Monetary Policy – Page 116 – Digital Finance Analytics (DFA) Blog

RBA On Inflation Targeting and Economic Welfare

RBA Governor Philip Lowe spoke today, and there were some important points.

First, expect rates to be lower for longer. ” It is highly unlikely that we will be contemplating higher interest rates until we are confident that inflation will return to around the midpoint of the target range”.

Second, the RBA has more capacity to cut if required (we think they will).

Third, moving the 2-3% inflation target band is not something they would want (the Treasurer is currently reviewing the RBA’s mandate and target!). They do not want to “shift the goalposts”!

Here is the speech:

I would like to start by winding the clock back, not by three years, but instead by 40 years. It was 40 years ago that I started studying economics in high school in Wagga Wagga. I sat the 3 unit economics exam for the Higher School Certificate (HSC) in 1979. At that time, the standard exam question was in two parts: why did Australia have both high inflation and high unemployment and what should policy do about it? I recall writing numerous essays on this troubling topic.

I also recall learning about the Misery Index. For those of you whose memories don’t go back that far, this index is the sum of the unemployment rate and the inflation rate. Few people talk about this index these days, but I thought it would be useful to show it to you as background (Graph 1). As you can see, things were pretty miserable in the 1970s and 1980s. Today, though, at least according to this metric, they are not too bad. The Misery Index is now as low as it has been since the late 1960s. Today, we are living in a world of low and stable inflation and low unemployment. It is useful to remind ourselves of this sometimes.

So this means that today’s HSC students are likely to be writing about why inflation is so low at the same time that unemployment is also low. I hope that they are also being asked to write about how public policy should respond to low inflation and its close cousins of slow growth in nominal wages and household incomes.

These are important issues to be thinking about. Given this, I would like to use this opportunity to address two related questions that I am asked frequently.

The first of these is why is inflation so low globally and in Australia?

And the second is, is inflation targeting still appropriate in this low inflation world?

I will then draw on my answers to make some remarks about monetary policy here in Australia.

1. Why is Inflation so Low?

It is useful to start off with a couple of graphs.

The first is the average rate of inflation globally (Graph 2). The picture is pretty clear. Global inflation declined over the three decades to the early 2000s and has been low and stable for some time.

Low inflation has become the norm in most economies. This is evident in this next graph, which shows the share of advanced economies with a core inflation rate below 2 per cent and below 1 per cent (Graph 3). Currently, three-quarters of advanced economies have an inflation rate below 2 per cent, and one-third have an inflation rate below 1 per cent.

Graph 3: Distribution of Inflation — Graph 3

The obvious question is why this has happened?

There is no single answer. But there are three factors that, together, help explain what has happened. These are: the credibility of the current monetary frameworks; the continuing existence of spare capacity in parts of the global economy; and structural factors related to technology and globalisation.

I will say a few words about each of these.

First, the credibility of the monetary frameworks. One of the responses to the high inflation rates of the 1970s and 1980s was to put in place monetary frameworks with a strong focus on inflation control. In some countries, this took the form of rewriting the law to require the central bank to focus on just one thing: inflation. Many countries also adopted an inflation target, with monetary policy decisions being explained primarily in terms of inflation.

This increased focus on inflation has helped cement low inflation norms in our economies. Many people understand that if inflation were to pick up too much, the central bank would respond to make sure the pick-up was only temporary. This means that workers and firms can make their decisions on the basis that the rate of overall inflation will not be too different from the target rate. This has made the system less inflation prone than it once was.

The second explanation for low inflation is the continuing existence of spare capacity in parts of the global economy.

The existence of spare capacity was an important factor explaining low inflation in the aftermath of the global financial crisis. And today, it remains a factor in some countries, including here in Australia. But, on the surface, it is a less convincing explanation for low inflation in countries where unemployment rates are now at multi-decade lows. Based on conventional measures of capacity utilisation, these economies are operating close to their sustainable limits. One explanation for continuing low inflation in this environment is that the current rate of aggregate demand growth is simply not fast enough to put meaningful pressure on capacity. If so, stronger demand growth would be expected to see inflation pick up. Another possibility is that the unemployment rate, by itself, no longer provides a good guide to spare capacity, partly due to the flexibility of labour supply. I will come back to this idea in the discussion of inflation outcomes in Australia.

The third explanation is that globalisation and advances in technology have changed pricing dynamics. There are two main channels through which this appears to be happening. The first is by lowering the cost of production of many goods. And the second is by making markets more contestable and increasing competition. The main effect of these changes should be on the level of prices, rather than on the ongoing rate of inflation. But this level effect is playing out over many years, so it appears as persistently low inflation.

It is widely accepted that the entry into the global trading system of hundreds of millions of people with access to modern technology put downward pressure on the prices of manufactured goods. Reflecting this, goods prices in the advanced economies have barely increased over the past couple of decades (Graph 4). But the effects of globalisation and technology extend beyond this and into almost every corner of the economy, including the services sector.

Graph 4: Advanced Economies - Core Inflation — Graph 4

In today’s globalised world, there are fewer and fewer services that can be thought of as truly non-traded. Many services can now be delivered by somebody in another country. Examples include: the preparation of architectural drawings, document design and publishing, customer service roles and these days many people in professional services work with team members located in other countries. In addition, many tasks, such as accounting and payroll, are being automated. All this has been made possible by technology and by globalisation.

The new global technology platforms have also revolutionised services such as retail, media and entertainment, and transformed how we communicate and search for information and compare prices.

These changes are having a material effect on pricing, with services price inflation lower than it once was. Many firms know that if they don’t keep their prices down, another firm somewhere in the world might undercut them. And many workers are concerned that if the cost of employing them is too high, relative to their productivity, their employer might look overseas or consider automation. And, more broadly, better price discovery keeps the competitive pressure on firms. The end result is a pervasive feeling of more competition. And more competition normally means lower prices.^[1]

So these are the three important factors that are contributing to low inflation. None of them by themselves is sufficient to explain what is happening, but together they are having a powerful effect. The current high inflation rates in Argentina and Turkey remind us that globalisation and technology, by themselves, do not drive low inflation. The monetary framework clearly matters too. Weaknesses in that framework still result in high inflation.

2. Is Inflation Targeting Still Appropriate?

This brings me to my second question: is inflation targeting still the appropriate monetary framework for most countries?

It is understandable that people are asking this question. Given the factors that I have just discussed, some commentators have argued that central banks will find it increasingly difficult to achieve their inflation targets. Some then go on to argue that central banks should just accept this, not fight it; perhaps they should shift the goal posts, or even adopt another monetary framework. A related argument is that the very low interest rates that have accompanied the pursuit of inflation targets are pushing up asset prices in an unsustainable way and sowing the seeds for damaging problems in the future.

You might, or might not, agree with these perspectives. Either way, it is reasonable to ask if we are on the right track: is inflation targeting still appropriate?

Before I address this question, I would like to push back against the idea that central banks simply can’t achieve their inflation targets. As we all know, some central banks have struggled to achieve their targets over a long period of time; Japan and the euro area are the obvious examples. But this is not a universal experience. Over recent times, inflation has been around target in Canada, Norway, Sweden and the United Kingdom. So the experience is mixed (Graph 5).

Graph 5: Core Inflation in Advanced Economies — Graph 5

There is no single factor that explains this mixed experience. But countries that are operating nearer to full capacity are more likely to have inflation close to target. It also appears that if you have an extended period of very low inflation – as did Japan and the euro area – it is harder to get back to target as a deflationary mindset takes hold. It is also possible that demographics may be playing a role, although the evidence here is mixed.

Overall, these varying experiences do not support the idea that it has become impossible for central banks to achieve their targets.

Here in Australia, some have argued that a lower inflation target would be a good idea given the ongoing low rates of inflation; that we should adjust our formulation of 2–3 per cent, on average, over time. Lowering the target might have the short-run advantage of allowing us to say we have achieved our goal, but shifting the goalposts hardly seems a good way to build long-term credibility. Shifting the goal posts could also entrench a low inflation mindset.

More broadly, over recent years the international debate has gone in the other direction: that is, to argue for a higher, not lower, inflation target. The argument is that a higher rate of inflation – and thus a higher average level of interest rates – would promote economic welfare by providing more room to lower interest rates, without running up against the lower bound. This greater flexibility for monetary policy could stabilise the economy when it was hit with a negative shock. To be clear, I am not arguing for a higher inflation target, but rather acknowledging there are arguments in both directions.

This brings me back to the question: is inflation targeting still appropriate?

The short answer is yes, but it is important to be clear what this means in practice.

Inflation targeting can mean different things to different people. It comes in different shapes and sizes. Some versions require a central bank to focus on inflation alone and set monetary policy so that the forecast rate of inflation is equal to the target. But inflation targeting does not need to be rigid like this.

In my view, an inflation targeting regime should consist of the following four elements.

The inflation target should establish a clear and credible medium-term nominal anchor for the economy. A high degree of uncertainty about future inflation hurts both investment and jobs. The economy works best if there is a degree of predictability. Most people can cope with some variation in the inflation rate from year to year. But dealing with uncertainty about what inflation is likely to average over the medium term is more difficult. Inflation targeting plays an important role in reducing that uncertainty by providing a strong nominal anchor.
The inflation target should be nested within the broader objective of welfare maximisation. It is worth remembering that inflation control is not the ultimate objective. Rather, it is a means to an end. And that end is the welfare of the society that we serve. I sometimes feel that as some central banks sought to establish their credentials as inflation fighters they over-emphasised the importance of short-run inflation outcomes. And this has been difficult to walk back from. Some central banks have been concerned that if they gave weight to other considerations, the community might doubt their commitment to inflation control. So, it became all about inflation. But central banks have a broader task than just controlling inflation in a narrow range. They play an important role in preserving macroeconomic stability and thus the steady creation of jobs. Also, their decisions affect borrowing and asset prices and thus financial stability too. Central banks have to determine how to balance these considerations when making monetary policy decisions. This means it makes sense for inflation targeting to be embedded within the broader objective of maximising the welfare of society.
The inflation target should have a degree of flexibility. This is not to say that the target itself should be flexible; this would diminish its usefulness in providing a medium-term anchor. Rather, some variation in inflation from year to year is acceptable and indeed unavoidable. How much variation is too much is difficult to know, but the variation should not be so large that it generates doubt about the commitment of the central bank to achieving the target over time.
The inflation target needs to be accompanied by a high level of accountability and transparency. If the inflation target is operated flexibly and is nested within the broader objective of welfare maximisation, the central bank has a degree of discretion. It is important that when exercising this discretion, the central bank is transparent. Problems can arise if the community doesn’t understand the central bank’s actions, or if they see it as acting unpredictably or inconsistently with its mandate. This means you should expect us to explain what we are doing, why we are doing it and how we are balancing the various trade-offs.

So these are the four elements that I see as important to an effective inflation-targeting regime.

We have all four elements in Australia. Our commitment to deliver an average inflation rate over time of 2 point something provides a strong nominal anchor. We have always viewed the inflation target in the wider context, reflecting the broad mandate for the RBA set out in the Reserve Bank Act 1959. That Act was passed 60 years ago and has stood the test of time. The RBA was also one of the earliest advocates of flexible inflation targeting – this is evident in our use of the words, ‘on average, over time’ when describing our target. We also place a heavy emphasis on explaining our decisions and their rationale to the community.

Our overall assessment is that Australia’s monetary policy framework has served the country well over the past three decades. The flexibility that has always been part of our regime has helped underpin a strong and stable economy and has helped Australia deal with some very large economic shocks. We are not inflation nutters. Rather, we are seeking to deliver low and stable inflation in a way that maximises the welfare of our society.

Over the nearly 30 years we have had the inflation target, inflation has averaged 2.4 per cent, very close to the midpoint. It has, however, been below this average over recent years and I will talk about this in a few moments.

Before I do so, it is important to note that we periodically review the formulation of the current target and examine alternative monetary frameworks, including at our annual conference last year.^[2] We are also monitoring closely the discussions that are taking place in the academic community and in other central banks. In my view, the evidence does not support the idea that a change to our inflation target would deliver better economic outcomes than achieved by our current flexible inflation target. Some alternative frameworks would also be more difficult to implement and/or be harder to explain to the community. But it is important that we regularly examine the arguments.

Australian Monetary Policy

I would now like to discuss recent inflation outcomes and monetary policy in Australia.

Like other countries, Australia has had low inflation over recent years. Over the past four years, headline inflation has mostly been below 2 per cent, although it has been slightly above that mark on a couple of occasions (Graph 6). In underlying terms, inflation has been below the band for three years.

Given this history, it is reasonable to ask why this happened and how the Reserve Bank Board has thought about it.

I will first focus on the period from late 2016 to late 2018. Through most of this period, gradual progress was being made in returning inflation to target and the unemployment rate was moving lower. Inflation was on a gentle upswing and the unemployment rate was coming down more quickly that we had expected. Reflecting this, in August 2017 the two-year ahead inflation forecast was 2½ per cent. Since then it has been lower than this, at 2–2¼ per cent.

Throughout this period, the Board discussed the case for seeking a faster and more assured return of inflation to around the midpoint of the target range. It was natural to be discussing this because having inflation around the midpoint of the target range allows more scope for surprises in either direction.

As you know, in the end the Board did not adjust interest rates through this period. It judged that seeking to achieve a faster return of inflation to the midpoint of the target range would have been accompanied by more rapid growth in debt, at a time when household balance sheets were already very extended. Our judgement was that, given the progress that was being made towards our goals, it was appropriate to use the flexibility in our inflation target to pursue a course that was more likely to be in the country’s long-term interest. We could have generated a bit more inflation, but we would have had faster growth in household debt as well.

I acknowledge that others might see this trade-off differently. But given the unemployment rate was coming down and inflation had lifted from its trough, we did not see a strong case for monetary easing.

Towards the end of last year, that assessment began to shift. Inflation was turning out to be lower than we had earlier expected and our forecasts for inflation were being marked down. There are a few reasons for this, but the one I want to highlight today is the flexibility of labour supply, as this links back to my earlier discussion of the reasons for low inflation globally.

When we prepared our forecasts in mid 2017, we did so on the basis that the share of the adult population participating in the labour market (the participation rate) would remain steady over the next couple of years (Graph 7). At the time, this was considered a reasonable forecast: while we expected some increase in participation from an encouraged worker effect because of solid employment growth, we thought this would be offset by the ageing of the population.

Since then, things have turned out quite differently. Employment growth has been much stronger than expected and the participation rate has risen by 1½ percentage points, which is a large change over a fairly short period. Put simply, the strong demand for labour has been met by more labour supply.

It is useful to consider the following thought experiment. Suppose the participation rate had still risen materially, but by ¾ per cent, rather than 1½ per cent. All else constant, this would have meant the unemployment rate today would have been well below 5 per cent.

This flexibility of labour supply is a positive development and has meant that strong employment growth has not tested the economy’s supply capacity. More demand for workers has been met with more labour supply. This has contributed to the subdued wage outcomes over recent times, which in turn has contributed to the low inflation outcomes.

The more flexible supply side means that employment growth can be stronger without fears of overheating. At the same time, the unemployment rate that would put upward pressure on inflation is also lower than it once was.

As the evidence accumulated in support of these propositions, the outlook for monetary policy changed and the Board lowered the cash rate in June and July. In making these decisions the Board also recognised that the earlier concerns about the trajectory of household debt had lessened. The Board has also paid attention to the shift in the outlook for monetary policy globally.

These two recent reductions in the cash rate will support demand in the Australian economy. So too will recent tax cuts, higher commodity prices, some stabilisation in the housing market, ongoing investment in infrastructure and a lift in resource sector investment. We also need to remember that the underlying foundations of the Australian economy remain strong.

It remains to be seen if future growth in demand will be sufficient to put pressure on the economy’s supply capacity and lift inflation in a reasonable timeframe. It is certainly possible that this is the outcome. But if demand growth is not sufficient, the Board is prepared to provide additional support by easing monetary policy further. However, as I have discussed on other occasions, other arms of public policy could also play a role in this scenario.

Whether or not further monetary easing is needed, it is reasonable to expect an extended period of low interest rates. On current projections, it will be some time before inflation is comfortably back within the target range. The Board is strongly committed to making sure we get there and continuing to deliver an average rate of inflation of between 2 and 3 per cent. It is highly unlikely that we will be contemplating higher interest rates until we are confident that inflation will return to around the midpoint of the target range.

RBA Minutes A Bit Contradictory

The minutes out today spelled out the slowing momentum in the economy, and the cuts in rates would help with spare capacity, but would not lift risks emanating from higher debt in the medium term. Cannot see how both can be true, when the focus appears to be on rekindling the housing market! And given the calls from the RBA for the Government to spend more to assist in stronger growth. The sums just do not add up!

International Economic Conditions

Members commenced their discussion by noting that growth in the global economy had remained moderate over preceding months. Global trade and manufacturing activity had slowed over the preceding year. Trade tensions had remained elevated, although no new measures had been introduced since the previous meeting.

In China, recent indicators of economic activity suggested that growth had slowed since the March quarter. Growth in industrial production had fallen following a strong reading in March and the level of fixed asset investment had declined. Conditions in the Chinese property market had also softened and underlying demand conditions were expected to moderate over time, given the ageing of the population and a slowing in the rate of urbanisation. Over the preceding month, the Chinese authorities had introduced additional measures to support growth, including more favourable financing conditions for local governments investing in infrastructure projects.

In east Asia, the combination of weaker Chinese growth, the downturn in global semiconductor demand and the trade and technology disputes had weighed on trade, although new export orders suggested that conditions might be stabilising. The effect of the US–China trade dispute had not been even across the region. Some economies, such as Thailand and Vietnam, had seen strong growth in their exports to the United States, which reflected some diversion of trade that had previously been between the United States and China.

Growth in output in the United States had continued to be supported by strong growth in consumption, while growth in investment appeared to have slowed further. Members noted that capital goods orders had slowed and that the stimulus to investment from tax cuts had largely run its course. Growth in domestic demand in the euro area had been relatively resilient in the March quarter, but more recent data had been mixed. Growth in Japanese domestic demand had slowed in early 2019, partly as a result of spillovers from weak external demand conditions, but growth was likely to be supported in the near term by a pick-up in consumption growth in the lead-up to an increase in the consumption tax in October 2019.

Labour markets remained tight in the major advanced economies. Members noted that participation rates for people aged between 15 and 64 years had increased significantly in recent years and unemployment rates were at historically low levels. This suggested that there was relatively little spare capacity in these labour markets. Members noted that participation rates of people aged 65 years and over had also been increasing. Wages growth had picked up, but this had not yet been translated into stronger inflationary pressures and inflation remained below target in most advanced economies. Although inflation had been around target in the United States, some measures suggested US inflation had shifted lower more recently. The decline in oil prices, by around 15 per cent since their peak in mid May, would weigh on headline inflation globally in the near term.

Iron ore prices had increased by more than 25 per cent since the previous meeting and had more than doubled over the previous year. Chinese steel production had continued to grow strongly in recent months, despite slowing industrial activity in China. At the same time, there was limited spare capacity in the seaborne market to increase supply and inventories of iron ore at Chinese ports had been declining. Rising iron ore prices had underpinned a 3 per cent increase in the Australian terms of trade in the March quarter.

Domestic Economic Conditions

Members noted that the main domestic economic news over the previous month had been the release of the national accounts for the March quarter and updates on the labour and housing markets.

The national accounts reported that the domestic economy had grown by 0.4 per cent in the March quarter. Public demand had continued to support growth in the quarter, with public consumption boosted by the rollout of the National Disability Insurance Scheme and increased spending on the Pharmaceutical Benefits Scheme. Growth in public sector investment had been positive despite a decline in defence spending. Members noted that there was a strong pipeline of public infrastructure projects that could support activity for some time.

Private demand had contracted for the third consecutive quarter because there had been further falls in mining investment and housing construction. Consumption growth had remained subdued.

Growth in business investment had been weaker than expected in the March quarter. This was partly because it had taken longer than expected for liquefied natural gas (LNG) projects to reach final completion. However, investment in automation and other productive efficiencies had supported machinery & equipment investment in the mining sector. Non-mining business investment had continued to expand in the March quarter, supported by a further increase in non-residential construction, while non-mining machinery & equipment investment had fallen. Members observed that there had been some differences in the findings of surveys of business conditions. In the main, surveyed measures of business conditions had declined to around or a little above average levels. However, both the retail and transportation sectors had experienced well below-average conditions.

Exports had increased in the March quarter, primarily driven by growth in rural and service exports. The boost to meat exports in the quarter as a result of ongoing drought conditions leading to destocking had been larger than the subtraction from lower crop exports. Resource exports (excluding non-monetary gold) had fallen in the March quarter because of temporary supply disruptions. More recent data on trade and shipments suggested that iron ore and LNG exports had increased since the March quarter, while coal exports appeared to have fallen. Higher iron ore prices had supported overall export values and the trade surplus had increased to almost 3 per cent of GDP in the March quarter. The trade surplus was at its highest level, and the current account deficit at its lowest level, measured as a share of GDP, since the 1970s.

Consumption had grown by 1.8 per cent over the year to the March quarter, which was well below average. Members noted that, in per capita terms, consumption had been broadly flat. Growth in household spending on essential items had been relatively steady, while the level of spending on discretionary items had fallen in the March quarter. This weakness had been broadly based across the states and recent retail trade data suggested that discretionary spending had remained soft in the June quarter.

Members had a detailed discussion of the effects on price inflation in the retail trade sector of increased competition from foreign entrants and online retailers over the preceding decade or so. Members noted that the increase in the supply of retail items and lower retail prices in response to increased competition were positive developments for consumers, other things equal. Many retailers and wholesalers had also become more efficient in response to more intense competition, often using new technology (including in logistics), which had resulted in relatively rapid multifactor productivity growth in these sectors. Members noted that the adjustment in the retail sector had been protracted and had put downward pressure on inflation for some years. In the more recent period, the effects on prices of greater competition had been difficult to separate from the effects of the prevailing weak demand conditions.

Growth in household disposable income had increased in recent quarters, supported by growth in labour income, but had remained low in year-ended terms. Members noted that growth in labour income had been driven by strong employment growth and that growth in hourly earnings had remained subdued. New private sector enterprise bargaining agreements had incorporated slightly faster wages growth than agreements reached a year earlier. However, wages growth for workers on existing enterprise bargaining agreements had remained subdued, and there was little prospect of a near-term pick-up in public sector outcomes given the ongoing wage caps.

A small decline in growth in tax payments had also contributed to growth in household disposable income in the March quarter. By contrast, the income of unincorporated enterprises had remained weak, partly because of drought-related falls in farm incomes and the downturn in housing construction. Members noted that this weakness was likely to continue in the near term.

Dwelling investment had declined in the March quarter. Further falls were expected given the sharp decline in building approvals over the preceding year and a half. While the pipeline of construction work yet to be done in New South Wales and Victoria remained high, liaison contacts expected housing construction could drop off more sharply because pre-sales activity had been so weak.

Conditions in the established housing markets of Sydney and Melbourne had improved a little since the previous meeting. Housing prices had stabilised in June in these cities and auction clearance rates had picked up further, albeit still on low volumes. More generally, turnover in the housing market had remained low. Housing prices had continued to fall in Perth and Darwin.

Employment growth had remained strong, at 2.9 per cent over the year to May. Despite this, there was still spare capacity in the labour market. Some of the additional labour demand had been met by an increase in the participation rate, which had reached its highest level on record. Even so, forward-looking indicators, such as job advertisements and employment intentions, suggested that growth in employment would moderate over coming months. The unemployment rate had remained at 5.2 per cent in May and the underemployment rate had remained elevated.

In view of the fact the meeting was held in Darwin, members had a thorough discussion of economic conditions and future economic opportunities in the Northern Territory. They noted that the Northern Territory economy had experienced a significant cycle related to the construction and then completion of the INPEX LNG plant. The downturn in the mining cycle had had significant spillovers to other parts of the Northern Territory economy because, aside from the public sector, mining and construction are the largest industries in terms of gross value added. Employment had fallen in the Northern Territory over 2019 and this had been accompanied by large flows of people moving to other parts of the country. As a result, the unemployment rate for the Northern Territory had increased, but it remained lower than the national average. More generally, the Northern Territory had a relatively young population and high labour market participation rates. The decline in the Northern Territory population had also led to a significant decline in dwelling investment in the Northern Territory over recent years.

Members observed that the broad statistics on the labour market for the Northern Territory masked the relative disadvantage of the Indigenous population. The unemployment rate for Indigenous Australians on average was relatively high, and Indigenous Australians were less likely to complete school and more likely to experience poor health. These measures of Indigenous disadvantage were particularly acute in remote locations, where it is more difficult to deliver services.

Members noted that there were a number of opportunities for economic growth in the Northern Territory in the future, including tourism, agricultural exports (including live beef exports), the defence industry and mining. Higher mining investment in the Northern Territory in the future could come from some small-scale mining projects that had not yet reached final investment decision and the possibility of some onshore unconventional gas projects.

Financial Markets

Members commenced their discussion of financial markets by noting the significant change in the expected path of monetary policy around the world, particularly in the United States. This change had reflected a combination of weaker-than-expected economic activity and inflation over recent months, as well as the downside risks from the trade and technology disputes between the United States and China.

Monetary policy in the United States had been unchanged in June, but the Federal Reserve had indicated that it was prepared to act to sustain the economic expansion. Members of the Federal Open Market Committee (FOMC) saw a stronger case to reduce the federal funds rate during 2019, in contrast with the earlier ‘patient’ stance as the FOMC had awaited further data. Market pricing had moved to imply an expectation that the federal funds rate would decline by 100 basis points over the following year, compared with 50 basis points a month earlier.

In other major economies, the European Central Bank had indicated that it was prepared to add more monetary stimulus if the outlook for growth and inflation did not improve, including by expanding its bond-buying program. The Bank of Japan had intimated that it would allow bond yields to move below the lower end of its ‘yield curve control’ target and reiterated that there was scope to ease monetary policy further if needed. And in China, market participants expected the People’s Bank of China to ease monetary policy further in the period ahead.

As expectations for monetary policy easing had firmed over the course of this year, government bond yields had declined further in major markets, to a record low in Germany and further into negative territory in Japan. In the United States, lower bond yields reflected lower expected real policy rates for an extended period, as well as persistently low inflation and term premia. Yields on 10-year Australian government bonds had reached a historical low of 1.3 per cent, with yields remaining around 70 basis points below US treasury bond yields of similar maturity. Compensation for risk on corporate bonds globally remained compressed, as market participants judged that policy easing would support growth in economic activity and profits. Members noted that, as a result, the cost of funds for corporations remained low, including in Australia.

Equity prices had increased in major markets over the preceding month, to a record high level in the United States, despite prominent downside risks. Higher equity prices owed primarily to a lowering of discount rates, reflecting the expected easing of monetary policies, whereas the outlook for corporate earnings had been little changed. Recent movements in equity prices in Australia had broadly followed international trends, with increases in equity prices in all main sectors over the preceding month. Members noted that analysts’ forecasts of earnings of Australian non-resource companies had declined over the course of the past year, consistent with broader surveys of business conditions.

Members noted that bank liquidity conditions in China had remained accommodative overall. However, the solvency and liquidity of small banks (which account for one-quarter of banking assets) had been attracting more scrutiny from both investors and the authorities after a period of rapid asset growth, amid wider financial stability concerns.

In foreign exchange markets, the US dollar had remained around multi-year highs on a trade-weighted basis, although it had depreciated somewhat in the weeks leading up to the meeting as US bond yields had declined relative to those in other major economies. The euro had remained within the relatively narrow range of the preceding few years on a trade-weighted basis, while the yen had broadly appreciated over recent months. The Australian dollar had been largely unchanged following the decision to lower the cash rate in June. Nevertheless, having depreciated by about 3 per cent in TWI terms since late 2018, the Australian dollar was around its lows of recent years, with the effect of the decline in Australian bond yields relative to other major markets over that period partly offset by the unexpected strength in commodity prices.

In Australia, monthly housing credit growth had remained broadly stable in recent months, particularly for lending for owner-occupation. Aggregate housing credit had been growing at an annualised rate of around 3 per cent, with much of the decline in the rate of growth over the preceding year driven by weaker demand for finance associated with the correction in the housing market. Loan approvals by both owner-occupiers and investors had continued to decline in May. However, an easing in the loan serviceability interest-rate floor was likely to see a boost in borrowing capacity for many new borrowers, which would be in addition to the positive effect on the cash flow of the household sector overall following the reduction in the cash rate at the previous meeting.

The three-month bank bill swap rate (BBSW) had declined further over the preceding month. Accordingly, the increase in the spreads of BBSW and other short-term money market rates to the overnight indexed swap rate in 2018 had been fully unwound. Wholesale funding costs (which affect two-thirds of banks’ debt funding) had also declined in line with the cash rate. As a result, the major banks’ debt funding costs had reached a historic low.

Members noted that the favourable financing conditions for non-financial corporations had supported corporate bond issuance. Although business credit growth had declined over recent months, growth in total business debt had remained little changed. Meanwhile, yields on residential mortgage-backed securities had also been at low levels and issuance by non-banks in this market had increased significantly in the June quarter, to levels not seen since prior to the global financial crisis.

Members noted that most lenders had passed on the 25 basis points reduction in the cash rate in June to mortgage rates. Business borrowing rates had declined in line with the decline in BBSW. Members also noted that the reduction in the cash rate had been passed through to many retail deposit rates, although some of these rates were already very low.

Market pricing implied that further monetary policy easing was expected following recent data and the Bank’s communication since the previous meeting. A 25 basis points reduction in the cash rate had been fully priced in by August 2019, with a further easing expected by the end of the year.

Considerations for Monetary Policy

Members observed that the outlook for the global economy remained reasonable, although the risks from the international trade and technology disputes remained high. Growth in trade had remained weak and there had been further signs that heightened uncertainty was affecting investment decisions. Despite tight labour markets and rising wages growth, inflation had generally remained low in the advanced economies. Both the trade-related downside risks to global growth and ongoing subdued inflation had spurred an increased expectation that major central banks would ease monetary policy. This had reinforced already very accommodative conditions in global financial markets.

In considering the policy decision, members discussed the recent data on output and the labour market. On the former, GDP growth had been well below trend over the year to the March quarter. Despite strong growth in employment, growth in household disposable income had remained low and this had contributed to low growth in consumption. Members noted the near-term prospects for a lift in income growth and the contribution of the low and middle income tax offset. Higher growth in disposable income was expected to support consumption, although the outlook for consumption remained uncertain. Accommodative monetary policy, strong public demand, a renewed expansion in the resources sector and growth in exports were also expected to support a return of GDP growth to trend over coming years.

Members observed that employment growth continued to outpace growth in the working-age population. However, most of the strength in labour demand over preceding months had been met by an increase in participation, which had risen to a record high level, rather than a decline in the unemployment rate. Although there had been a modest pick-up in wages growth in the private sector, wages growth had remained low overall. In combination, these factors suggested that spare capacity was likely to remain in the labour market for some time.

Declining housing prices had also contributed to low growth in consumption, although there were signs that conditions in some housing markets, notably in Sydney and Melbourne, had stabilised. Members noted that mortgage rates were at record lows and that there was strong competition for borrowers of high credit quality. However, demand for credit by investors continued to be subdued and credit conditions for small and medium-sized businesses remained tight.

In assessing the outlook for inflation, members agreed that further improvements in the labour market would be required for wages growth to increase materially. As assessed at the previous meeting, members agreed that the Australian economy could sustain a lower rate of unemployment, while achieving inflation consistent with the target. In light of this, the recent run of data and the lower level of interest rates resulting from the decision taken at the previous meeting, the case for a further reduction in the cash rate was considered.

Members recognised that, in the current environment, the main channels through which lower interest rates would support the economy were a lower value of the exchange rate than otherwise would be the case and lower required interest payments on borrowing, which would free up cash for other expenditure by households and businesses.

Members judged that a further reduction in the level of interest rates would support the necessary growth in employment and incomes, and promote stronger overall economic conditions, which would in turn support a gradual increase in underlying inflation. Members also judged that the extent of spare capacity in the economy, and the likely pace at which it would be absorbed, meant that a decline in interest rates was unlikely to encourage an unwelcome material pick-up in borrowing by households that would add to medium-term risks in the economy. Members recognised the uneven effect of lower interest rates on different households.

Taking into account all the available information, the Board decided that it was appropriate to lower the cash rate by 25 basis points. This decision, together with the reduction in the cash rate decided at the previous meeting, would assist in reducing spare capacity in the economy and making faster progress in reducing the unemployment rate. Lower interest rates would provide more Australians with jobs and assist with achieving more assured progress towards the inflation target. The Board would continue to monitor developments in the labour market closely and adjust monetary policy if needed to support sustainable growth in the economy and the achievement of the inflation target over time.

Fed Confirms Easing Bias

In the latest FOMC minutes, the tone suggests a potential easing rate bias, recognising the rising economic risks. Uncertainties have increased they say.

In their discussion of monetary policy for the period ahead, members noted the significant increase in risks and uncertainties attending the economic outlook. There were signs of weakness in U.S. business spending, and foreign economic data were generally disappointing, raising concerns about the strength of global economic growth. While strong labor markets and rising incomes continued to support the outlook for consumer spending, uncertainties and risks regarding the global outlook appeared to be contributing to a deterioration in risk sentiment in financial markets and a decline in business confidence that pointed to a weaker outlook for business investment in the United States. Inflation pressures remained muted and some readings on inflation expectations were at low levels. Although nearly all members agreed to maintain the target range for the federal funds rate at 2-1/4 to 2-1/2 percent at this meeting, they generally agreed that risks and uncertainties surrounding the economic outlook had intensified and many judged that additional policy accommodation would be warranted if they continued to weigh on the economic outlook. One member preferred to lower the target range for the federal funds rate by 25 basis points at this meeting, stating that the Committee should ease policy at this meeting to re-center inflation and inflation expectations at the Committee’s symmetric 2 percent objective.
Members agreed that in determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee would assess realized and expected economic conditions relative to the Committee’s maximum-employment and symmetric 2 percent inflation objectives. They reiterated that this assessment would take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments. More generally, members noted that decisions regarding near-term adjustments of the stance of monetary policy would appropriately remain dependent on the implications of incoming information for the economic outlook.
With regard to the postmeeting statement, members agreed to several adjustments in the description of the economic situation, including a revision in the description of market-based measures of inflation compensation to recognize the recent fall in inflation compensation. The Committee retained the characterization of the most likely outcomes as “sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee’s symmetric 2 percent objective” but added a clause to emphasize that uncertainties about this outlook had increased. In describing the monetary policy outlook, members agreed to remove the “patient” language and to emphasize instead that, in light of these uncertainties and muted inflation pressures, the Committee would closely monitor the implications of incoming information for the economic outlook and would act as appropriate to sustain the expansion, with a strong labor market and inflation near its symmetric 2 percent objective.

Adams/North: Federal Politicians Are In Negative Equity And Stressed!

Economist John Adams and Analyst Martin North examine “the kitchen sink” being thrown at the property market and consider the implications.

RBA’s Explanation For The Cut

Courtesy of Philip Lowe, speaking in Darwin tonight. Savers do not even warrant a mention… more the shame!

As I am sure you are aware, this morning the Board decided to reduce the cash rate by a quarter of a percentage point to 1 per cent. This follows a similar adjustment last month. This easing of monetary policy will support jobs growth across the country and provide greater confidence that inflation will be consistent with the medium-term target of 2 to 3 per cent.

Our assessment is that despite the Australian economy having performed reasonably well over recent years, there is still a fair degree of spare capacity in the economy. It is both possible and desirable to reduce that spare capacity. We should be able to achieve a lower rate of unemployment than we currently have and we should also be able to reduce underemployment. If, as a country, we can do this, we could expect a further lift in wages growth and stronger growth in household incomes. These would be good outcomes. As I hope you are aware, the Reserve Bank’s monetary policy framework is centred on the inflation target, but the ultimate objective of our policies is to promote the collective economic prosperity of the people of Australia.
In the Board’s judgement, the easing of monetary policy last month and this month will help promote our collective welfare. At the same time, though, we recognise that the benefits are not evenly distributed across the community and that there are some downsides to monetary easing. Partly for these reasons, over recent times I have been drawing attention to the fact that, as a nation, there are options other than monetary easing for putting us on a better path.
One option is fiscal support, including through spending on infrastructure. This spending adds to demand in the economy and – provided the right projects are selected – it also adds to the country’s productive capacity. It is appropriate to be thinking about further investments in this area, especially with interest rates at a record low, the economy having spare capacity and some of our existing infrastructure struggling to cope with ongoing population growth.
Another option is structural policies that support firms expanding, investing, innovating and employing people. A strong, dynamic, competitive business sector generates jobs. It can help deliver the productivity growth that is the main source of sustainable increases in our wages and incomes. So, as a country, we need to keep focused on this.
To repeat the point, it is important that we think about the task ahead holistically. Monetary policy does have a significant role to play and our decisions are helping support the Australian economy. But, we should not rely on monetary policy alone. We will achieve better outcomes for society as a whole if the various arms of public policy are all pointing in the same direction.
The two cuts in interest rates the Board has delivered recently will make an important contribution to putting us on a better path and winding back spare capacity. It is also worth drawing your attention to a few other developments.
First, borrowing costs for almost all borrowers are now the lowest they have ever been. As an illustration, the Australian Government can borrow for 10 years at around 1.3 per cent, the lowest rate it has faced since Federation in 1901. It is also able to borrow for 30 years at an interest rate of less than 2 per cent. Private businesses and households also face low borrowing rates. This is not only because official interest rates are low, but because credit spreads are low too.
Second, Australia’s terms of trade have risen again, largely due to higher iron ore prices. Investment in the resources sector is also expected to increase over the next few years, after having declined steadily for almost seven years. To be clear, we are not expecting another major mining boom, but we are expecting a solid upswing in the resources sector, which will help the overall economy. I hope that, in time, the effects of this upswing will be felt here in the Northern Territory too.
Third, the exchange rate has depreciated over the past couple of years and, on a trade-weighted basis, is at the bottom end of its range of recent times. This is helping support important parts of the economy.
And fourth, we are expecting stronger growth in household disposable income over the next couple of years, partly due to the expected implementation of the low and middle income tax offset. Stronger growth in incomes should support household spending.
Together, these various developments will help the Australian economy.
At the same time, though, we need to watch global developments very closely. Over recent times, the uncertainty generated by the trade and technology disputes between the United States and China has made businesses in many countries nervous about investing. Many are preferring to sit on their hands, rather than commit to capital spending that is difficult and costly to reverse. The result is less international trade and a weakening trend in investment globally. If this continues for too much longer, the effects on economic growth are likely to be significant. For this reason, the risks to the global economy remain tilted to the downside.
The combination of these persistent downside risks and continuing low rates of inflation has led investors around the world to expect interest rate reductions by all the world’s major central banks. In Europe and Japan, official interest rates are already negative but investors are expecting the central banks to go further into negative territory. And in the United States, investors are expecting a substantial reduction in interest rates over the period ahead. This is quite a different world from the one we were facing earlier in the year.
What all this means for us here in Australia is yet to be determined.
We need to remember that the central scenario for both the global and Australian economies is still for reasonable growth, low unemployment and low and stable inflation. As I discussed a few moments ago, there are a number of developments that are providing support to the Australian economy. So we will be closely monitoring how things evolve over coming months. Given the circumstances, the Board is prepared to adjust interest rates again if needed to get us closer to full employment and achieve the inflation target in a way that supports the collective welfare of all Australians, including those who call the Northern Territory home

Has The RBA Lost Its Way?

We discuss monetary policy in the light of today’s rate cut.

Has The RBA Lost Its Way? [Podcast]

We discuss monetary policy in the light of today’s rate cut.

Digital Finance Analytics (DFA) Blog

Has The RBA Lost Its Way? [Podcast]

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Time to ignite all engines: BIS

Monetary policy can no longer be the main engine of economic growth, and other policy drivers need to kick in to ensure the global economy achieves sustainable momentum, the Bank for International Settlements (BIS) writes in its Annual Economic Report.

In its flagship economic report, the BIS calls for a better balance between monetary policy, structural reforms, fiscal policy and macroprudential measures. This would allow the global economy to move away from the debt-fuelled growth model that risks turbulence ahead.

“Navigating the way to clearer skies means balancing speed with stability and conserving some fuel to cope with possible headwinds,” says BIS General Manager Agustín Carstens. “A sustainable flight path requires the long-overdue full engagement of all four engines of policy, rather than short-term turbo charges.”

In the report, the BIS says that although global expansion hit a soft patch last year, the resilience of service industries and strong labour markets can support growth in the near term. Employment increases and solid wage rises have sustained consumption. Still, significant risks remain, including trade tensions and rising debt, particularly in the corporate sector in some economies.

“As well as clouding future demand and investment prospects, the trade tensions raise questions about the viability of existing supply chain structures and about the very future of the global trading system,” says Carstens. “Trade wars have no winners.”

Other risks to the outlook include weak bank profits in several advanced economies and deleveraging in some major emerging market economies (EMEs), particularly China. Necessary moves to curb credit growth there act as a drag on activity.

EMEs’ greater sensitivity to global financial conditions and resulting capital flows has meant that, since the financial crisis, they have had to cope with strong spillovers from accommodative monetary policy in advanced economies. One chapter of the report analyses how EME monetary policy frameworks have sought to tackle the resulting trade-offs. The frameworks typically combine inflation targeting with currency intervention, and are complemented with macroprudential measures to address the build-up of financial vulnerabilities.

“This kind of multiple-tool policymaking is not yet very well anchored conceptually. EME monetary policy practice has moved ahead of theory. Theory has to catch up,” says Claudio Borio, Head of the Monetary and Economic Department.

A chapter on big tech and financial services was released on 23 June.

The BIS’s financial results, published at the same time in the Annual Report 2018/19, include a balance sheet total of SDR 291.1 billion (USD 403.7 billion) at end-March 2019 and a net profit of SDR 461.1 million (USD 639.5 million).

Fed Chair On Economic Outlook and Monetary Policy Review

Jerome H. Powell spoke at the Council on Foreign Relations, New York.

He said when the FOMC met at the start of May, tentative evidence suggested economic crosscurrents were moderating, so they left the policy rate unchanged. But now, risks to their favorable baseline outlook appear to have grown with concerns over trade developments contributing to a drop in business confidence. That said, monetary policy should not overreact to any individual data point or short-term swing in sentiment.

They are also formally and publicly opening their decisionmaking to suggestions, scrutiny, and critique.

It is a pleasure to speak at the Council on Foreign Relations. I will begin with a progress report on the broad public review my Federal Reserve colleagues and I are conducting of the strategy, tools, and communication practices we use to achieve the objectives Congress has assigned to us by law—maximum employment and price stability, or the dual mandate. Then I will discuss the outlook for the U.S. economy and monetary policy. I look forward to the discussion that will follow.
During our public review, we are seeking perspectives from people across the nation, and we are doing so through open public meetings live-streamed on the internet. Let me share some of the thinking behind this review, which is the first of its nature we have undertaken. The Fed is insulated from short-term political pressures—what is often referred to as our “independence.” Congress chose to insulate the Fed this way because it had seen the damage that often arises when policy bends to short-term political interests. Central banks in major democracies around the world have similar independence.
Along with this independence comes the obligation to explain clearly what we are doing and why we are doing it, so that the public and their elected representatives in Congress can hold us accountable. But real accountability demands more of us than clear explanation: We must listen. We must actively engage those we serve to understand how we can more effectively and faithfully use the powers they have entrusted to us. That is why we are formally and publicly opening our decisionmaking to suggestions, scrutiny, and critique. With unemployment low, the economy growing, and inflation near our symmetric 2 percent objective, this is a good time to undertake such a review.
Another factor motivating the review is that the challenges of monetary policymaking have changed in a fundamental way in recent years. Interest rates are lower than in the past, and likely to remain so. The persistence of lower rates means that, when the economy turns down, interest rates will more likely fall close to zero—their effective lower bound (ELB). Proximity to the ELB poses new problems to central banks and calls for new ideas. We hope to benefit from the best thinking on these issues.
At the heart of the review are our Fed Listens events, which include town hall–style meetings in all 12 Federal Reserve Districts. These meetings bring together people with wide-ranging perspectives, interests, and expertise. We also want to benefit from the insights of leading economic researchers. We recently held a conference at the Federal Reserve Bank of Chicago that combined research presentations by top scholars with roundtable discussions among leaders of organizations that serve union workers, low- and moderate-income communities, small businesses, and people struggling to find work.
We have been listening. What have we heard? Scholars at the Chicago event offered a range of views on how well our monetary policy tools have effectively promoted our dual mandate. We learned more about cutting-edge ways to measure job market conditions. We heard the latest perspectives on what financial and trade links with the rest of the world mean for the conduct of monetary policy. We heard scholarly views on the interplay between monetary policy and financial stability. And we heard a review of the clarity and the efficacy of our communications.
Like many others at the conference, I was particularly struck by two panels that included people who work every day in low- and middle-income communities. What we heard, loud and clear, was that today’s tight labor markets mean that the benefits of this long recovery are now reaching these communities to a degree that has not been felt for many years. We heard of companies, communities, and schools working together to bring employers the productive workers they need—and of employers working creatively to structure jobs so that employees can do their jobs while coping with the demands of family and life beyond the workplace. We heard that many people who, in the past, struggled to stay in the workforce are now getting an opportunity to add new and better chapters to their life stories. All of this underscores how important it is to sustain this expansion.
The conference generated vibrant discussions. We heard that we are doing many things well, that we have much we can improve, and that there are different views about which is which. That disagreement is neither surprising nor unwelcome. The questions we are confronting about monetary policymaking and communication, particularly those relating to the ELB, are difficult ones that have grown in urgency over the past two decades. That is why it is so important that we actively seek opinions, ideas, and critiques from people throughout the economy to refine our understanding of how best to use the monetary policy powers Congress has granted us.
Beginning soon, the Federal Open Market Committee (FOMC) will devote time at its regular meetings to assess the lessons from these events, supported by analysis by staff from around the Federal Reserve System. We will publicly report the conclusions of our discussions, likely during the first half of next year. In the meantime, anyone who is interested in learning more can find information on the Federal Reserve Board’s website.¹
Let me turn now from the longer-term issues that are the focus of the review to the nearer-term outlook for the economy and for monetary policy. So far this year, the economy has performed reasonably well. Solid fundamentals are supporting continued growth and strong job creation, keeping the unemployment rate near historic lows. Although inflation has been running somewhat below our symmetric 2 percent objective, we have expected it to pick up, supported by solid growth and a strong job market. Along with this favorable picture, we have been mindful of some ongoing crosscurrents, including trade developments and concerns about global growth. When the FOMC met at the start of May, tentative evidence suggested these crosscurrents were moderating, and we saw no strong case for adjusting our policy rate.
Since then, the picture has changed. The crosscurrents have reemerged, with apparent progress on trade turning to greater uncertainty and with incoming data raising renewed concerns about the strength of the global economy. Our contacts in business and agriculture report heightened concerns over trade developments. These concerns may have contributed to the drop in business confidence in some recent surveys and may be starting to show through to incoming data. For example, the limited available evidence we have suggests that investment by businesses has slowed from the pace earlier in the year.
Against the backdrop of heightened uncertainties, the baseline outlook of my FOMC colleagues, like that of many other forecasters, remains favorable, with unemployment remaining near historic lows. Inflation is expected to return to 2 percent over time, but at a somewhat slower pace than we foresaw earlier in the year. However, the risks to this favorable baseline outlook appear to have grown.
Last week, my FOMC colleagues and I held our regular meeting to assess the stance of monetary policy. We did not change the setting for our main policy tool, the target range for the federal funds rate, but we did make significant changes in our policy statement. Since the beginning of the year, we had been taking a patient stance toward assessing the need for any policy change. We now state that the Committee will closely monitor the implications of incoming information for the economic outlook and will act as appropriate to sustain the expansion, with a strong labor market and inflation near its symmetric 2 percent objective.
The question my colleagues and I are grappling with is whether these uncertainties will continue to weigh on the outlook and thus call for additional policy accommodation. Many FOMC participants judge that the case for somewhat more accommodative policy has strengthened. But we are also mindful that monetary policy should not overreact to any individual data point or short-term swing in sentiment. Doing so would risk adding even more uncertainty to the outlook. We will closely monitor the implications of incoming information for the economic outlook and will act as appropriate to sustain the expansion.

The Risks Ahead

Agustín Carstens, General Manager, Bank for International Settlements spoke in Beijing recently and discussed the challenges going forward for central banks, as the monetary policy normalistion (following a decade of ultra-low interest rates, QE and the like), are unwound. He admits that the starting point of the ongoing normalisation is unprecedented, and there are extreme uncertainties involved.

Household debt is high and rising in many advanced and emerging market economies. Quantitative easing has been a “volatility stabiliser” in financial markets and when it is removed or reversed, it is not clear how the market will react. We are in uncharted territory! Yet, monetary policy normalisation is essential for rebuilding policy space, creating room for countercyclical policy.

Monetary policy normalisation in the major advanced economies is making uneven progress, reflecting different stages of recovery from the GFC. The Federal Reserve has begun unwinding its asset holdings by capping reinvestments and has increased policy rates. The ECB has scaled back its large-scale asset purchases, with a likely halt of net purchases by end-year. Meanwhile, the Bank of Japan is continuing with its purchases and has not communicated any plan for exiting.

The ongoing unwinding of accommodative monetary policy in core advanced economies is a welcome step. It is a sign of success as economies have been brought back to growth and inflation rates back towards target levels. Monetary policy normalisation is essential for rebuilding policy space, creating room for countercyclical policy. Moreover, it can help restrain debt accumulation and reduce the risk of financial vulnerabilities emerging.

But there are also significant challenges. The starting point of the ongoing normalisation is unprecedented, and there are extreme uncertainties involved. The path ahead for central banks is quite narrow, with pitfalls on either side. Central banks will need to strike and maintain a delicate balance between competing considerations. This includes, in particular, the challenge of achieving their inflation objectives while avoiding the risk of encouraging the build-up of financial vulnerabilities.

Central banks have prepared and implemented normalisation steps very carefully. Policy normalisation has been very gradual and highly predictable. Central banks have placed great emphasis on telegraphing their policy steps through extensive use of forward guidance. As a consequence, major financial and economic ructions have so far been avoided. In this regard, the increased resilience of the financial sector as a consequence of the wide regulatory and supervisory reforms undertaken since 2009 has also helped.

That said, there are still plenty of risks out there.

First, central banks are not in control of the entire yield curve and of the behaviour of risk premia. Investor sentiment and expectations are key factors determining these variables. An abrupt repricing in financial markets may prompt an outsize revision of the expected level of risk-free interest rates or a decompression in risk premia. Such a snapback could be amplified by market dynamics and have adverse macroeconomic consequences. It could also be accompanied by sudden sharp exchange rate fluctuations and spill across borders, with broader repercussions globally.
Second, many intermediaries are in uncharted waters. Exchange-traded funds (ETFs) have grown faster than actively managed mutual funds over the past decade, and needless to say, they have brought very important benefits to bond markets, among other factors, by enhancing the depth of such markets and making possible new ways of financing for many sovereigns and corporations. ETFs are especially popular among equity investors, but they have also gained importance among bond investors.

They have attracted investors because they charge lower fees than traditional mutual funds, which has proved to be an important advantage in the ultra-low interest rate environment. Moreover, they promise liquidity on an intraday basis, hence more immediately than mutual funds, which provide it only daily.

Such promise of intraday liquidity is, however, a double-edged sword. As soon as ETF investors are confronted with negative news or observe an unexpected fall in the underlying asset price, they can run – that is, sell their ETF shares immediately – adding to the downward pressure on market prices. As equity markets become choppier, we will need to be on the look-out for ETFs possibly accentuating the volatility of the underlying asset market.

Currently, bond ETFs are still small compared with bond mutual funds in terms of their assets under management. However, as the market share of ETFs increases, their impact on market price dynamics will also increase. Moreover, they have yet to be tested in periods of high interest rates.
More generally, investors may face unforeseen risks – in particular, unforeseen dry-ups in liquidity. As I mentioned earlier, the growing size of the asset management industry may have increased the risk of liquidity illusion: market liquidity seems to be ample in normal times, but dries up quickly during market stress. Asset managers and institutional investors do not have strong incentives to play a market-making role when asset prices fall due to large order imbalances. Moreover, precisely when asset prices fall, asset managers often face redemptions by investors. This is especially true for bond funds investing in relatively illiquid corporate or EME bonds. Therefore, when market sentiment shifts adversely, investors may find it more difficult than in the past to liquidate bond holdings.

Central banks’ asset purchase programmes may also have contributed to liquidity illusion in some bond markets. Such programmes have led to portfolio rebalancing by investors from safe government debt towards riskier bonds, including EME bond markets, making them look more liquid. However, such liquidity may disappear in the event of market turbulence. Also, as advanced economy central banks unwind their asset purchase programmes and increase policy rates, investors may choose to rebalance from riskier bonds back to safe government bonds. This can widen spreads of corporate and EME bonds.

Moreover, asset managers’ investment strategies can collectively increase financial market volatility. A key source of risk here is asset managers’ “herding” in illiquid bond markets. Fund managers often claim that their performance is evaluated over horizons as long as three to five years. Nevertheless, they tend to have a strong aversion to underperforming over short periods against industry peers. This can lead to increased risk-taking and highly correlated investment strategies across asset managers. For example, recent BIS research shows that EME bond fund investors tend to redeem funds at the same time. Moreover, the fund managers of the so-called actively managed EME bond funds are found to closely follow a small number of benchmarks (a practice known as “benchmark hugging”).

Third, the fundamentals of many economies are not what they should be while at the same time there seems to be less political appetite for prudent macro policies. High and rising sovereign debt relative to GDP in many advanced economies has increased the sensitivity of investors to the perceived ability and willingness of governments to ensure debt sustainability. Sovereign debt in EMEs is considerably lower than in advanced economies on average, but corporate leverage has continued to rise and has reached record levels in many EMEs.

Also, household debt is high and rising in many advanced and emerging market economies. In addition, a large amount of EME foreign currency debt matures over the next few years, and large current account and fiscal deficits in some EMEs could induce global investors to take a more cautious stance. Tightening global financial conditions and EME currency depreciation may increase the sensitivity of investors to these vulnerabilities.

Fourth, other factors may augment the spillover effects from unwinding unconventional monetary policy. Expansionary fiscal policy in some core advanced economies may further push up interest rates, by increasing government bond supply and aggregate demand in already-overheating economies. Trade tensions have started to darken the growth prospects and balance of payments outlook of many countries. Such tensions also have repercussions on exchange rates and corporate debt sustainability. Heightened geopolitical risks should not be ignored either. The sharp corrections in advanced economy and EME equity markets alike in October 2018 are generally attributed to both aggravating trade tensions and geopolitical risks.

Fifth, there is much uncertainty about how investors will react to monetary policy normalisation. Quantitative easing has been a “volatility stabiliser” in financial markets. Thus, when it is removed or reversed, it is not clear how the market will react. Market segments of particular concern are high-yield bonds and EME corporate bonds. As I pointed out a moment ago, liquidity tends to dry up more easily in these markets. Knowing this, asset managers may try to rebalance their portfolios by deleveraging more liquid surrogates first, which creates an avenue for contagion to other markets.

“Tourist investors” are another source of concern. For example, in contrast to “dedicated” bond funds, which follow specific benchmarks relatively closely, “crossover” funds have benchmarks but deviate from them and cross over to riskier asset classes such as EME bonds and high-yield corporate bonds in search of yield. Crossover funds are not new, but they have gained prominence recently. They include high-yield, high-risk bonds in their portfolio by arguing that the extra return from such investments is high enough to compensate for their risk. They are likely to underprice risks when markets are calm, but overprice risks when markets become volatile. They are, indeed, very responsive to interest rate and exchange rate surprises and tend to pull out suddenly from risky investments.

Finally, significant allocations by global asset managers to domestic currency bond markets, in particular to EME local currency sovereign bonds, have generated new challenges. After the Asian financial crisis of 1997–98, many emerging Asian economies made concerted efforts to develop their local currency bond markets. This was a welcome development, overcoming “original sin”, a term coined by Barry Eichengreen and Ricardo Hausmann in 1999 for the inability of developing countries to borrow in their domestic currency. By relying on long-term local currency bonds instead of short-term foreign currency loans, many Asian EME borrowers were able to avoid currency mismatch and reduce rollover risk. In addition, over the past several years, the average maturity of EME local currency bonds has increased overall.

However, as the share of foreign investment in EME local currency bond markets has increased, currency and rollover risks have been replaced by duration risk. The effective duration of an investment measures the sensitivity of the investment return to the change in the bond yield. Recent BIS research shows that EME local currency bond yields tend to increase in tandem with domestic currency depreciation. This can make returns of EME local currency bond investors, whose investment performance is measured in the US dollar (or the euro), extremely volatile. As an analogy, incorporating exchange rate consideration is similar to viewing temperatures with and without a wind chill factor.

This suggests that the exchange rate response to capital flows might not stabilise economies as textbooks predict: it might instead lead to procyclical non-linear adjustments. Exchange rate changes can drive capital in- and outflows via the so called risk-taking channel of exchange rates.

The core mechanism of the risk-taking channel works as follows. In the presence of currency mismatch, a weaker dollar flatters the balance sheet of the EME’s dollar borrowers. This induces creditors (either global banks or global bond investors) to extend more credit. As a consequence, a weaker dollar goes hand in hand with reduced tail risks and increased EME borrowing. However, when the dollar strengthens, these relationships go into reverse.

Policy implications

Monetary policy normalisation by major advanced economies, escalating trade tensions, heightened geopolitical risks and new forms of financial intermediation all pose challenges going forward for both advanced and emerging market economies. How can policymakers rise to these challenges?

Inadequate growth-enhancing structural policies have been a major deficiency over the past years. Such policies would facilitate the treatment of overindebtedness. In contrast to expansionary monetary and fiscal policies, which boost both debt and output, growth-enhancing structural reforms would primarily boost output, thus reducing debt burdens relative to incomes. Moreover, by improving the supply side of the economy, they would contain inflationary pressures. And, if sufficiently broad in scope, they would have positive distributional effects, reducing income inequality.

Advanced economies should be mindful of spillovers, also because they can mutate into spillbacks. During phases in which interest rates remain low in the main international funding currencies, especially the US dollar, EMEs tend to benefit from easy financial conditions. These effects then play out in reverse once interest rates rise. A reversal could occur, for instance, if bond yields snapped back in core advanced economies, and especially if this went hand in hand with US dollar appreciation. A clear case in point is the change in financial conditions experienced by EMEs since the US dollar started appreciating in the first quarter of 2018.

Global spillovers can also have implications for the core economies. The collective size of the countries exposed to the spillovers suggests that what happens there could also have significant financial and macroeconomic effects in the originating economies. At a minimum, such spillbacks argue for enlightened self-interest in the core economies, consistent with domestic mandates. This is an additional policy dimension that complicates the calibration of the normalisation and that deserves close attention.

Financial reforms should be fully implemented. If enforced in a timely and consistent manner, these reforms will contribute to a much stronger banking system. Indeed, the Basel Committee’s Regulatory Consistency Assessment Programme has found that its members have put in place most of the major elements of Basel III. But implementation delays remain. It is important to attain full, timely and consistent implementation of all the rules. This would improve the resilience of banks and the banking system. It is also necessary for attaining a level playing field and limiting the room for regulatory arbitrage.

For EMEs, keeping one’s house in order is paramount because there is no room for poor fundamentals during tightening global financial conditions. EMEs may nevertheless face capital outflows, and their currencies may depreciate abruptly, which would trigger further capital outflows. In such instances, EME authorities must be prepared to respond forcefully. They should consider combining interest rate adjustments with other policy options such as FX intervention. And they should consider using the IMF’s contingent lending programmes.

At the same time, EMEs should not disregard non-orthodox policies to deal with stock adjustment. If a large amount of foreign capital has flowed into domestic markets and threatens to flow out quickly, the central bank can use its balance sheet to stabilise markets. As an example, the Bank of Mexico has in the past swapped long-term securities for short-term securities via auctions. This was done because such long-term instruments were not in the hands of strong investors, and there was market demand for short-term securities. This policy stabilised conditions in peso-denominated bond markets.

Finally, policymakers need to better understand asset managers’ behaviour in stress scenarios and to develop appropriate policy responses. One key question for policymakers is how to dispel liquidity illusion and to support robust market liquidity. Market-makers, asset managers and other investors would need to take steps to strengthen their liquidity risk management. Policymakers can also provide them with incentives to maintain robust liquidity during normal times to weather liquidity strains in bad times – for example, by encouraging regular liquidity stress tests.