Minutes of the Monetary Policy Meeting of the Reserve Bank Board

Videoconference – 5 May 2020

Members Participating

Philip Lowe (Governor and Chair), Guy Debelle (Deputy Governor), Mark Barnaba AM, Wendy Craik AM, Ian Harper, Steven Kennedy PSM, Allan Moss AO, Carol Schwartz AO, Catherine Tanna

Others Participating

Michele Bullock (Assistant Governor, Financial System), Luci Ellis (Assistant Governor, Economic), Christopher Kent (Assistant Governor, Financial Markets)

Anthony Dickman (Secretary), Ellis Connolly (Deputy Secretary), Alexandra Heath (Head, Economic Analysis Department), Bradley Jones (Head, International Department), Jonathan Kearns (Head, Financial Stability Department), Marion Kohler (Head, Domestic Markets Department)

International Economic Developments

Members commenced their discussion of the global economy by focusing on the deep economic contraction arising from the measures to contain the spread of COVID-19. GDP in Australia's major trading partners was expected to decline significantly over the first half of 2020. The timing and size of the contraction in activity was likely to vary across countries, depending on the strictness and duration of the lockdowns, and on the industrial structure of their economies. When the restrictions are eased, economies could be expected to begin to recover, supported by stimulus from both fiscal and monetary policy. Members noted that lingering concerns about the virus, including over possible renewed outbreaks, could nonetheless continue to weigh on the spending decisions of households and businesses. Although the global economy was expected to begin to recover in the second half of 2020, the International Monetary Fund was forecasting a large contraction for 2020 as a whole.

The Chinese economy had contracted by almost 10 per cent in the March quarter. While some parts of the economy had already begun to recover in the month of March as restrictions were eased, members noted that the improvement had been uneven. Industrial production had recovered strongly in the month and other timely indicators suggested that activity more broadly was approaching pre-outbreak levels. Exports had also recovered to a large extent, and members noted that concerns about China-related disruptions to global supply chains had receded. In contrast, fixed asset investment had picked up only modestly and retail spending had remained subdued.

In the major advanced economies, GDP was expected to contract from peak to trough by between 10 and 15 per cent because of lockdowns and other restrictions on activity. Most of this contraction was expected to occur in the June quarter, although some of the effect had been apparent in figures for the March quarter; in that period, GDP had contracted by 1.2 per cent in the United States and by 3.8 per cent in the euro area. Survey data had recorded sharp declines in business conditions in April, particularly in the services sector, which had been most affected by containment measures.

Some economies in Asia, including South Korea, were expected to have smaller contractions in the first half of 2020 because their restrictions had been more targeted. However, economies across the region had faced weak external demand, initially from China and more recently from other trading partners. Service exports had been particularly affected given that inbound tourism had essentially ceased as a result of travel restrictions. India's economy had been under a relatively stringent nationwide lockdown since late March, although there had been some easing in early May.

The labour market implications of the lockdowns and social distancing measures had been severe. For example, claims for unemployment benefits had reached unprecedented levels in the United States and Canada, and unemployment rates were expected to have risen to double digits in many advanced economies in April. Wage subsidy schemes were expected to have tempered the increase in unemployment in some economies, including Germany. These schemes were also expected to support the subsequent recovery by avoiding a wide-scale severing of employment relationships.

The decline in global demand had affected the prices of many commodities, especially oil. Production cuts agreed by major oil producers had not been enough to offset this. The fall in oil prices would flow through to contract prices for liquefied natural gas (LNG) with a lag; in response, some large LNG investment projects in Australia had been deferred. In contrast, iron ore prices had been supported because Chinese demand had held up and supply from Brazil had remained constrained. More generally, global inflation was expected to decline and remain low for some time given the weakness in aggregate demand.

Domestic Economic Developments and Outlook

The Australian economy had been severely affected by the imposition of measures to contain the outbreak of COVID-19. Australian GDP was expected to contract by around 10 per cent over the first half of 2020. Most of the contraction was expected to occur in the June quarter, although a decline in travel service exports and some domestic spending had weighed on activity in the March quarter. An economic contraction of such speed and magnitude would be unprecedented in the 60-year history of Australia's quarterly national accounts. Members noted that the nature of the contraction and the expected recovery was also unprecedented because they were driven by public health measures, rather than induced by economic or financial factors.

Retail spending had increased strongly in March because households had prepared for the period of social distancing and potential supply chain disruptions by stocking up on some grocery and pharmaceutical items and purchasing household goods such as home office and exercise equipment; in contrast, spending in cafes and restaurants had fallen very significantly. Overall, preliminary data for March indicated that retail sales had experienced one of the largest monthly increases in the history of the series, similar in size to the increase in retail sales in the lead-up to the introduction of the goods and services tax in 2000. However, estimates from retailers in the Bank's business liaison program suggested that retail sales had fallen in April. Spending on services and other categories of consumption was also expected to have fallen, consistent with the social distancing and travel restrictions that had been put in place.

Household consumption was expected to contract by around 15 per cent over the first half of 2020. Members observed that, as restrictions were lifted, the effects of lower employment, incomes and wealth would become relatively more important for the consumption outlook.

Social distancing restrictions on home inspections and in-person auctions, as well as heightened uncertainty about the future, had significantly reduced turnover in the established housing market. Members noted that some of the concerns that construction activity could be severely affected in the near term by supply chain disruptions and health-related site closures had not been realised. However, contacts in the liaison program had reported that demand for both new and established housing had fallen. Lower incomes and confidence, as well as lower expected population growth, were expected to affect demand for new housing for an extended period. Members also discussed the effect of a possible increase in the number of people moving back home or living in larger households for financial reasons. At the same time, the supply of rental housing had been boosted as properties that had previously been offered as short-term accommodation were shifted to the long-term rental market.

Businesses had been grappling with deteriorating economic conditions and low confidence about future demand. Many liaison contacts had reported that they were taking steps to preserve cash flow, including deferring non-essential investment. Non-mining business investment was therefore expected to decline significantly. Mining investment was likely to be relatively more resilient, although weaker than previously expected largely because of deferred LNG projects.

Members also discussed the impact on investment of possible changes in the pattern of activity after the recovery. Examples included the potential for significant changes in demand for office space if more people worked from home on a regular basis, and a continuing shift of retail activity away from bricks-and-mortar stores if retailers expand their online operations.

The March labour force survey had referenced the first half of the month and therefore had not shown signs of contraction; employment had increased modestly and the unemployment rate had been 5.2 per cent. However, payroll data published by the ABS indicated that over the five weeks to mid April there had been a significant decline in the number of paid jobs across many industries, especially those related to tourism, entertainment and dining out. As well as being the activities most affected by social distancing requirements and movement restrictions, these industries employ a high share of workers on casual arrangements. Job advertisements had declined noticeably in March and April. Members noted that, at the same time, firms in some industries, including agriculture, were looking to employ more workers.

Overall, the peak-to-trough decline in total hours worked was expected to be around 20 per cent; this was expected to be larger than the decline in output, partly because many of the most-affected activities were highly labour-intensive. ABS surveys of households and businesses suggested that some of the labour market adjustment had occurred through lower average hours worked by those remaining in employment rather than through job losses. Information from the business liaison program suggested that many firms had asked staff to take paid leave or work shorter hours. These weak labour market conditions were in turn expected to result in slower wages growth; wage freezes were likely to become more common, and there had already been isolated reports in liaison of wage cuts.

The unemployment rate was expected to peak at around 10 per cent in the June quarter. Members noted that this figure would have been much higher were it not for the JobKeeper wage subsidy scheme. The temporary suspension of job search requirements for eligibility for the JobSeeker unemployment benefit was also expected to lower measured unemployment rates, as some recipients would not actively search for work, in part because public health measures had made doing so more difficult. Members observed that, despite the size and breadth of these programs, some people who had lost work would not be eligible for either payment.

The outlook for the labour market suggested that growth in labour income would fall in the near term, although the increase in social assistance payments would provide some support to household incomes over this period. Lower interest payments had already provided a small boost to the disposable incomes of households with mortgages and other debt. In terms of government finances, members noted that lower household income growth would result in lower tax receipts at the same time as there was an increase in social assistance payments and other fiscal stimulus measures.

Inflation pressures had increased a little up to the March quarter. Year-ended CPI inflation had been 2.2 per cent and trimmed mean inflation had been 1.8 per cent. The effect of the COVID-19 outbreak on prices had been limited in the quarter, although it had been evident in the prices of items where retail demand was strongest in March, in particular rice, pasta and non-durable household products such as toilet paper, soap and hand sanitiser. Grocery prices had continued to be boosted by the effects of drought in the March quarter.

The COVID-19 restrictions were expected to have a very large effect on prices in the June quarter. Headline CPI was expected to fall by around 2¼ per cent in the June quarter, driven by the decline in petrol prices and the removal of childcare fees. More generally, government actions to reduce some administered prices in the current environment, while assisting households, were also expected to contribute to lower inflation in the near term. The anticipated slowing in growth in labour costs and decline in rent inflation were expected to put downward pressure on inflation over the forecast period. These factors were expected to more than offset any price rises stemming from supply disruptions or the depreciation of the exchange rate.

Members noted that beyond the first half of 2020, the outlook for the domestic economy would depend on how long restrictions on economic activity were in place and how long uncertainty and diminished confidence weighed on the spending, hiring and investment plans of households and businesses. Given the uncertainties, members considered three plausible scenarios for the outlook.

The baseline scenario assumed that the process of relaxing social distancing measures would continue over coming months, but that restrictions on large gatherings and national border controls would remain in place until towards the end of the year. Under the baseline scenario, the economy was expected to begin recovering gradually over the second half of 2020. However, the level of output was expected to remain lower – and the unemployment rate higher – at the end of the forecast period than had been projected in February.

Australia had achieved a relatively rapid decline in new cases of COVID-19 and some states had already relaxed some restrictions. Members therefore also contemplated an upside scenario that assumed most domestic activity restrictions would be relaxed sooner and that the economy would recover somewhat faster than in the baseline scenario. In this scenario, it was likely that employment growth and spending would recover more rapidly, while the unemployment rate would decline more quickly; better health outcomes elsewhere in the world would reinforce this positive dynamic. The level of GDP at the end of the forecast period in this scenario would still be lower than had been expected in February, in part because of the lags involved in non-residential construction projects and the deferral of large LNG projects.

Members also considered a more negative scenario, which could occur if the lifting of restrictions were to be delayed or the restrictions needed to be reimposed. In this scenario, there could be ongoing concerns about the virus, and a slower pick-up in spending even after the restrictions were lifted because household and business confidence would remain low for longer. GDP would be expected to remain around its trough for several quarters and unemployment near its peak into the following year. The subsequent recovery would also be slower than in the other scenarios, even if the virus were eventually contained, because the longer downturn would involve more job losses and business failures, and therefore do more lasting damage to employer–employee connections and supplier networks.

Inflation was expected to remain below the trajectory anticipated in February in all three scenarios. The main differences in the expected paths for inflation related to different degrees of spare capacity in the labour market, resulting in growth in labour costs slowing to varying degrees.

International Financial Markets

Following the sharp tightening in March, financial conditions in many economies eased in April, aided by extensive policy measures by central banks and governments and reflecting less pessimism amid a slowing in the spread of COVID-19 in most advanced economies.

Members noted that market functioning in sovereign bond markets had improved significantly, as had conditions in key money markets. As a result, a number of central banks had scaled back bond purchases aimed at supporting market functioning, as well as the extent of their market operations to provide liquidity. This was also the case in Australia. Sovereign bond yields had stabilised or declined slightly in April in a number of advanced economies, including in Australia, to be at or near historic lows. This was despite the issuance of public debt having picked up noticeably and it being likely to remain at historically high levels in the period ahead.

Since early April, a number of central banks in advanced economies had also expanded existing programs or introduced new programs to support the provision of credit to specific sectors or markets that remained under strain. Members noted that this had helped to lower borrowing costs for some corporations, and state and local governments in some economies. Central banks had made clear that they stood ready to provide further stimulus if required.

The easing in financial conditions through April was evident in a range of other indicators, but had not been uniform. Corporate credit spreads had tightened and bond issuance in the United States and Europe had rebounded strongly, with a resumption of investment flows into credit-focused money market and corporate bond funds. At the same time, many corporations had drawn on pre-existing credit lines as a source of funding. Nevertheless, for lower-rated corporate and sovereign borrowers, funding costs remained higher than before the onset of the pandemic and market conditions remained fragile. This included parts of Europe, where there was a risk of sovereign credit rating downgrades and borrowing costs remained volatile.

Members also noted that equity prices in many advanced economies, including Australia, had recovered around half the losses since their trough in late March, reflecting a slowdown in the spread of COVID-19 and the strong policy responses. Nevertheless, valuations for certain sectors, including banks and energy companies, had fallen materially over the preceding quarter or so. This reflected expectations of a particularly challenging period for earnings growth and capital raising for those industries in the months ahead. Volatility of equity prices overall remained higher than longer-term averages. These developments in global equities had also been observed in Australia.

In China, conditions in financial markets had remained relatively stable throughout the COVID-19 pandemic and credit growth had continued at a steady pace. As in the financial crises of 2008 and 1998, the renminbi had remained stable, with foreign exchange reserves having declined a little from high levels. Financial conditions in other emerging market economies had recently stabilised after a sharp tightening in March. The return of capital flows and policy easing domestically and in advanced economies had supported asset prices, and exchange rates had appreciated somewhat. However, members noted that substantial risks in emerging markets remained, particularly for those economies that are vulnerable to a sustained period of low commodity prices and/or have sizeable foreign debt, particularly where denominated in foreign currencies and unhedged.

Like many other financial markets, the functioning of global foreign exchange markets had improved, helped in part by the supply of US dollars made available through foreign exchange swap lines. But conditions had yet to return fully to those prevailing prior to the COVID-19 outbreak. Over the preceding few weeks, the US dollar had recorded a small but broad-based depreciation after appreciating strongly during the first quarter of the year. Members also noted the appreciation of the Australian dollar from its low point in mid March. This had followed an earlier period where the Australian dollar had depreciated even more sharply, such that the exchange rate remained around 5 per cent lower over the year to date.

Domestic Financial Markets

The package of monetary policy measures implemented by the Bank in mid March was working broadly as expected.

Since mid March, the Bank had purchased a total of about $50 billion of Australian Government Securities (AGS) and semi-government securities (semis). The yield on 3-year AGS had remained at the target of around 25 basis points and market functioning had significantly improved for government bonds. Daily volatility in AGS bond yields and bid-offer spreads had declined since their peaks in mid March, while measures of market depth had increased. Consequently, the Bank had gradually reduced the size, and more recently the frequency, of its bond auctions, which initially had been conducted daily. This had occurred at the same time as there had been a large increase in the issuance of both AGS and semis, which had been achieved at low yields. The various tenders for AGS had been met by consistently strong demand, and the yield curve had shifted down significantly since early March. The amount and maturity of the Bank's daily open market operations had also been scaled back over the prior month in response to improving market conditions and reduced demand for liquidity from the Bank's counterparties. This reflected the ample liquidity already in the banking system, including as a result of other elements of the Bank's policy package.

Members noted that, in response to the large amount of liquidity in the banking system, Exchange Settlement balances held by banks were high, reducing banks' need to borrow from each other in the overnight market. Consequently, the cash rate had drifted a little lower, to be around 14 basis points, where market participants expected it to remain for some time.

The package of monetary policy measures had also contributed to a further decline in bank funding costs. Members noted that deposit rates, and short- and long-term domestic wholesale borrowing rates, were as low as they had ever been in Australia. There had been some issuance by Australian banks in wholesale markets, and a number of foreign banks had raised bonds in the Australian market in April. Overall, Australian banks' needs for additional funding were currently low, since they had strong liquidity and funding positions. Reflecting this, members noted that, to date, there had been modest take-up of funding from the Bank's Term Funding Facility, which provides low-cost funding at 0.25 per cent for a term of three years. However, banks were expected to draw on this facility to replace more expensive term funding as it matures, which would help to keep funding costs low.

Banks had lowered interest rates for business borrowers substantially since mid March, in light of the Bank's policy package as well as government initiatives to support lending to small and medium-sized businesses. Interest rates for small businesses had declined most and many of these businesses had been offered loan payment deferrals for up to six months. Liaison with banks suggested that around 20 per cent of eligible businesses had taken up this option.

Members noted that business credit growth had picked up strongly in March. Most of this rise reflected larger businesses drawing on existing credit lines, as had been seen in a range of other countries. It was too early to assess how much of this funding was urgently required or more precautionary in nature. Several large non-financial corporations had also issued bonds offshore in the recent period. In contrast to larger firms, bank lending to small and medium-sized businesses was little changed. Members noted that loan applications were often taking longer to process, partly reflecting administrative delays as financial institutions responded to a high volume of enquiries.

Banks had also reduced housing interest rates to record lows. Members observed that a large share of the monetary policy easing since May 2019 had been passed through to variable mortgage rates, and advertised fixed mortgage rates had declined even further over recent months. Banks had also offered housing borrowers loan payment deferrals for up to six months, with a reported take-up rate of around 10 per cent for the largest lenders and somewhat less for smaller lenders. Meanwhile, many other borrowers were maintaining mortgage payments in excess of their required minimum payments.

The sharp decline in economic activity was expected to dampen the demand for borrowing from businesses and households for some time.

Financial Stability

Members continued their discussion of financial stability issues from the previous meeting, focusing on some particular risks to financial stability that were being monitored closely.

Internationally, banks were generally in a stronger position than they had been entering the global financial crisis, since they now had substantially more capital and liquidity. However, in some jurisdictions, banks had low profits and their large holdings of sovereign debt in their home country exposed some of them to concerns about high government debt.

The preceding seven years had seen a very large increase in the stock of BBB-rated non-financial corporate debt, which was on the ratings threshold for being considered investment grade. For both US dollar and euro-denominated debt, BBB-rated debt was around three times the stock of BB and lower-rated debt. Members noted that this debt would fall outside the investment mandates for some asset managers if it were downgraded to sub-investment grade; as a result, downgraded firms could face greater difficulty rolling over their borrowings. There had also been a very large increase in the value of leveraged loans made to less creditworthy corporate borrowers, and a higher share of these loans were ‘covenant-lite’. There had been a sharp decline in the price of these loans as a result of increased risk associated with the global economic contraction.

Members were briefed on the resilience of Australian households in the current downturn. Around one-third of households with mortgages had prepayment buffers of three years or more. But a smaller share had no mortgage prepayment buffer and were more susceptible to financial stress. Housing loan arrears were likely to increase, but the extent would depend on the severity of the economic contraction and the associated increase in unemployment. Loan payment deferrals would reduce the increase in arrears rates for at least the following six months.

Members discussed vulnerabilities associated with commercial property, particularly for office and retail property. A large amount of new office space was expected to be completed in Sydney and Melbourne in 2020. Members noted that demand was not expected to keep pace with stronger supply in the near term and therefore it was likely that vacancy rates would rise and office rents would fall. Rising vacancies and reduced rent would be likely to lead to lower valuations, which would pose challenges for leveraged property investors and developers. Retail property was already experiencing rising vacancies and falling capital values prior to the current downturn. The effect on retail businesses of the social distancing measures was likely to exacerbate these problems.

Considerations for Monetary Policy

In considering the policy decision, members recognised that the global economy was experiencing a very severe downturn as countries sought to contain the COVID-19 outbreak through restrictions on activity. Many countries were likely to experience their biggest peace-time economic contractions since the 1930s and labour markets were very weak. The outlook remained uncertain, although if infection rates continued to decline and restrictions were eased, a recovery could be expected to start later in 2020, supported by both the large fiscal packages and the monetary policy response.

The functioning of financial markets had improved over the prior month, although conditions had not completely normalised. Credit markets had progressively opened to more firms and long-term bond yields remained at historically low levels.

Members discussed the very significant economic contraction that was taking place in Australia and the substantial, coordinated and unprecedented fiscal and monetary response. This response was softening the contraction and would help support the economic recovery once the health crisis had passed and restrictions had been removed. It was supporting incomes, maintaining employment relationships, underpinning the supply of credit to businesses and households, and keeping borrowing costs low. Members noted that the Australian banking system, with its strong capital and liquidity buffers, remained resilient and was helping the economy traverse this difficult period.

Members agreed that the Bank's policy package was working broadly as expected. The package had helped to lower funding costs and stabilise financial conditions, and was supporting the economy. The package had also contributed to a significant improvement in the functioning of government bond markets, and the 3-year Australian Government bond yield was at the target of around 25 basis points. Given these developments, the Bank had scaled back the size and frequency of bond purchases. The Bank was prepared to scale up these purchases again, if necessary, to achieve the yield target and ensure bond markets remain functional. The yield target was expected to remain in place until progress was made towards the goals for full employment and inflation.

The Bank's daily open market operations were continuing to support credit and maintain low funding costs in the economy. To assist with the smooth functioning of Australia's capital markets, the Board endorsed a proposal to broaden the range of eligible collateral for the Bank's domestic market operations to include Australian dollar securities issued by non-bank corporations with an investment grade credit rating. This change would bring the treatment of corporate bonds in the Bank's collateral framework into close alignment with that of bank debt. It would improve the liquidity characteristics of some corporate bonds, helping to facilitate the smooth functioning of the market. The proposed approach was consistent with the collateral frameworks of the major central banks, which accept corporate paper under repurchase agreements (repos), and it would not have a material impact on the Bank's risk profile. Members noted that the Bank would not be purchasing corporate paper on an outright basis, but only under repos.

In the various scenarios for the Australian economy considered by the Board, the labour market was expected to have ongoing spare capacity, and inflation was expected to be below 2 per cent over the following few years. Given this outlook, the Board would maintain its efforts to support the economy by keeping funding costs low and credit available to households and businesses. As the Bank's policy package had been introduced only recently, members assessed that the best course of action was to maintain the current policy settings and monitor economic and financial outcomes closely. The Board remained committed to supporting jobs, incomes and businesses during this difficult period and to assisting Australia to be well placed for the expected recovery.

The Decision

The Board reaffirmed the elements of the policy package announced on 19 March 2020, namely:

• a target for the cash rate of 0.25 per cent
• a target of 0.25 per cent for the yield on 3-year Australian Government bonds
• a Term Funding Facility to support credit to businesses, particularly small and medium-sized businesses
• an interest rate of 10 basis points on Exchange Settlement balances held by financial institutions at the Bank.

The Board confirmed that the target for three-year yields would be maintained until progress was made towards the Bank's goals of full employment and the inflation target, and that it would be appropriate to remove the yield target before the cash rate itself was raised. The Board determined that it would not increase the cash rate target until progress is made towards full employment and it is confident that inflation will be sustainably within the 2–3 per cent target band.

To assist with the smooth functioning of Australia's capital markets, the Board endorsed broadening the collateral eligible for the Bank's domestic market operations to include debt issued by non-bank corporations with an investment grade credit rating.^[1]

Endnotes

Mark Barnaba, Ian Harper and Catherine Tanna did not participate in the discussion of this matter, nor did they take part in the decision. They withdrew on the basis that entities with which they are associated have either issued bonds in the past or might possibly issue bonds in the future, and this could give rise to a perceived conflict of interest on their part. [1]