15 January 2020

Reserve Bank’s fallen guiding stars

As avid sailors know, every well-equipped cruising yacht has a sextant. For those people who have never seen or used one, it is a brass, handheld celestial navigational instrument, first used by sailors in the early 1700s.


Although a modern Global Positioning System device can pin-point your location with exceptional accuracy, if the battery dies, it’s back to navigating by the stars.

Central bankers also navigate by the ‘stars’ – two in particular.

The first is U-star (U*), which is the full employment level of the unemployment rate. This is the ‘natural rate of unemployment’, or ‘non-accelerating inflationary rate of unemployment (NAIRU) or what you could think of as ‘full employment’. When the unemployment rate falls to U*, this is the point at which wages growth typically picks up and inflation usually follows.

The second is R-star (R*). This the neutral rate of interest at which saving and investment in the economy balance.

The challenge for central bankers is that these stars have both been falling, which has made it difficult to navigate.

For Australia, much of this challenge revealed itself in 2019.

Recall that after almost three years of policy stasis from the central bank, 2019 was a year of action. The RBA had kept its cash rate steady at 1.50% from August 2016 until June 2019. Then came three cuts in four months (June, July and October) to a new record low of 0.75%.

The proximate cause of the cuts was that jobs market was losing momentum, growth was below trend, inflation was below target and other central banks were cutting. Something needed to be done.
But a deeper re-assessment also occurred.

The guiding ‘stars’ that the RBA had used to navigate the course for monetary policy had fallen.
In June 2019, the RBA published its new estimates of U*. Whereas previously the central bank had thought that U* was around 5.0%, it was now estimating it to be around 4.5%.

Of course, there is considerable uncertainty around these estimates and, in truth, you only really know that the economy is at full employment when you actually start to see wages growth and inflation pick up. Nonetheless, an estimate of U* is a key navigational tool for a central bank.

R* had fallen too. Excess global saving relative to investment has been pushing down the R* everywhere. With an open capital account and a floating currency, these global forces have a large bearing on a medium-sized economy like Australia’s.

As other central banks cut their policy rates in 2019, the RBA felt it had to move too. If not, Australia would have to be prepared to tolerate a stronger currency, which is hard when growth is below trend and inflation is too low.

In making this re-assessment the RBA gave up on a previous pretence that Australia might be different. For many years, Australia had higher interest rates than elsewhere, but no longer. Australia was finally getting sucked into the global vortex of ‘lower for longer’ interest rates.

As a result, earlier narratives that the RBA had used to raise concerns about cutting further, including that rate cuts would not do anything useful, that rates were not the constraint on businesses and that further cuts could pump prime already high household debt, were largely cast aside.

This re-assessment meant that, not only did the RBA cut its cash rate, but from mid-2019 it started to provide clear forward guidance that rates would be low for a ‘considerable period of time’.

At the same time, the RBA increasingly asked for fiscal policy to do more of the heavy lifting to support economic growth. The RBA Governor, Phil Lowe, has spoken more about the need for fiscal policy and structural reform in his recent speeches than ever before, and by a wide margin.

And why wouldn’t he? At the same time that ‘lower for longer’ interest rates dis-empower the RBA – as the cash rate nears its effective lower bound – they empower governments, which can now borrow at very low interest rates for long periods of time.

Like a skipper yelling at crew into a 40-knot gale, this ‘jawboning’ has largely been ignored.

Fiscal policy has remained tight as the government seeks to deliver on its May 2019 election promise to deliver a budget surplus. This was re-iterated in December with the mid-year fiscal update confirming the government’s plans to return to budget surplus this financial year, despite a sub-par growth outlook.

2020 does not look any easier. The economy is in the doldrums and with little room to cut its cash rate further the RBA may be forced to take emergency action, like a bond-buying programme. Fiscal policymakers seem unwilling to hoist a spinnaker, or any other new sails. The falling stars have made navigating the economy much harder.

Better keep that sextant handy.

This article first appeared in The Australian Financial Review on 15 January 2020.