Via Bill Evans of Westpac on the RBA and the Australian dollar:
The Reserve Bank Board meets next week on December 3.
As we have argued consistently, despite confident market pricing at various stages over the last few months, we see little chance that the Board will decide to change the cash rate in December. However we do expect an even lower cash rate in 2020 than had been our view.
Westpac now expects two rate cuts next year from the RBA with the cash rate cut to 0.25% in June 2020. Quantitative Easing is also expected to begin in the second half of 2020.
Westpac has not changed its rate call for the RBA since July 24 this year. At that time we envisaged two more cuts from the RBA in October 2019 and in February 2020.
That would have seen the terminal cash rate in this cycle at 0.5%.
We expected that the final cut in February would have been insufficient to provide the RBA with enough comfort that the economy was moving into line with their growth; inflation; and unemployment targets.
Consequently, we expected that the RBA would have seen the need for unconventional policies, largely centred around the purchase of Australian government securities and clear forward guidance, to maintain the emphasis that it was still easing policy.
That emphasis was going to be important to maintain downward pressure on the Australian dollar, in particular.
Of course there was always the option to push the cash rate even lower than 0.5% but we assessed that the RBA would see the impact on confidence and inflationary expectations of even lower rates to be counter–productive.
The minutes of the November RBA Board meeting provided some support to our view when it was noted the Board “also discussed the possibility that a further reduction in interest rates could have a different effect on confidence than in the past, when interest rates were at higher levels”.
That observation was certainly consistent with the 5.5% fall in the Westpac MI Consumer Sentiment Index following the announcement of the rate cut in October. Concerns around the implications of ultra– low rates for the state of the economy along with negative publicity around the limited impact of rate cuts on private sector rates are likely to have largely explained that development.
Indeed, since the RBA started this current easing cycle, the Index has fallen by 4.2% to now be firmly in the range where pessimists outnumber optimists.
However in a speech to the Australian Business Economists last night the Governor stated, “Our current thinking is that QE becomes an option to be considered at a cash rate of 0.25%, but not before that.” During the presentation he noted that 0.25% represents the Effective Lower Bound of the cash rate as the interest rate paid on reserves at the RBA is 25bp under the prevailing cash rate and therefore would mean the “Reserve Bank would already be at zero”.
That is a clear signal to us that the RBA will be prepared to cut the cash rate down to 0.25%, rather than the lower bound we had expected of 0.5%.
Accordingly, we have adjusted our cash rate forecast to include a second cut in June 2020 following the cut we expect in February.
We have also delayed the timing of the expected introduction of Quantitative Easing.
In identifying the likely timing of the second cut we need to make a number of points:
• The Governor has indicated considerable reluctance to adopt Quantitative Easing. Consequently the RBA will be attracted to convincing the market that it has a strong commitment to ease policy, to keep downward pressure on the AUD, without actually implementing its last cut too soon.
• It is also likely to be attracted to holding back its final cut until after it gets an indication around the structure of the Federal Budget.
• Our forecast is that the unemployment rate is likely to reac 5.6% by March 2020 and hold around that level through 2020. Consequently, the case for further stimulus following the February cut will be strong throughout 2020 with no apparent progress in bringing the unemployment rate back towards full employment.Taking these issues into account we expect that a cut in June to 0.25% would be the most prudent approach.
We see this June RBA rate cut as complementing fiscal policy – with the May Federal Budget likely to include some new policy measures (Westpac strongly supports a partial bring forward of the already legislated personal income tax cuts, which are not due to be implemented until July 2022). We doubt that any package of budget measures will be sufficiently expansionary to preclude the need for additional monetary policy easing.
The timing of the expected follow up adoption of Quantitative Easing must be impacted by the Governor’s comment “ there is no smooth continuum running from interest rate reductions to quantitative easing. It is a bigger step to engage in money– financed asset purchases by the central bank than it is to cut interest rates”.
Taken at face value, it would appear that the hurdle for Quantitative Easing is high with a further deterioration in the unemployment rate and, potentially, the inflation rate required.
However we expect that with the unemployment rate “stuck” at around 5.6%; the US Federal Reserve easing rates (we expect three FOMC rate cuts in 2020) and no further interest rate flexibility available, Quantitative Easing will surely become an attractive option.
Note that the Governor did observe that “there are, however, circumstances where QE could help… QE does put additional downward pressure on both interest rates and the exchange rate”. However, as discussed, he did put a fairly tough pre condition for using QE, “if we were moving away from, rather than towards, our goals for both employment and inflation.”
Moving too slowly towards QE runs the risk of an unwelcome rise in AUD.
If we look forward to the second half of 2020, with no interest rate flexibility available, and the RBA still holding, at best, its current inflation and unemployment forecasts – 1.9% trimmed mean inflation in 2021 (outside 2–3% target zone); 2.3% wage inflation in 2021 (totally inconsistent with the inflation target);
and 4.9% unemployment rate (well above the 4–4.5% full employment target); it seems a reasonable prospect that the QE option will become quite attractive.Note that we qualify the comment “at best” given our own comparable forecasts of 1.7%; 2.3% and 5.3% respectively.
We also expect that a small ($2–3 billion) open ended monthly commitment to purchases would have a meaningful impact for the RBA.
The Australian Dollar
Westpac’s forecast for the AUD, since July 24, have been a narrow range of USD0.66 in the first half of 2020 followed by USD 0.67 in the second half of 2020.
We remain comfortable with that view given the delayed introduction of QE being offset by the lower cash terminal rate.
And note that these forecasts are in a world where the Federal Reserve does three rate cuts in 2020 and “risk off” remains the dominant theme.
Conclusion
The RBA has indicated it is prepared to push the cash rate to 0.25%.
Westpac has always argued that monetary easing will be necessary in 2020 but assessed that the RBA would see 0.5% as the effective lower bound for the cash rate.
The Governor has corrected that view and we have adjusted our forecasts accordingly to anticipate a second rate cut to 0.25% in June 2020.
Furthermore, while detecting a reluctance to adopt Quantitative Easing we expect that economic conditions in the second half of 2020, coupled with the need to maintain a credible easing policy, will see the RBA adopt QE in the second half of 2020.
David Llewellyn-Smith is Chief Strategist at the MB fund and MB Super which is overweight international shares that will benefit from a falling Australian dollar.
