Uncertainty around RBA forecasts suggests 2021 will not be boring: Bill Evans

At its December meeting the Reserve Bank Board decided to maintain the policy settings it adopted at the November Board meeting.

The Governor confirmed the key forecasts that were adopted for the November Statement on Monetary Policy: “It will not be until the end of 2021 that the level of GDP reaches the level attained at the end of 2019. In the central scenario, GDP is expected to grow by around 5 per cent next year and 4 per cent over 2022”.

That growth profile is expected to be consistent with an unemployment rate of 8% by end 2020; 6.5% by end 2021; and 6% by end 2022.

It is this persistently high unemployment rate that is expected to weigh on wages growth and ultimately inflation prompting the Governor to confirm that “the Board is not expecting to increase the cash rate for at least 3 years”.

Over the course of the next few months, as we move to the next Board meeting on February 2 the Board may need to significantly review its forecasts.

Firstly, the unemployment rate in December, seems unlikely to reach 8% given its current level of 7.1%.

Westpac expects strong employment growth in November as Victoria reopens and while the participation rate is likely to rise a jump in the unemployment rate to 8% seems unlikely.

Secondly, the RBA is forecasting growth in 2020 of minus 4% implying growth of around 3.5% in the second half. We expect the GDP report for the September quarter will print around 3% leading to a growth rate in 2020 of minus 3% including growth in the second half of around 4.5%. That further supports the likelihood that the unemployment rate finishes the year well below the RBA’s 8% forecast.

With population growth in 2021 reflecting a likely contraction in net immigration potential growth in 2021 could be in the 1.5% – 2.0% range, (the Government’s current forecasts are for net migration in 2020/21 of minus 70,000 and for 2021/22 of minus 20,000).

The RBA’s forecast of GDP growth of 5% in 2021 currently implies a fall in the unemployment rate of 1.5 ppt’s – such a gap between potential and actual growth (3–3.5 ppt’s) could well see a more significant fall in the unemployment rate. Certainly, if we end 2020 with an unemployment rate below 7.5% and markets “buy” the 5% growth forecast for GDP in 2021 markets are likely to be projecting an unemployment rate of well below the RBA’s current 6.5% forecast.

For 2022 the RBA is forecasting another “above potential “growth rate of 4%. While population growth will have lifted in 2022 as foreign borders reopen we are almost certain to get a below par rate of population growth in 2022- implying perhaps a potential growth rate of 2.25% – well below the forecast rate of 4%. Markets may also be surprised that in such circumstances the unemployment rate is only forecast to fall by 0.5% from 6.5% to 6.0%.

We are sceptical about the 5% growth forecast in 2021 but would expect that if it was “delivered” the unemployment rate would finish 2021 well below the RBA’s 6.5% forecast; equally a 4% growth rate in 2022 with sub-par population growth would likely see a bigger fall in the unemployment rate than 0.5 ppt’s.

Faster than forecast falls in the unemployment rate in 2021 and 2022 would certainly invite speculation in the market about the RBA’s policy direction.

Taking the RBA’s unemployment rate forecasts at face value there is clear scope for more policy support. The RBA sees its role as complementary to fiscal policy – “monetary and fiscal support will be required for some time” and “the Board is not expecting to increase the cash rate for at least three years”.

The decision to peg the three year target bond rate at the cash rate is the strongest form of forward guidance – much bolder than we see from other central banks that engage in forward guidance.

On the face value of the RBA’s current forecasts, Westpac’s view that the RBA will be required to adjust the target rate on the three year bond around mid 2022, seems reasonable but, as discussed, the risks around the forecasts will see significant market speculation around this issue through 2021.

We also learned from Deputy Governor Debelle’s speech last week that the 3 year rate is more significant for the private sector than the longer maturities (say 5 – 10 years).

That implies that the sequence of any unwinding of the policy package of the November Board meeting is likely to be QE first; followed by yield curve control; followed by adjusting the cash rate.

In the near term the Governor’s confirmation that “The Board will keep the bond purchase program under review, particularly in light of the evolving outlook for jobs and inflation … is prepared to do more if necessary”. raises the real prospect that the $100 billion program, which is targeted to be completed by June, will be extended. That decision would certainly be consistent with the timing that Westpac currently envisages for the adjustment of the yield curve control policy.

Since the Board announced its suite of policies on November 3 the AUD has risen from USD0.716 to USD 0.737. As noted in the Governor’s Statement the policy response contributes to “a lower exchange rate than otherwise”.  Reasonably the Governor attributes the vaccine related “improvement in risk sentiment” with a depreciation of the US dollar and an appreciation of the Australian dollar”. There is no hint of disappointment or impatience with this rise in the AUD.

Conclusion

Whereas 2021 might appear to be an uneventful year from the perspective of the cash rate the introduction of the RBA’s other policy tools raises a range of uncertainties about the policy mix.

All of these uncertainties will have significant implications for markets; the yield curve; and ultimately the economy.

2021 might not be that boring after all!