Reserve Bank scraps bond yield target
Reserve Bank Board meeting

The Reserve Bank (RBA) left the cash rate target at 0.1 per cent.

However the RBA will discontinue the target of 0.1 per cent for the April 2024 Australian Government bond.

The RBA continues to purchase government securities at the rate of $4 billion a week until at least mid-February 2022.

Background

• In the lead up to today’s Reserve Bank Board meeting an aggressive repricing of short-term market interest rates took place with the Aussie bond market, experiencing its biggest rout since 1994. The sharp move followed the release of the September quarter inflation report last Wednesday (October 27). The data showed an acceleration in the Reserve Bank’s preferred inflation measure – the trimmed mean – which strips out volatile one-off items, like energy, food and child care prices. In fact, the core or underlying mean inflation lifted by 0.7 per cent in the September quarter to be up 2.1 per cent on a year ago – the strongest annual pace in 6 years – and reaching the bottom of the Reserve Bank’s 2-3 per cent inflation target range.

• The inflation reading sparked a reaction from investors who fixated on whether the supply-side inflation shock – prompted by pandemic-induced supply chain disruptions, port blockages, surging freight costs, elevated commodity prices and labour shortages – would be persistent. Of course, global central banks and economists have been expecting inflationary pressures to be ‘transitory’ as economies re-open and markets rebalance, amid rising vaccination rates. But recurring Delta virus outbreaks, rising producer and consumer prices, and soaring crude oil prices amid a slowing of global growth have raised fears of a period of ‘stagflation.’

• And back in Australia the ‘inflation scare’ contributed to extreme volatility in bond markets last week. In fact, the benchmark Australian Government 3-year bond yield (November 2024) surged by 91 basis points to 1.22 per cent in October, the biggest spike in the yield since June 1994. The rate on Australia’s April 2024 bond note – which the RBA sought to hold around 0.1 per cent to lower borrowing and funding costs across the economy – saw its yield jump by 73 basis points to 0.775 per cent in October amid thin liquidity.

• The extraordinary moves in bond markets, fuelled by the Reserve Bank’s reluctance to defence its yield curve target, raised speculation that the Board could abandon its framework, including the 2024 interest rate forward guidance at today’s meeting.

Today’s decision: What happened?

• Yield curve target: The Reserve Bank has abandoned the April 2024 bond yield target of 0.1 per cent with immediate effect, “reflecting the improvement in the economy and the earlier-than-expected progress towards the inflation target. Given that other market interest rates have moved in response to the increased likelihood of higher inflation and lower unemployment, the effectiveness of the yield target in holding down the general structure of interest rates in Australia has diminished.”

• Cash rate forward guidance: The Reserve Bank also removed its previous forward interest rate guidance. It had previously said that the conditions for an interest rate lift-off were unlikely to be met before 2024. Instead now the RBA says, “The Board will not increase the cash rate until actual inflation is sustainably within the 2 to 3 per cent target range. This will require the labour market to be tight enough to generate wages growth that is materially higher than it is currently. This is likely to take some time. The Board is prepared to be patient, with the central forecast being for underlying inflation to be no higher than 2½ per cent at the end of 2023 and for only a gradual increase in wages growth.”

• Updated economic forecasts: According to the Reserve Bank, “The central forecast is for [economic] GDP growth of 3 per cent over 2021 and 5½ per cent and 2½ per cent over the following two years. The central forecast is for the unemployment rate to trend lower over the next couple of years, reaching 4¼ per cent at the end of 2022 and 4 per cent at the end of 2023. The central forecast is for underlying inflation of around 2¼ per cent over 2021 and 2022 and 2½ per cent over 2023. The central forecast is for underlying inflation of around 2¼ per cent over 2021 and 2022 and 2½ per cent over 2023. Wages growth is expected to pick up gradually as the labour market tightens, with the Wage Price Index forecast to increase by 2½ per cent over 2022 and 3 per cent over 2023.”

Implications

• The Reserve Bank’s updated economic forecasts – which sees the unemployment rate hitting 4 per cent in 2023, wages growth of 3 per cent and underlying inflation at 2½ per cent – implies that the Board now sees the conditions necessary for underlying inflation to sit sustainably within the 2-3 per cent target range to be achieved by the end of 2023.

• However, Commonwealth Bank (CBA) Group economists expect the RBA to commence increasing the cash rate from November 2022 due to earlier-than-expected reopening of the NSW and Victorian economies and elevated vaccination rates, enabling a paring back of government restrictions.

• We also expect the bond purchase program (QE) to be tapered from $A4 billion per week to $A2 billion per week in February 2022 and for the program to end in May 2022.

• Of course, the reopening of Australia’s international borders could be a wildcard as a renewed inflow of foreign workers boosts labour supply, potentially dampening wages pressures. Also, consumers could redirect spending away from the domestic economy towards international travel.

• While the RBA left its cash rate unchanged today, the lift in short-term market interest rates has already fed through to fixed rate mortgage increases, as overseas interest rates lift with global central banks continuing to tighten monetary policy settings. So the rollover or refinancing of fixed rate mortgages could eventually see mortgage holders confronted with significantly higher borrowing costs and repayments. That said, increased competition has seen variable mortgage rates fall.

• In response to today’s decision, the Australian benchmark 3-year bond yield dropped by 7 basis points to 0.93 per cent and is currently sitting around 0.97 per cent. The Aussie dollar fell from highs of US75.31 cents to lows of US74.86 cents and is currently around US75 cents. And the S&P/ASX200 index pared losses following the interest rate announcement, down 0.4 per cent after falling 0.8 per cent earlier in the session.
Perspectives on interest rates
• The RBA left the cash rate at 0.1 per cent for the 10th meeting after cutting the rate from 0.25 per cent on November 3, 2020. The RBA previously cut the cash rate on March 3 and March 19, 2020, each by 25 basis points. The target rate for 3-year bond yields was left at 0.1 per cent, but the 3-year bond target was discontinued on November 2, 2021. On November 3, 2020 the RBA cut the 3-year bond target from 0.25 per cent to 0.1 per cent. The RBA implemented the 0.25 per cent target rate for 3-year bond yields on March 19, 2020.

Published by Ryan Felsman, Senior Economist, CommSec