Reserve Bank Governor reflects on ‘nirvana’

Testimony to Parliament

• Reserve Bank Governor testimony: Reserve Bank Governor Philip Lowe spoke to the House of Representatives Economics Committee.
• The Reserve Bank Governor said that economic nirvana is inflation at 2.5 per cent, unemployment at 4 or 4.5 per cent and wage growth of 3.5 per cent.
• The Governor believes our economy has become less dynamic.

What did he say and what does it all mean?

• The opening statement by the Governor was very similar in content to the speech delivered on Wednesday. The Governor is watching coronavirus closely, saying that the impact on the Australian economy could be bigger than the impact of SARS 16 years ago. And in terms of interest rates, Governor Lowe is watching the balance of risks. If unemployment was to rise then risks would tilt in favour of lower rates.
• Australia: “When we met six months ago, I said that there were signs that the Australian economy may have reached a gentle turning point. The data that we have received since then are consistent with this. Our central forecast is that economic growth in Australia will pick up from an average rate of 2 per cent over the past couple of years to 2¾ per cent this year and 3 per cent over 2021.”
• Uncertainties: “there are still some significant areas of uncertainty. One of these is the possibility of a re-escalation of the US–China disputes. The ‘phase one’ deal has alleviated some of the earlier uncertainties, but it has not eliminated them. There are also a number of other trade disputes that are simmering elsewhere around the world.”
• Coronavirus: “…the outbreak of the coronavirus represents a new source of uncertainty. It is too early to tell what the impact will be, but the SARS outbreak in 2003 may provide a guide. On that occasion, there was a sharp slowing in output growth in China for a few months, before a sharp bounce back as the outbreak was controlled and economic stimulus measures were introduced. Today, China is a larger part of the global economy and it is more closely integrated, including with Australia, so the international spillovers could be larger than they were back in 2003. Much will depend on the success of the various efforts to control the virus so we are watching developments carefully.”
• Bushfires & drought: “Our current estimate is that over the December and March quarters, the fires will have reduced Australian GDP growth by around 0.2 percentage points. The rebuilding effort is expected to broadly offset that effect over the rest of this year. The drought is also continuing to act as a drag on the economy and is expected to reduce GDP growth by a quarter of a percentage point this year.”
• Monetary policy: “I understand that some people in our community have concerns about interest rates being at very low levels and that low interest rates makes it more difficult for people relying on interest income. I would like to assure these people that we did not take those decisions lightly. Rather, we have been responding to two major developments. First, the low interest rates globally. And second, a period of balance sheet adjustment by Australian households.”
• Quantitative easing: “the threshold for undertaking QE – that is, the RBA purchasing assets through balance sheet expansion – has not been reached in Australia and I do not expect it to be reached. So, it is not on our agenda at the moment.”
• QE: “QE would be considered only at a cash rate of 0.25 per cent. Our focus would be on purchasing government securities to put downward pressure on longer-term interest rates.”

Question & answers

•  If the unemployment rate moves in the wrong direction (rises) then the risks tilt in favour of rate cuts.
• The issue that “worries me most is weak productivity growth”. “I fear that our economy is becoming less dynamic”.
• The RBA Board is focussed on the balance of risks – the benefit obtained from lower rates versus the risk that people significantly borrow more
• The likelihood of interest rates going up any time soon is exceedingly low.
• Lower interest rates have allowed people to pay off their debts more quickly. So lower rates have provided benefits.
• The Reserve Bank Governor expects inflation to be at 2 per cent next quarter and then bounce around this level over 2020.
• The discussion that central banks are having across the globe is whether inflation targets should be lifted, not reduced.
• The inflation target is like a “North Star” – providing the direction of monetary policy.
• Last year our (Reserve Bank) forecast on economic growth was overly optimistic. The main reasons for the miss was the balance sheet adjustment of households. The other big surprise was the big lift in labour force participation last year. That is fantastic but it has mean the unemployment rate has stayed higher.
• Coronavirus. SARS provides a guide but the Chinese population is far bigger and China is more engaged in the global economy. Risks to the Australian economy from coronavirus are bigger than SARS. Coronavirus affects tourism, education, agriculture & aquaculture and some disruption to supply chains.
• Lower interest rates have boosted home prices and have benefited the economy by lifting household asset values. Over the past six months lower interest rates have boosted home prices and household asset values and in turn have boosted spending. But you can have too much of a good thing.
• “Our fundamentals are fantastic”. Lowe noted that Australia was a rich and prosperous country.
•  The ‘big shock’ is the rise in the workforce participation rate. The US hasn’t seen the same lift. A 5.1 per cent unemployment rate is “reasonable” but it is desirable to have a lower rate.
• Wage growth above 3 per cent is desirable but I can’t see that happening any time soon.
• There was discussion about the link between lower interest rates and lower confidence levels. Lowe believes that low wage growth and falling home prices have had the greatest impact on confidence
• Reserve Bank Governor said that economic nirvana is inflation at 2.5 per cent, unemployment at 4 or 4.5 per cent and wage growth of 3.5 per cent.
• The Reserve Bank Governor believes Australia has become more risk averse.
• The Governor describes the economy as ‘OK’.
• Deputy Governor Guy Debelle is using the business liaison programme to focus on how companies are being affected by the coronavirus outbreak
•  The Governor believes a slow and steady approach is important in meeting inflation target.
• Borrowers should be shopping around for a better deal on their mortgage or borrowing costs.

What is the importance of the testimony

• The Reserve Bank Governor delivers testimony to the House of Representatives Economics Committee every six months. The testimony enables investors to have more insights on the economy and the operation of monetary policy

What are the implications for interest rates and investors?

• The unemployment rate is the key indicator to watch. If unemployment was to rise the Reserve Bank Governor indicated that rate cuts would be back on the table. At present the risks are more balanced.