The current economic downturn is like nothing Australia has seen in the post-war period. It calls for policy responses that are unprecedented.
An enormous ‘whole of government’ effort has already been announced, with the main focus being fiscal spending worth AUD194 billion (9.8% of GDP), mostly aimed at keeping workers employed. As the government and RBA have described, the aim is to ‘build a bridge’ for the economy from the pre-COVID-19 to the post-COVID-19 world.
The RBA has a key role to play. However, this role is likely to be quite different to previous downturns over the past thirty years.
In these previous downturns, the RBA’s primary role has been to pump-prime demand by cutting interest rates, with the clear aim of boosting employment and keeping inflation on target.
Although we expect the central bank to continue to target inflation and seek to deliver full employment, in the face of an expected sharp rise in the unemployment rate, these can be thought of as longer term goals. This is consistent with the first two prongs of the RBA’s three-pronged mandate, as specified in the 1959 RBA Act.
However, we expect the third prong, which states that the central bank acts to contribute to economic prosperity and improve the welfare of the Australian people, to be the key focus.
This mandate gives the RBA considerable scope to define its role.
We view the likely choices through three lenses: forbearance, liquidity and financial stability.
Forbearance is our way of describing the key policy measures that are being used by fiscal and monetary policy makers as a part of the ‘build a bridge’ strategy. For households that are temporarily out of work, or businesses that are temporarily not making revenue, the monetary and fiscal actions are designed to tide them over until the economy revives.
To do this, the RBA has cut its cash rate to the lower nominal bound (0.25%) and is buying and selling bonds to keep the 3 year government bond yield close to 0.25%. This has lowered mortgage and business borrowing rates, but also, critically, it has lowered the cost of funding for the government, to help facilitate more fiscal spending.
The RBA has also set up a term funding facility. It allows banks to borrow directly from the RBA at close to zero cost so they can lend to small and medium sized businesses. The lowered cost of funding supports the banks and their own effort at forbearance, through actions such as repayment holidays for mortgage holders and businesses.
As the RBA has ruled out negative interest rates, we see the term funding facility as the main aspect of the central bank’s tool kit that is now expandable in size and scope.
A second role is provision of adequate liquidity. The COVID-19 shock has seen massive capital flows, particularly back to US dollars, and significant market dislocation. The RBA’s increased daily repo transactions – which helps short-term bank funding – and sovereign bond purchases are helping to make these markets more liquid and price more efficiently.
A third key role for the RBA is financial stability. This is set to be a key challenge for the period ahead.
Although forbearance makes sense if the post-COVID-19 world looks structurally similar to the pre-COVID-19 world, it does not make as much sense if there are large differences. This is the challenge that markets are trying to come to grips with and a key reason why markets, particularly equity markets, have been so volatile recently.
For example, if international travel is affected by this event for an extended period, then providing public support for these industries may be costly.
As the RBA has pledged not to buy private sector assets, the choices about how much and which risks will be ‘socialised’ will be made by the government.
This risk also extends to the housing market, which is set to be a critical focus for the RBA and other arms of policy, given high levels of household debt.
While mortgage holders are on repayment holidays, loan arrears are likely to remain low, even in the face of a rising unemployment rate. However, it will be hard to discern which mortgage holders can return to making payments once the repayment holiday ends.
If large enough groups of mortgage holders still are unable to make repayments after the repayment holidays, this will be costly. This could threaten financial stability, which would see the RBA needing to play a bigger role. Expanding the term funding facility to support the mortgage market would be an option.
But it would also raise key questions about how this cost should be allocated between the mortgage holders, the banks and the government.
Having largely delivered policy that provides forbearance and liquidity, for the RBA, the focus should now be expected to shift to financial stability.
This article was first published by The Australian Financial Review.