History tells us that when an economy is hit by a black swan event, pull every policy lever you have, quickly and hard. And this is what the Reserve Bank has done today with its announcement. Using a five pronged approach, the RBA remains focused on supporting jobs and incomes and ensuring the ongoing functioning of lending markets, by
- cuting the official cash rate to 0.25%
- announcing a version of Quantitative Easing (QE) package aimed at keeping the three year bond yield at, or close to, 0.25%
- providing strong forward guidance
- announcing a three year funding facility to drive lending to small and medium sized businesses
- providing banks with some relief on exchange settlement balances.
This is in addition to providing liquidity through the repo market which was announced earlier this week. All of these actions are aimed at ensuring liquid, functioning credit markets and lowering interest rates from overnight, variable rates right across the yield curve to longer-dated securities. Interest rates from overnight to three years will be anchored at 0.25%.
Australia will almost certainly record a recession – the first in 29 years. Importantly, however, Australia has a well-capitalised and liquid banking system as well as a central bank with a very healthy balance sheet. And, we learnt a lot during the GFC. Nonetheless, maintaining credit growth and efficient working of the financial system will be important. There is concern around the cashflows of businesses, especially small business, which will impact the ability to service debt, to ride out the economic dislocation and keep people in jobs.
While interest rates – both short and long term - were already low, the RBA's measures will still have an impact on the economy.
In the current environment, lower interest rates may not encourage spending but it still helps improve cashflow for households and small businesses in particular. It will reduce minimum payments on residential mortgages, for one. Some households – especially those where budgets are tight or income drops – are likely to spend some or all of that additional disposable income. Many households may – if they are able to – boost precautionary savings, particularly given that we have already seen a unemployment expectations rise sharply. By comparison, the household savings rate peaked at almost 11 per cent of disposable income after the GFC, compared to 3.6% at the end of 2019. While boosting savings does not boost current economic activity, it does assist households rebalance their balance sheets, leaving them better placed to spend in the future.
And the cuts help the currency to work as an automatic stabiliser. The Australia dollar is now at decade lows which helps to boost export revenue, albeit constrained by supply chain and trade avenues being temporarily disrupted.
Moreover, the RBA's unconventional measures, namely QE, will push liquidity in to the financial system and flatten the yield curve by lowering long term interest rates, which flows through to fixed rate lending. In Australia’s case, QE will be in the form of yield curve control, where the RBA will purchase government bonds to keep the 3 year Government bond yield at “around 0.25%”, as well purchasing bonds to provide liquidity if there is dislocation in financial markets. Already we have seen a considerable drop in bond yields today after the announcement. When the RBA buys these securities, it drives prices up and reduces the interest rate (or yield).
The targeted nature of fiscal policy means it is an effective tool when facing supply and demand disruptions. In addition to the RBA actions, the Federal government will provide support, through the Australian Office of Financial Management to the non-bank financial sector, small lenders and the securitisation market. That is in addition to its package last week of direct support for the health sector; stimulus aimed at maintaining jobs, credit and investment particularly for small businesses and cash payments to some households; a $715 million support package for the aviation industry. And it has a second significant stimulus package expected within days. State Governments are also assisting with payroll tax relief.
Australia in particular is well placed to borrow and support the economy. We have relatively low government debt– according to the OECD, Australia's gross government debt is 64% of GDP, compared to Canada at 114%, Germany at 81%, UK 112%, US 136%, and Japan 237%. We are one of only eleven AAA rated economies, with net government debt less than 30% of GDP.
A key question in terms of what the recovery may look like is how much of the lost activity is permanent versus temporary. If it is skewed towards permanent, then recovery takes longer as you wait for B.A.U to lift growth. If it is skewed towards temporary, then recovery is aided by the ‘snap back’. For example, an annual sporting event that is cancelled versus delayed.
The bad news is, this no longer looks like an event that will cause temporary economic disruption with a recovery in three to six months. The good news is that nor is it likely to be a ‘lost decade’ like we saw during the Great Depression. Most likely, we will see a period of economic disruption and slow recovery that takes one to three years. The best news is that Australia is comparatively well placed to weather the catastrophe: we are leveraged into China stimulus; we are well placed to push fiscal stimulus; our financial system is robust.
But we are not well placed to look to the household sector to drive the recovery. Household debt is high by both historical standards and compared to other countries, where the household sector deleveraged post GFC (chart). And even before the impact of the pandemic, unemployment was well above full employment (at 5.1% in February, compared to full employment of 4.5%) and core inflation below the target band, at just 1.6% y/y.
What the RBA will be hoping is that its forward guidance provides certainty to households, businesses, financial institutions and investors, and that interest rates will remain low for a prolonged period. This can help to anchor longer term interest rates as well.