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Markets doubt RBA can achieve its jobs target – 23 July 2019

Australian Financial Review

Fixed income traders reckon the cash rate will average below 1 per cent over the coming five years, suggesting easier policy will not bring inflation back.

The RBA has moved to explicitly targeting a lower unemployment rate. The problem: markets don’t believe they can do it.

The overnight indexed swaps (OIS) market reveals traders now expect the cash rate to average below 1 per cent over the next five years.

The RBA has moved to explicitly targeting a lower unemployment rate. The problem: markets don’t believe they can do it.

The overnight indexed swaps (OIS) market reveals traders now expect the cash rate to average below 1 per cent over the next five years.

The market’s vote of no confidence in the efficacy of extreme monetary policy comes ahead of Reserve Bank governor Philip Lowe’s most important speech of the calendar year at the annual Anika Foundation lunch in Sydney on Thursday.

The title of that speech is “Inflation Targeting and Economic Welfare”.

It suggests Lowe will use the occasion to mount a spirited defence of the bank’s decision to push rates towards zero, thereby embarking on a well-trodden path taken by peers such as the European Central Bank, the US Federal Reserve and the Bank of Japan.

Right or wrong, it has not escaped the market’s attention that all the countries that pushed rates below 1 per cent “spent literally a decade” below that level, says ANZ head of Australian economics David Plank.

Traders are looking at those experiences and asking: “Why would the RBA be any more successful?”

“The market is saying once you get trapped in to a low-rate environment, you stay there for a very long time,” Plank says.

The other implication from the market’s rates outlook is, perhaps, the more worrying one: that traders judge the RBA’s unemployment target to be “incredibly ambitious”, Plank says.

With inflation below target and falling amid too much spare capacity in the labour market, the Reserve Bank has retuned its policy framework to target a jobless rate of 4.5 per cent. Around this level, wages growth should begin to pick up and put the RBA back on track to meeting its 2-3 per cent inflation target over time.

The trouble is that the jobless rate, now sitting at 5.24 per cent, has been drifting higher, not lower.

This makes it “incredibly difficult” for the RBA to forecast falling unemployment, Westpac’s Bill Evans notes. This is particularly the case when the central bank’s economists expect only trend growth through 2020.

The RBA remains convinced monetary policy still works, even as it approaches the zero lower bound. Lower loan costs boost borrowers’ cash flow. And banks have passed on an average 45 basis points of that 50-point reduction, Westpac estimates.

Even if the Aussie dollar is stubbornly stuck above US70¢ thanks to a sky-high terms of trade and the prospect of easier policy overseas, the RBA argues –reasonably – that rate cuts have resulted in the currency being lower than it otherwise would have been.

So, yes, lower rates will make a difference to growth and jobs growth, even if the market is saying it won’t be enough to achieve escape velocity from the trap of low rates.

But it is not a costless trade-off.

As has been reported extensively, very low rates make it hard for savers and investors to generate the income they need in retirement, and will push investors into taking risks with which they are perhaps not entirely comfortable.

More fundamentally, the OIS market’s rates expectation also implies that the cash rate after inflation will be below zero for a very long time.

Very low and negative real rates are distortionary.

“If everybody can finance themselves at very low rates, then you end up with zombie companies,” Plank says. That is, companies that otherwise would struggle to stay in business, or which would be swallowed up by stronger competitors, end up trading on thanks to the very low cost of funding.

ANZ’s Plank says this reduced competitive tension as a result of very low rates is something his clients are discussing.

In particular, property developers who would normally be quite active in taking over struggling businesses in tough periods are failing to do so as cheap money keeps weaker competitors afloat.

No surprise, then, that Plank believes negative real rates will lead to more financial engineering, such as increased share buybacks among listed companies, “because the return on issuing debt and buying shares is greater than anything else”.

Article appeared in The Australian Financial Review on 23 July 2019.

Article written by Patrick Commins.

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