Analysis: Could RBA Prevent QE?

• Published on
• 10 Oct 2019, 07:03 AM

By Sophia Rodrigues

Could the Reserve Bank of Australia make a more clever use of forward guidance as an unconventional monetary policy tool (UMPT) to avoid using other forms of UMPT like quantitative easing?

In theory it could and it is likely it already is.

But as the cash rate nears the Effective Lower Bound (ELB), time is running out for the RBA. It needs to make very skillful use of forward guidance, so the combination of rate cuts and forward guidance are enough to bridge the demand gap in the economy, so other forms of UMPT could be avoided.

FORWARD GUIDANCE

After lowering the cash rate in June and July this year, RBA Governor Philip Lowe resorted to the use of forward guidance in a speech in late July when he said, “whether or not further monetary easing is needed, it is reasonable to expect an extended period of low interest rates.”

Since then the RBA has used “extended period of low interest rates” as a forward guidance in its statements and minutes, and in speeches by senior officials.

Another statement by RBA which might be considered a form of forward guidance is the one on structural (downward) shifts in global interest rates, and its impact on the Australian dollar.

In a speech last month, Governor Lowe said, “If we did seek to ignore these shifts, our exchange rate would appreciate, which, in the current environment, would be unhelpful in terms of achieving both the inflation target and full employment.”

Put differently, the statement means the RBA would do what it can to deal with upward pressure on the exchange rate. This is a guidance about the future and could thus be a forward guidance.

At the same time as using forward guidance, the RBA has lowered the cash rate – three times this year for a total of 75 basis points, and there is expectation of one more cut this year. The last time the RBA lowered the cash rate by more than 75bps in a year was 2012.

What is interesting is at the start of this year no one expected the cash rate to fall to 0.75% by October. The RBA’s actions so far is thus more than what was expected and it may well be intentional.

PRE-EMPTIVE EXPANSIONARY ACTION

The RBA may be following what is called a pre-emptive expansionary monetary policy stance.

Faced with demand gap and slow progress to inflation and employment goals, and more importantly, the prospect of reaching the ELB for the cash rate, the RBA is doing what experts suggest a central bank could do.

“In this case, central banks might choose to cut rates more rapidly than they otherwise would have – and more rapidly than the public might expect – were they not facing the risk of being constrained by the ELB,” a report published earlier this week by BIS said.

The report is titled “Unconventional monetary policy tools: a cross-country analysis,” and is authored by the Committee on the Global Financial System whose chairman is RBA Governor Lowe.

The focus of the report is on four sets of UMPT tools: negative interest rate policies (NIRP), new central bank lending operations (LO), asset purchase programmes (APP), and forward guidance (FG).

In a discussion on ELB scenarios where an economy faces a demand shock, the report says it is conceivable that central banks may find it useful to deploy UMPTs in response to relatively mild negative demand shocks that raise the prospect of an impending ELB event.

“As long as the real rate implied by the policy action remains below r* (neutral rate), the stance of monetary policy would be expansionary, increasing the likelihood of an upward correction of inflation expectations. This may be advisable, even if such a move would leave less space for further moves, should further negative shocks emerge,” the report says.

However, such an expansionary stance also requires clever forward guidance to deal with the risk that the public might misinterpret the rapid decline in the policy rate as a signal that the economy is faring far worse than is actually the case.

“So while this scenario may not require the use of central bank balance-sheet policies, it would require adroit use of FG (forward guidance), before the policy rate sinks to the ELB, in order to manage expectations effectively,” the report says.

CLEVER FORWARD GUIDANCE

The RBA’s cash rate is currently at 0.75% and policy space to lower the rate further is estimated to be around 50bps before the ELB is reached.

If the RBA continues its pre-emptive expansionary stance, it would lower the cash rate to the ELB faster than expected by the market. But at the same time as doing so, the RBA would need to make its communication very effective because its actions may be already denting consumer confidence.

The Westpac-Melbourne Institute’s consumer sentiment report for October showed a 5.5% fall to 92.8 which is the lowest since July 2015. According to Westpac, the fall was due to negative reaction to the RBA’s latest rate cut, and overall concerns about the economy.

It is no secret RBA is keen to prevent quantative easing. As recently as few weeks ago, Lowe reiterated that QE is unlikely

“We’ve done something about under what conditions we would do it, but I think it’s unlikely and I certainly hope that we don’t have to go in that direction.”

Lowe’s hope could well come true but it requires more clever use of forward guidance and communication strategies. Difficult but not impossible!

--Email: sophia@centralbankintel.com