WHEN RATE CUTS AREN'T ENOUGH: Why the RBA could get experimental if Australia's economy really hits the skids

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  • Most economists and those in financial markets expect the RBA will deliver multiple rate cuts — perhaps as many as three quarter-point reductions — by the middle of 2020.
  • That despite unemployment siting near an 8-year low of 5% and economic growth being sluggish but not horrendous.
  • If a sudden economic shock were to hit, a lack of conventional monetary policy ammunition could see the RBA turn to unconventional policy measures to stimulate the economy.
  • Rather than QE or negative interest rates, Citibank believes “helicopter money”, or printing money to be distributed to the public, is the “ultimate” unconventional monetary policy tool the RBA could use in such a scenario.
  • It says there’s around “a one-third chance” such a policy response could occur in the next three years.
  • Citi’s base case is that the RBA will go hard and early with rate cuts, forecasting a 25 basis point decline in May with the risk of a follow up move in June.

Having been stable since August 2016, financial markets, and most mainstream economists, expect the Reserve Bank of Australia (RBA) will cut Australia’s cash rate in the months ahead, potentially as soon as May 7.

Weak inflationary pressures, combined with falling home prices and increased risks to the global economic outlook, have seen markets price in two 25 basis point rate cuts by the end of this year, with a small risk of a third cut also being contemplated by the middle of 2020.

Should those views be proven correct, it will see Australia’s cash rate fall to just 0.75%, a new record low.

But what if conventional rate cuts aren’t enough to help boost economic activity, lift inflation and help to lower unemployment, in the period ahead?

What if the perceived risks in the global economy actually materialise, or if Australian home prices fall for a longer and greater amount than many currently expect, potentially weighing on economic activity and increasing the risk of a lift in unemployment?

It’s not inconceivable that such a scenario may occur, particularly as many of the factors that have led to widespread expectations for rate cuts weren’t being considered until just a few months ago.

With underlying inflationary pressures already weak and moving further away from the RBA’s 2-3% medium-term annual inflation target, such an environment will make it even harder for the RBA to achieve its inflation mandate, raising the spectre that disinflationary pressures may evolve into something far, far worse: outright deflation.

There’s not exactly a lot of traditional monetary policy ammunition left for the RBA to use — the cash rate is, at just 1.5%, already the lowest level on record.

Back before the GFC, it stood at 7.25%.

If 575 basis points of rate cuts hasn’t been enough to help boost inflation and return unemployment to the levels seen before the GFC, what good will 50, or maybe even 75 basis points of additional monetary policy easing, do to improve the current predicament? It may help at the margin, but for how long?

While some believe that’s a good reason for the RBA to not cut official rates again, particularly with Australia’s unemployment rate still sitting near the lowest level in eight years at 5%, to others, the threat posed by a potential adverse economic shock means the debate now needs to move beyond rate cuts to other ways the RBA can stimulate activity if and when traditional monetary policy support becomes exhausted.

In the past quantitative easing, or QE for short, has been mentioned as one possible policy response, a scenario that would see the RBA follow in the footsteps of other major central banks during the post-GFC era and begin a program of asset purchases to help lower market interest rates.

The RBA has openly discussed this option in the past, including in a well-publicised speech from RBA Deputy Governor Guy Debelle late last year.

Negative interest rates — where the cash rate is reduced below 0% — may also be an option, although whether it could be implemented in practicality remain debatable given Australia still runs a current account deficit, requiring funding from abroad given limited domestic savings.

Citibank’s Australian economics and interest rate strategy team believe there’s a third option available to the RBA should the need arise: “helicopter money”, or printing money to be distributed to the public via the government.

“Whilst on the experimental end we think it deserves serious consideration by the RBA,” said Paul Brennan, Josh Williamson, Carl Ang and Steven Mansell, members of Citi’s Australian economic and interest rate strategy team in a research note.

Citi believes this is the “ultimate unconventional monetary policy [tool] for the RBA”, providing greater bang for its buck in helping to stimulate the economy without some of the negative side effects of alternate unconventional policy measures such as QE.

“Helicopter money would be more effective than negative interest rates,” Citi said.

“For example, it could take the form of government cash handouts to households for spending, financed by a permanent increase in RBA money supply.

“Unlike negative interest rate and quantitative easing policies, helicopter money can be designed to boost economic efficiency [such as lowering unemployment] whilst limiting negative spillovers to other areas like financial systems stability [such as risks associated with asset bubbles] and distributional equity [such as wealth inequality].”

Citi points to the impact of cash handouts delivered to households by the Australian government in the immediate aftermath of the GFC as evidence of the effectiveness in helping to kick-start economic activity.

“Consumer spending contracted in the three quarters prior to the delivery of the stimulus but rebounded strongly following their delivery and in conjunction with RBA rate cuts with annual growth in real consumer spending going from negative to above trend,” Citi said.

“We would expect a similar response in the case of a large helicopter drop of payments to households and the response could well be larger given that more households are probably income constrained now as wage growth has slowed materially since the GFC.”

Citi also believes cash payments to households, particularly if targeted to low and middle-income households, are less likely to encourage greater leverage and asset price inflation than other unconventional policies such as QE and negative interest rates, potentially limiting the risk of exacerbating debt levels and wealth inequality between asset rich and poor households.

While only a hypothetical policy response at this stage, and one that is unlikely to be considered unless the economy really falls into a funk, Citi believes there’s a decent chance the helicopter’s may be fired up in the not too distant future.

“The monetary/fiscal coordinated easing scenario suggested… would be an unorthodox policy response to a deep cyclical slowdown in Australia as it would blur the boundary between monetary and fiscal policy and raise issues around central bank independence,” it said.

“However, to us, the RBA seems legally and operationally capable of its implementation which makes it a material policy scenario both in terms of its probabilities — conceivably up to a one-third chance over the next 3 years — and possibilities.”

Although a non-insignificant risk in its opinion, Citi doesn’t expect such a policy response at this point, believing instead that the RBA will go hard and early with rate cuts, forecasting a 25 basis point reduction in May with the risk of a follow-up cut in June.

Along with a sharp deterioration in economic conditions, Citi only sees helicopter money being introduced after Australia’s cash rate falls to and remains at its lower-bound — deemed to be 0% to 0.5% — for a considerable period of time.

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