Commentary |
8 May 2020

Normality is at least a couple of years away

While the medical prognosis looks less alarming, the economic prospect is as grim as ever. The Reserve Bank has done what it can, now it's up to the government, writes Stephen Grenville. Originally published in the Australian Financial Review.

Stephen Grenville
Stephen Grenville

The RBA was quick off the mark in responding to the crisis, with its policy initiatives in mid-March. With the epidemic aspect of the crisis now a little clearer, the Statement on Monetary Policy offered an opportunity to reassess. While the medical prognosis looks considerably less alarming than envisaged in the early epidemiological modelling, the economic prospect is as grim as ever. As a result, the Statement offers much fascinating detail on the evolving downturn and the possible shape of the recovery, but no changes in overall assessment.

Back in March, while there was debate on whether the recession would be look like a V, W, L or U, its profile was clearly not going to fit any simple alphabet shape. Those sectors of the economy which had to close down were clearly very substantial. Thus the initial hit would be huge.

Then, as restrictions were relaxed, there could be a reasonably rapid return towards normality. The unknown was the timetable.

Looking further ahead, some sectors wouldn’t be returning to normal in the foreseeable future. No matter how effective the stimulus, the productive potential of the economy has been reduced, debt burdens will be higher, some businesses will not revive and precautionary behaviour will persist.

We don’t know much more about the key issue of timing than we did in March. The opening-up process was always going to be tentative and experimental. We already had a good reading of the RBA’s thinking on the cyclical profile from Philip Lowe’s speech on 21 April: output down 20% in the June quarter, with recovery starting in the September quarter. Unemployment would register 10%, with many more hidden by the Jobkeeper wage subsidy.

The Statement’s alternative scenarios are evenly balanced between optimism and pessimism. Even the optimistic scenario has normality ‘a couple of years away’.

It’s not surprising, then, that the RBA hasn’t seen the need to tweak the March policy package much.

Conventional policy – the short-term interest rate – was set at effective-zero in March. Forward guidance assured financial markets that this would stay for the duration. Nothing more to do here.

The March package had two more objectives. First, to encourage the banking sector to play a shock-absorber role by funding the cash-flow consequences of business hibernation and recession. Second, to ensure that the government could fund the huge deficit in prospect.

These objectives are taking the RBA into territory which has become conventional for many other central banks since the 2008 GFC, but where the RBA hasn’t ventured, at least in the post-1980s deregulated world.

There was clearly a huge need for funding to bridge the cash-flow shock. The RBA can’t help these borrowers directly -- it has no mandate to lend to the private sector. But its $115 billion of new Term Lending Facility encourages banks to maintain existing loans and maybe even expand lending. Only $4 billion of the TLF has been drawn so far, but business borrowing picked up sharply in March.

As part of the March package, the RBA overcame its earlier lack of enthusiasm for quantitative easing and began yield-curve management, buying three-year bonds to keep the yield at 0.25%.

This has dual objectives. It facilitates and cheapens commercial banks’ funding. This has been brought down by around 75 bp. At the same time, it underwrites budget funding, by standing ready to buy any three-year bonds the AOFM issues.

The RBA does this indirectly, buying in the secondary market. But when the market knows that it can on-sell at will to the RBA, this is not much different from the RBA purchasing the bonds directly.

Already, in just a month, the RBA has purchased over $50 billion of government bonds, not far short of half the size of the proposed budget stimulus. The Bank hopes that a more moderate pace of purchase will be enough not just to keep the three-year rate at 0.25%, but to keep the 10-year rate at its current extraordinarily low yield, under 1%.

Let’s see how this works out over time. It would be unfortunate if the Bank extends its yield-curve management to the long end of the curve, as this commitment could be difficult to unwind when interest rates need to return to normality.

The message of the Statement is that the Bank, in its March measures, has done all it can sensibly do to help bridge the downturn. The heavy-lifting has to be done with fiscal policy.

Stephen Grenville is a non-resident fellow at the Lowy Institute and former deputy governor at the Reserve Bank.