

All of this brings me to Lowe’s blockbuster speech this week. Traders and economists had convinced themselves that they could force the RBA to discard its 3-year “yield curve control” policy, whereby it targets keeping 3-year government bond yields at 0.1 per cent, because of its struggles to defend the policy in recent times. In particular, some in the market were aggressively betting against 3-year Aussie yields remaining at 0.1 per cent by short-selling the relevant bonds and lifting yields above the RBA’s official target.

These traders were encouraged by chatter that the RBA was a reluctant QE participant, which was ostensibly reinforced by an awkward and unnecessarily academic debate between Labor politician Andrew Leigh and the RBA on whether they could do more. This left the impression that the RBA was sceptical about the benefits of additional QE despite its restraint on the exchange rate, incentivising traders to take Lowe on.

The brewing battle resembled a central bank trying to defend a currency peg. Every day trading desks were advising clients that there were mounting questions regarding the RBA’s credibility. As long-term rates started to soar around the world in February, some offshore investors felt the RBA’s battle with markets was becoming a test-case for all central banks.

On Tuesday, the RBA delivered a savage knock-out blow to the short-sellers by two brutal means. First, they stopped the Commonwealth treasury lending-out 3-year government bonds, which partially denied short-sellers access to these assets to dump on market. This meant the main lender of 3-year bonds was the RBA itself, as their single largest owner (via QE). The second hammer was the RBA massively increasing the cost of borrowing these bonds, making it prohibitively expensive to short-sell them.

In just one day Martin Place brought short-sellers to their knees, and 3-year government bond yields rapidly converged back to the 0.1 per cent target. This was followed on Wednesday by Lowe’s speech, which was, as the governor remarked afterwards, designed to deliver some “clear messages” to investors.

The first was that contrary to widely-held expectations, “the Bank remains committed to the 3-year yield target”. In case you missed that message, Lowe repeated it: “We are not considering removing the target or changing the target from 10 basis points”. The only question was whether “to keep the April 2024 bond as the target bond, or to move to the next bond – that is the November 2024 bond – later this year”.

One bank commented that there was substantial interest in buying Aussie government bonds after “Lowe reiterated the RBA's commitment to its 3-year bond yield target, which we see as a response to markets challenging the credibility of the policy”.

Lowe’s second message was that ( silly ) expectation for “possible increases in the cash rate as early as late next year and then again in 2023” were plainly wrong. Or, in Lowe’s blunt words: “This is not an expectation that we share.” And by “we” he means the people that set interest rates!

A third message was that the RBA is comfortable with the idea of increasing QE whenever it needs to, as it did a couple of weeks ago when it bought $4 billion of bonds on a single day. “We remain prepared to alter the timing of purchases under the current programs in response to market conditions,” Lowe affirmed. “We did this last week when liquidity conditions deteriorated...and will do so again if necessary.”

The fourth message was that markets should be pricing in a high likelihood of QE3 after the second $100 billion bond-buying program ends. “Later in the year, the Board will also consider the case for further extending the bond purchase program,” Lowe stressed. “We are prepared to undertake further bond purchases if that is required to reach our goals.”

The final, and arguably most significant message, was that the RBA has materially lowered its estimate of its “full-employment” target down to a jobless rate in the low 4 per cent range. Only a few years ago this was figured to be 5 per cent. When asked by the AFR’s John Kehoe whether full employment could be consistent with a jobless rate of just 3-point-something per cent (as has been the case in the US), Lowe responded that this was “entirely possible”.

“I certainly hope, and it’s not inconceivable, that we could sustain an unemployment rate in Australia starting with a 3,” Lowe said. This column foreshadowed that a 3-point-something per cent full employment estimate was plausible only a week ago.

Read the full column here.

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