It’s clear that financial markets are struggling to adapt to a fundamental change in central bank thinking driven by the pandemic — one that has elevated employment as a central bank goal.
For bond markets, it’s all about inflation and how it will drive the next move in interest rates. That’s what has driven recent ructions that forced the RBA to step in and spend more to keep both three year and ten year bond prices down. To an extent it’s understandable — any bond trader under 40 grew up in a world where central banks were fixated on inflation, even at the cost of higher unemployment.
After a prolonged period in which central banks serially undershot their inflation targets, that’s changed. The US Federal Reserve last year softened its inflation target and adjusted its full employment expectations to allow for higher employment and inflation before it would tighten monetary policy. Here, the Reserve Bank has shifted its inflation target thinking from expectations to sustained actual inflation.
It has taken a while for financial markets to comprehend this, and RBA governor Philip Lowe has been saying it more and more loudly.
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In his speech to a business conference yesterday — the only one of note — Lowe further amplified his message about what was driving monetary policy now, and what would continue to drive it in coming years:
I also want to emphasise that the monetary stimulus is not just about achieving an inflation rate of two-point-something. It is just as much about achieving the maximum possible sustainable level of employment in Australia. Unemployment is a major economic and social problem and the board places a high priority on a return to full employment.
This is the same institution, remember, that raised interest rates by 2.75 points from August to December 1994, when unemployment was still above 9%. It was a different time, of course, when memories of Australia’s persistently high inflation in the 1980s were still fresh, but tell that to the workers who lost jobs as unemployment, which had been falling, spiked back again and the recovery was delayed and slowed — or Paul Keating, who had to wear the charge of “five minutes of economic sunshine”.
Keating — along with others like Ross Garnaut — now argues the RBA was equally guilty of holding rates, and the Aussie dollar, too high before 2019, costing jobs and wages growth. That’s a claim that is more contested, but Philip Lowe appears determined to avoid similar charges in the future — and will keep saying it until financial markets get the message.
What’s full employment by Lowe’s standards? “But based on this experience, it is certainly possible that Australia can achieve and sustain an unemployment rate in the low fours, although only time will tell.”
Lowe says the bank will “be relying on the wages and prices data to provide a signal as to how close we are. The current signal is that we are still a long way away from full employment.”
Life’s somewhat easier for Lowe than for Bernie Fraser in 1994 given that, as Lowe said, “at the moment underlying inflation is running at 1.25%, and we expect it to remain below 2% over at least the next two years”. It was over 4% in August 1994 despite the slow recovery.
But Lowe added that even when inflation jumps to around 3% in the June quarter (because of the fall in the June, 2020 quarter due to the lockdowns and COVID), the central bank will not be looking to change policy.
There are still many people who want a job and can’t find one and many others want to work more hours. And on the nominal side of the economy, we have not yet experienced the same type of bounce-back that we have seen in the indicators of economic activity.
In his August 1994 statement commencing the cycle of significant interest rate rises, Bernie Fraser barely mentioned unemployment, except to note it was falling. Instead, he mentioned inflation eight times.
What’s also apparent from Lowe’s speech yesterday is that economic leadership has now been ceded to the Reserve Bank while the Morrison government goes back to reducing stimulus and “reforming” industrial relations.
Time was when it was the treasurer who would offer some big-picture thinking about the trade-off between inflation and unemployment. But Josh Frydenberg isn’t even a Peter Costello, let alone a Paul Keating — he’s a cipher for his department.