Australia holds rate but drops bond yield target

November 3, 2021

Australia’s central bank left its key interest rate unchanged but dropped its policy of targeting the yield on a benchmark government bond and pulled forward the likely time for a rate hike to 2023 due to what it said was “the improvement in the economy and the earlier-than-expected progress towards the inflation target.”
The Reserve Bank of Australia (RBA) kept its cash target of 0.10 percent, unchanged since November 2020 when it was lowered for the third time last year during the first wave of the COVID-19 pandemic.

And while RBA will no longer target a 0.10 percent yield on the benchmark April 2024 Australian government bond, it confirmed it will continue to buy government bonds at a rate of $4 billion a week until at least mid-February 2022.

“The Australian economy is now growing again, after the recovery from the pandemic was interrupted by the Delta outbreak,” RBA Governor Philip Lowe said, adding the economy is expected to record a solid gain in the fourth quarter after contracting in the third quarter.

By the middle of next year, the RBA expects economic output to return to its pre-Delta path.

But RBA also reiterated its guidance that will not raise the cash rate until inflation is sustainably within its target range of 2 to 3 percent.

“The board is prepared to be patient,” Lowe said, seeking to dampen speculation in financial markets that RBA will soon follow the lead of 34 central banks in other countries that have raised rates this year in reaction to the recent rise in inflation.

RBA expects underlying inflation to be no higher than 2.5 percent by the end of 2023, with wages growing 3 percent the same year. Previously it did not expect these conditions to be met before 2024.

Lowe stressed the bank’s board would look through spikes in inflation and only expects inflation to reach the target once the labour market is tight enough to generate wage growth that is “materially higher than it is currently.”

“While on the issue of timing, the latest data and forecasts do not arrange an increase in the cash rate in 2022,” Lowe said.

Lowe said Australia is in a different situation than many other countries, with the labour force participation not falling and nor are supply disruptions showing up in consumer prices.
Although inflation has risen, the core or underlying rate, remains low and wages are only expected to pick up gradually as the labour market tightens.

Australia’s headline inflation rate eased to 3.0 percent in the third quarter from 3.8 percent while core inflation rose to 2.1 percent from 1.6 percent.

The rise in core inflation illustrates the general rise in global inflation and triggered expectations in financial markets that RBA would start to tighten its policy. The yield on the April 2024 government bond last week surged to 0.8 percent, significantly over RBA’s target of 0.1 percent.

In addition to the three rate cuts last year, RBA also began targeting the yield on benchmark government bonds to anchor short-term interest rates and reinforce its guidance that its cash rate was unlikely to be raised until the bond matured.

“Today, more than a year and a half on, the balance of probabilities is a little different,” Lowe said, adding he wants to make clear that dropping the yield target doesn’t mean the cash rate will be raised before 2024.

Lowe said the yield target had been effective in supporting the economic recovery but its effectiveness as a monetary policy tool has declined as expectations about future interest rates shift due to the pace of the economic recovery and progress in reaching RBA’s goals.

“There is genuine uncertainty as to the timing of future adjustments in the cash rate,” Lowe said, adding it is entirely possible it will remain at the current level until 2024.

“But it is also possible that an earlier move will be appropriate,” Lowe said, adding: “But it is now also plausible that a lift in the cash rate could be appropriate in 2023.”

RBA forecasts Australia’s economy will grow 3 percent this year, 5.5 percent in 2022 and 2.5 percent in 2023.

Underlying inflation is seen around 2.25 percent this year and 2022, and 2.5 percent in 2023, while wages should grow 2.5 percent in 2022 and 3 percent in 2023.

– The Reserve Bank of Australia issued the following two statements: A statement by its governor, Philip Lowe, regarding the board’s policy decision and a speech at a webinar:

“At its meeting today, the Board decided to:

maintain the cash rate target at 10 basis points and the interest rate on Exchange Settlement balances at zero per cent
continue to purchase government securities at the rate of $4 billion a week until at least mid February 2022
discontinue the target of 10 basis points for the April 2024 Australian Government bond.

The Australian economy is recovering after the interruption caused by the Delta outbreak. As vaccination rates increase even further and restrictions are eased, the economy is expected to bounce back relatively quickly. The central forecast is for GDP growth of 3 per cent over 2021 and 5½ per cent and 2½ per cent over the following two years. One important source of uncertainty continues to be the possibility of a further setback on the health front.

The Delta outbreak caused hours worked in Australia to fall sharply, but a bounce-back is now underway. The Bank’s business liaison and the data on job ads suggest that many firms are now hiring, which will boost employment over coming months. The central forecast is for the unemployment rate to trend lower over the next couple of years, reaching 4¼ per cent at the end of 2022 and 4 per cent at the end of 2023.

Inflation has picked up, but in underlying terms is still low, at 2.1 per cent. The headline CPI inflation rate is 3 per cent and is being affected by higher petrol prices, higher prices for newly constructed homes and the disruptions in global supply chains. A further, but only gradual, pick-up in underlying inflation is expected. The central forecast is for underlying inflation of around 2¼ per cent over 2021 and 2022 and 2½ per cent over 2023. Wages growth is expected to pick up gradually as the labour market tightens, with the Wage Price Index forecast to increase by 2½ per cent over 2022 and 3 per cent over 2023. The main uncertainties relate to the persistence of the current disruptions to global supply chains and the behaviour of wages at the lowest unemployment rate in decades.

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Housing prices are continuing to rise in most markets and housing credit growth has picked up due to stronger demand for credit by both owner-occupiers and investors. The Bank welcomes APRA’s recent decision to increase the interest rate serviceability buffer on home loans. It is important that lending standards are maintained at a time of historically low interest rates.

Financial conditions in Australia remain highly accommodative, with most lending rates at record lows. Bond yields have increased recently and bond market volatility has also risen significantly. The exchange rate has appreciated a little, but remains within the range of the past year.

The decision to discontinue the yield target reflects the improvement in the economy and the earlier-than-expected progress towards the inflation target. Given that other market interest rates have moved in response to the increased likelihood of higher inflation and lower unemployment, the effectiveness of the yield target in holding down the general structure of interest rates in Australia has diminished.

The Board is committed to maintaining highly supportive monetary conditions to achieve a return to full employment in Australia and inflation consistent with the target. While inflation has picked up, it remains low in underlying terms. Inflation pressures are also less than they are in many other countries, not least because of the only modest wages growth in Australia.

The Board will not increase the cash rate until actual inflation is sustainably within the 2 to 3 per cent target range. This will require the labour market to be tight enough to generate wages growth that is materially higher than it is currently. This is likely to take some time. The Board is prepared to be patient, with the central forecast being for underlying inflation to be no higher than 2½ per cent at the end of 2023 and for only a gradual increase in wages growth.”

– Speech by RBA Governor Philip Lowe:

“Good afternoon and thank you for joining this webinar.
The Reserve Bank Board met this morning. At our meeting we agreed to:

1. maintain the target for the cash rate at 10 basis points

2. continue to purchase government bonds at the rate of $4 billion per week until mid February 2022, with a further review to be undertaken then

3. discontinue the target for the yield on the April 2024 bond.

I would like to take this opportunity to explain these decisions – particularly the decision to discontinue the yield target – and to answer your questions.

I would like to start with some background and our updated forecasts.

The Australian economy is now growing again, after the recovery from the pandemic was interrupted by the Delta outbreak. GDP is expected to record a solid gain in the December quarter, following the sharp contraction in the September quarter. And by the middle of next year, GDP is expected to be back on its pre-Delta path. Our central scenario is for the economy to grow by around 51⁄2 per cent over 2022 and by around 21⁄2 per cent over 2023.

At the outset of the pandemic, economic policy, including monetary policy, set out to build a bridge to the other side. That other side is now clearly in sight. As restrictions are eased, spending is expected to pick up relatively quickly as people seek a return to a more normal way of life. The rapid increase in vaccination rates has been critical in getting us to this point. More broadly, the support provided by both monetary and fiscal policy means that the Australian economy is well placed to resume its expansion.

The resilience of the economy continues to be evident in the labour market. A strong bounce-back in hours worked is now under way, after a sharp fall during the lockdowns. The unemployment rate is expected to trend lower over the next couple of years. Our central scenario is for the unemployment rate to reach 41⁄4 per cent by the end of next year, and 4 per cent by the end of 2023. This would be a welcome development. Australia has not experienced a sustained period of unemployment at levels this low since the early 1970s.

Inflation, in underlying terms, remains low in Australia, at 2.1 per cent. Inflation is, however, a little higher than it has been over recent years. This increase largely reflects higher oil prices in global markets, higher prices for residential construction and strained global supply chains. Looking forward, we are expecting a further, but gradual, increase in underlying inflation. Our central forecast is for underlying inflation of 21⁄4 per cent in 2022 and 21⁄2 per cent in 2023.

While these forecasts for inflation are higher than our previous forecasts, we are not expecting the surge in inflation that has been experienced in some other countries. The situation in Australia is different. We have not seen the same fall in labour force participation as experienced elsewhere, and the impact of other supply disruptions, including in energy markets, is less evident in our CPI.

It is also relevant that the starting points for inflation and wages growth are lower in Australia than in many other countries. In addition, our business liaison suggests that wage growth remains modest, although there are some hotspots. Wages growth is expected to pick up as the labour market tightens, but this pick-up is expected to be gradual.

So that is the economic backdrop against which today’s decision was made. I will now turn to the yield target.

The yield target was introduced in the exceptional days of March 2020. It was part of a package of monetary policy measures designed to help build that bridge that I spoke about before. That package has been effective and it is one of the reasons that the Australian economy is now well placed to recover from the pandemic.

The yield target had two motivations.

The first was to directly anchor the short end of the yield curve so that funding costs were low across the economy. In the exceptional circumstances of the time, we judged that the most efficient way of anchoring the curve was to target a risk-free yield further out along the curve than the cash rate.

The second motivation was to reinforce the Board’s forward guidance that the cash rate was very unlikely to be increased for three years, which at the time ran until March 2023.

On both counts, the yield target has been effective and has supported the recovery of the Australian economy. But its effectiveness as a monetary policy tool declined as expectations about future interest rates shifted due to the run of data and the forecast progress towards our goals.

At the time the yield target was introduced, the Board assigned a very low probability to an increase in the cash rate over the three-year horizon of the target – which at the time aligned with the maturity date of the April 2023 bond. Indeed, the central scenario was that the cash rate would need to be held steady beyond that date and the likelihood of an earlier increase in the cash rate was considered to be very low.

Today, more than a year and a half on, the balance of probabilities is a little different. Given our forecasts, it is still entirely plausible that the first increase in the cash rate will not be before the maturity of the current target bond – that is, the bond with a maturity date of April 2024. But it is now also plausible that a lift in the cash rate could be appropriate in 2023.

In our central scenario, underlying inflation reaches the midpoint of the 2 to 3 per cent range only in late 2023. Having underlying inflation reach the midpoint of the target range for the first time in seven years does not, by itself, warrant an increase in the cash rate. It is also relevant that wages growth at the end of 2023 is expected to be running at 3 per cent. While this is higher than it is now, it is still below the average over the two decades to 2015. This expected configuration of inflation and wages growth allows the Board to be patient in considering a lift in interest rates.

It is also possible that the global inflation shock is more persistent than currently expected and that this is transmitted to Australia. There is also uncertainty as to how wages growth responds to the unemployment rate being near 4 per cent for an extended period. We have little historical experience to guide us and there is also the question of the impact on labour supply of the opening of the international border. Given this, it is possible that faster-than-expected progress continues to be made towards achieving the inflation target. The recovery of the economy and the recent inflation data have increased the probability of this. If this faster progress were to be sustained, there would be a case to lift the cash rate before 2024.

It is, of course, also possible that we experience yet another setback that throws the economy off course and delays progress towards our goals. One source of such a shock would be a new strain of the virus or a decline in vaccine effectiveness. In this case, the cash rate would need to remain at its current level for longer than otherwise.

At its meeting this morning, the Board considered these various possibilities and their implications for the yield target.

One option discussed was to continue with the target on the basis that it remained consistent with our central forecasts for the economy.

A second option considered was to lift the target yield or change the maturity of the target bond. However, this would not have been consistent with the Board’s view that the yield target was an appropriate tool during an exceptional period, but not one to be used on an ongoing basis.

The third option considered was to discontinue the target on the basis of the shift in the distribution of possible outcomes for the cash rate that I just spoke about.

The Board decided on this third option.

I want to make it clear that this decision does not reflect a view that the cash rate will be increased before 2024. As I have discussed, there is genuine uncertainty as to the timing of future adjustments in the cash rate. Given the information we currently have to hand, it is still entirely possible that the cash rate will remain at its current level until 2024. But it is also possible that an earlier move will be appropriate. Given this, the Board judged that there were more costs than benefits in seeking to anchor the yield on the April 2024 bond at 10 basis points.

Given the progress towards our goals and the revised outlook, the Board judged that it was no longer sustainable to maintain the target of 10 basis points. The Board took into account the fact that the shift in the distribution of possible outcomes was being reflected in other term interest rates in Australia. If we had sought to pin the yield on the April 2024 bond at 10 basis points in the face of these developments, we would have ended up holding all the freely tradable bonds in the bond line, so that trading in that bond would cease. This would have further diminished the usefulness of the target.

I recognise that the past few days have been turbulent ones in the bond market. Our decision to stand out of the market in the days between the release of the CPI and the Board meeting did result in uncertainty as to our policy and affected market pricing and liquidity. We faced a difficult choice over those days: stand out of the market until the Board had an opportunity to review the latest data and forecasts in a matter of a few days; or enter a thin market in an effort to defend a target that was losing credibility for the reasons I have spoken about. I thought the better approach was for the Board to review the situation and decide whether or not to confirm or discontinue the target.

I would now like to turn to a broader point and that is the nature of the RBA’s forward guidance. As I have stressed on previous occasions, our forward guidance is based on the state of the economy, not the calendar. Our focus has been on returning inflation sustainably to the 2 to 3 per cent range and doing what we reasonably can to reach full employment. These are our goals and it is progress on these fronts that will continue to determine decisions about the cash rate. These decisions are not driven by the calendar.

We have, though, supplemented this state-based guidance with a reference to our forecasts and the calendar. We have done this to provide the community with our expected time frame and the factors that will influence that time frame. This in no way has constituted a promise that the cash rate would remain unchanged to any particular date. Rather, at the time of each policy statement we provided our best expectation of the timing of when the cash rate might change, recognising that expected timing can change.

While on the issue of timing, the latest data and forecasts do not warrant an increase in the cash rate in 2022. I recognise that some other central banks are raising rates, but our situation is different. The Board will not increase the cash rate until inflation is sustainably in the target range. We are prepared to look through spikes in the inflation rate, as we have done with headline CPI inflation this year. For inflation to be sustainably in the target range, wages growth will have to be materially higher than it is now. This is likely to take time. The Board is prepared to be patient.

Finally, in terms of the bond purchase program, we will be including the April 2024 bond in our regular auctions from next week. We will also continue with the program at the current rate of purchases until February, when we will review it again. That review will be based on the same threeconsiderations as previous reviews: (i) the actions of other central banks; (ii) how our bond market is functioning; and (iii) most importantly, the actual and expected progress towards our goals for inflation and unemployment.

Thank you. I am here to answer your questions.”

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