RBA calls the year ahead - The View - Clime Investment Management
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RBA calls the year ahead
The View
The View | RBA calls the year ahead 1
RBA calls the year ahead
By John Abernethy
Last week, the Governor of the Reserve Bank of Australia, Philip Lowe, gave a seminal address to the National
Press Club in Canberra titled “The Year Ahead”. Any speech by the Governor is important, but this address will
be far more influential than most because of its unusually forthright predictions and the context in which it
was delivered.
In terms of context, investment markets (particularly equities and property markets) are steaming ahead, and
this week saw Wall Street at an all-time high. The ASX has similarly been performing strongly, although not at
record levels, while property markets have been exceptionally robust.
It is clear that stimulus prospects and expectations for vaccine deployment have boosted investor optimism
over the pace of economic recovery from the pandemic recession.
Governor Philip Lowe of the RBA
Monetary policy and “Lowe” interest rates!
Governor Lowe was both clear and direct by stating that “very significant monetary support will need
to be maintained for some time to come. It is going to be some years before the goals for inflation and
unemployment are achieved. So it is premature to be considering withdrawal of the monetary stimulus.”
And further
“The cash rate will be maintained at 10 basis points for as long as is necessary. The Board has no appetite to
go into negative territory and has done as much as it reasonably can with interest rates. Before increasing
the cash rate, the Board wants to see inflation sustainably within the 2 to 3 per cent target range. Meeting
this condition will require a tighter labour market and stronger wages growth than we are currently forecasting.
It is difficult to determine exactly when this condition might be met but, based on the outlook I have discussed
today, we do not expect it to be before 2024, and it is possible that it will be later than this. So the message is:
interest rates are going to be low for quite a while yet. The Reserve Bank is committed to provide the support the
economy needs as its recovers from the pandemic.”
The View | RBA calls the year ahead 2
These statements and forecasts are significant for investors and particularly self-funded retirees in pension
mode. Low risk interest bearing investments (e.g. bonds and term deposits) are likely to generate yields that
are substantially below the rate of inflation for years. Therefore, passive and low risk investments will generate
income flows that are well below both the required return to match long term pension liabilities and the short
term cash flow needs of pension payments.
The sustainment of low interest rates was given extra support by the announcement of QE2 by Governor
Lowe. After the first $100 billion of QE is completed, a further $100 billion will be undertaken over the ensuing
12 months. The RBA will buy more bonds than the Commonwealth will issue, and we suspect it will also be
active in State Government bond markets. A particular focus will be on the Victorian and QLD governments
which have blown out their debt as they embarked on border closures.
Given the above, it is remarkable that these pressing issues are not debated in Parliament (bar an interesting
Senate enquiry - see below), nor do they receive serious press coverage or discussion. However, one positive
from this outlook is that no political party would dare contemplate either changes to or debasement of
franking credits. The franking overlay will be essential to sustain pension fund income.
Recovery is occurring and fairly rapidly
Governor Lowe observed that despite the pandemic having very significant economic costs, the downturn was
not as deep as feared, and the recovery has started earlier and has been stronger than expected. Employment
growth has been strong, as have retail sales and new house building. Across many indicators, including GDP,
the outcomes have been better than forecasts and “often better than our (the RBA) upside scenarios as well”.
As an illustration, in August the RBA’s central forecast was that the unemployment rate would end 2020 at
close to 10% and still be above 7% at the end of 2022. In the RBA’s upside scenario, the unemployment rate
was expected to end 2020 a little lower than 10%, but still be around 7% later this year. The actual outcome
for the unemployment rate has been much better than this, with the peak now looking to be behind us and
the unemployment rate ending 2020 at 6.6%.
What explains these better-than-expected outcomes?
The first is the success that Australia has had in containing the virus. That success has meant that the restrictions
on activity have been less disruptive than feared, and allowed more of us to get back to work sooner and it
has reduced some of the economic scarring from the pandemic.
The second factor is the very significant fiscal policy support in Australia, which is almost 15% of GDP. Most
of this support has been delivered by the Australian Government, but the states and territories have also
played a role. This support has been more substantial than was assumed in August, and has provided a boost
to incomes and jobs and helped front load the recovery by creating incentives for people to bring forward
spending.
The View | RBA calls the year ahead 3
The third factor is that Australians adapted and innovated: households and businesses have adjusted and
changed what they do and how they do it, and this resilience has helped keep the economy going and kept
people in jobs.
Many firms changed their business models, moved online, used new technologies and reconfigured their
supply lines. Households adjusted too, with spending patterns changing significantly. Some of the spending
that would normally have been done on travel and entertainment has been redirected to other areas, including
electrical goods, homewares and home renovations. Online spending also surged, increasing by 70% over the
past year.
A fourth factor, and one that has not been acknowledged, is the consumption and activity benefits that have
flowed from about 400,000 Australians that have returned from living overseas. Prior to COVID-19 some one
million Australians were living or working overseas. About 40% have now returned (so called expats) and
these people (in the main) have returned with capital (and possibly a tax bill).
This great inflow has to some extent offset the expenditure of overseas tourists. It has also added to the
expenditure that was redirected back into the Australian economy when Australians could not tour offshore.
Despite the flexibility and resilience of the national response, there is still substantial spare capacity in the
Australian economy. The unemployment rate is higher today than it has been for almost 2 decades and many
people cannot get the hours of work they want. And in terms of output, we remain well behind where we
thought we would be: when the National Accounts are published for the December quarter, they are likely to
show that the level of GDP is 4% lower than it was expected to be a year ago.
The View | RBA calls the year ahead 4
Inflation is running at 1.25%, well below the medium-term target of 2–3%, and wage growth is the lowest in
decades, with the Wage Price Index increasing by just 1.4% over the past year. Given the spare capacity that
currently exists, these low rates of inflation and wage increases are likely to be with us for some time.
The RBA view of the year ahead
Of course, much will depend upon the path of the pandemic. The development of vaccines in record time
is clearly good news. It has reduced one of the big uncertainties and could provide the foundation for a
vigorous and sustainable recovery in the global economy, even though the global rollout of vaccines faces
challenges and there are a range of other uncertainties about the global economy.
Nevertheless, the RBA has released its forecast of a “central scenario”, which is for the upswing in the Australian
economy to continue, with above-trend growth over the next couple of years. GDP is expected to increase by
3.5% over 2021 and 2022. The level of GDP should return to its end-2019 level by the middle of 2021, which is
6 to 12 months earlier than previously expected.
The View | RBA calls the year ahead 5
Notwithstanding this recovery, the RBA is expecting that growth in GDP will be checked over the forecast
period by lower population growth. The forecasts of a year ago were expecting the population to grow by
1.6% per year over 2020 and 2021, but the actual outcome is likely to be around 0.2% in 2021, the lowest
since World War I. This slower population growth has a direct effect on the size of our economy and means
that we will not get back to the previous trend for GDP until immigration recommences in earnest at some
point in 2023/24.
In the labour market, the RBA expects the rate of unemployment to continue to decline. In the central
scenario, it is expected to reach 6% by the end of 2021 and around 5.25% by mid-2023. Job vacancies, job
ads and business hiring intentions are at high levels, which suggests continuing solid employment growth
over the next few months. Beyond that, some slowing in employment growth is expected when the JobKeeper
program comes to an end in March.
Given this outlook, the RBA believes that both wages growth and inflation will remain subdued.
In its central scenario, the RBA believes that wages growth will pick up from its current low rate, but to do so
only gradually and still be below 2% at the end of 2022.
Consistent with this, and the ongoing spare capacity in the economy, inflation in underlying terms is also
forecast to stay below 2% over the next couple of years: the central forecast for 2021 is 1.25% and for 2022
it is 1.5%. In passing it should be noted by investors to not become “spooked” by inflation headlines over the
next 6 months. The RBA noted that inflation is expected to spike to around 3% in the June quarter, reflecting
swings in the prices of child care and other administered prices, but then to return to below 2% by the end
of 2021.
The View | RBA calls the year ahead 6
Income and household expenditure
Over the next 6 months, household income is expected to decline as the pandemic support payments unwind.
Normally, when income falls, so too does consumption. But we are not in normal times. The extra savings
over the past 6 months and the bigger financial buffers can support future spending – people will have more
freedom to spend as restrictions are eased and be more willing to spend as uncertainty recedes. As noted
above, the 400,000 returned expats will also contribute and ensure that the recovery in consumer spending
continues as parts of JobKeeper fall away from April.
Another important factor bearing on household spending is the housing market. The dynamics in the housing
market look to be in a positive phase, with prices rising across most of the country. It remains to be seen
how long this will continue, but sustainable increases in asset prices support household balance sheets and
encourage spending through positive wealth effects. Higher housing prices can also encourage additional
residential construction and lower mortgage rates are the icing on the cake – so to speak!
Governor Lowe goes to the Senate
After his presentation at the National Press Club, the Governor was joined by his Deputy Governor (Dr Guy
Debelle) and were cross examined (loosely speaking) by the ALP’s Shadow Assistant Treasurer Dr Andrew
Leigh (Harvard PhD and former Professor of Economics at ANU).
Labor Shadow Assistant Treasurer Dr Andrew Leigh
The View | RBA calls the year ahead 7
The dialogue between the parties was briefly covered in the press and it is worth reviewing because it seems
that Dr Leigh feels that the RBA is not achieving its mandates of higher inflation, full employment and higher
wages. Dr Leigh’s views seem to echo those of former Prime Minister Paul Keating, who has criticised the RBA
as being behind the economic curve.
The interesting part of the dialogue was Dr Leigh’s thoughts that the level of QE should or could be substantially
increased. In his view, that would drive interest rates lower (bond yields), lower the currency, create demand,
create imported inflation and push up wages.
Nothing that was suggested by Dr Leigh was remarkable - other than it was remarkable that he openly
promoted a massive QE program. Seemingly, he would suggest that Australia’s QE should match that of
overseas Central Banks (whom he also suggested had better qualified executives than the RBA) and maybe
the RBA should buy over 50% of all bonds on issue. Therefore seemingly he would support negative interest
rates for Australia and more extraordinary pain for retirees seeking reliable income.
While Governor Lowe and Dr Debelle did their best to push back against Dr Leigh, the discussion heightens
the risk that cash interest rates in Australia may be pushed negative at some point. Governor Lowe indicated
that cash rates of 0.1% were a ceiling and not a floor.
We therefore retain our strong view that investors need to critically review their portfolios to determine if
adequate income is being generated or is likely to be generated from it in coming years.
General Advice Warning
This document and its contents are general in nature and do not constitute or convey personal financial advice. It has been prepared without
consideration of anyone’s financial situation, needs, or financial objectives. You should obtain a copy of the relevant Product Disclosure Statement
before making any investment decisions.
Before acting on the areas discussed and contained herein, you should consider whether it is appropriate for you and whether you need to seek
professional advice.
The authors and distributors of this document accept no liability for any loss or damage suffered by any person as a result of that person, or any other
person, placing any reliance on the contents of this document.
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