Last year the economic policy response to the COVID-19 crisis was strong and highly coordinated. This year the trade-offs are more complex and the cracks are starting to show.
The challenges reflect the differing goals of the monetary and fiscal policymakers, the political backdrop and the limits of the policy tools available.
Let’s start with the goals.
In principle, both the fiscal and monetary policymakers have similar objectives. Both are seeking to grow the economy, create jobs and get the unemployment rate to fall.
In a highly constructive move, in the October 2020 budget, the government formalised this by adopting a labour market target, stating that fiscal policy will be used to seek to get the unemployment rate ‘comfortably below 6%’.
However, as the RBA Governor Phil Lowe stated last week in a speech, the central bank’s assessment is that ‘full employment’ is likely to only be achieved with an unemployment rate closer to 4%, or perhaps even 3-point something.
It is this, a much lower level of the unemployment rate, that the RBA believes will be needed to get wages growth to pick-up sufficiently to get inflation back to the central bank’s mandated target of 2-3% in the medium term.
Widespread caps on wage increases to public sector employees have also contributed to the low wages challenge, adding to private sector wage freezes that are in place.
Now that the unemployment rate has dropped below 6.0% (to 5.8% in February), the government could choose to start to tighten the fiscal settings.
Indeed, a literal read of the budget plans from October suggests that this is precisely the plan.
Keep in mind, up until the COVID-19 crisis, the current (centre-right) government was highly focused on delivering budget surpluses and reducing government debt. With an election needing to be held by May 2022, a shift back to fiscal conservatism ahead of it is entirely plausible.
This would be a considerable headwind to the RBA achieving its mandated inflation objective.
Over the past 30 years or so, the solution to a challenge like this has been simple.
The independent central bank would use its powerful cash rate policy tool to deliver more support as required.
But this is no longer an option. In the current world of low inflation and rock bottom global interest rates, the cash rate policy tool is at its limits.
As the RBA Governor also noted in his speech last week, at 0.10%, the cash rate is at its ‘effective lower bound’.
That leaves the RBA with its unconventional policy tools, including its three-year bond yield target, the term funding facility and its quantitative easing programme.
Despite an earlier reluctance to consider using unconventional policy tools to lift inflation, the COVID-19 crisis has seen the RBA whole-heartedly embrace these new tools.
Many of the RBA’s previous concerns have been pushed aside. For example, the RBA has been much more willing than in the past to state that if low interest rates drive excessive lending growth, prudential tools can be deployed.
The RBA has also been more willing to state that its own actions, in this case the quantitative easing programme, are explicitly putting downward pressure on the currency.
But these unconventional tools are still less powerful than the cash rate.
This is because, in Australia, the bulk of the borrowing by households and businesses is done at short-term (variable) interest rates. To the extent that fixed rates play a role, it is mostly shorter tenors, out to the three-year rate.
The three-year yield is already being held at 0.10% by the RBA’s yield curve control mechanism. So it too, is at its limits.
That leaves the term funding facility and quantitative easing programme. The term funding facility relies on banks tapping the facility in order to lend to households and businesses, which, in turn, must see the need to borrow. At this stage, businesses have been cautious in increasing their borrowing.
Quantitative easing puts downward pressure on the currency, but mostly works through lowering the cost of funding for the Federal and state governments. To be effective, the federal and state governments need to be prepared to borrow and spend.
The RBA clearly has considerable resolve to keep interest rates low. Witness the ramping up of its bond purchases when needed in recent weeks and the clear guidance that the central bank is set to keep its cash rate steady until 2024.
This is also understandable. If the fiscal narrative turns to heading towards surpluses and debt reduction the RBA’s task of getting inflation back to target will get considerably harder.
The optimal solution for the economy may be for the fiscal policymakers to also revise down their own unemployment rate target. The RBA could certainly use the help. But whether that will suit the political narrative remains to be seen. We doubt it.
This article first appeared in The Australian Financial Review