Statement on Monetary Policy – August 20241. Financial Conditions

1.1 Interest rate markets

Several advanced economy central banks have cut policy rates, while others are waiting for more evidence that inflation is declining sustainably towards target.

The European Central Bank (ECB), Bank of Canada, Bank of England and Sweden’s Riksbank all cited lower inflation and subdued economic growth as the main reasons for recent rate cuts. Nonetheless, these central banks still consider their policy rates to be restrictive. Other central banks – including the Fed and Reserve Bank of New Zealand (RBNZ) – have left their policy rates unchanged but have signalled that they are closer to cutting rates due to progress on disinflation and easing of labour market tightness.

On the other hand, higher-than-expected wages growth and weaker productivity growth led Norges Bank to push back its guidance on when it might reduce its policy rate, with inflation not forecast to return to target before the end of 2027. The Bank of Japan (BoJ) raised its policy rate by 15 basis points to 25 basis points, citing increased confidence that it would sustainably achieve its 2 per cent inflation target. It signalled that it may tighten policy further from still accommodative levels.

Consistent with central banks’ communications, further progress on disinflation in some economies and easing in labour market conditions, market participants’ policy rate expectations have generally declined since the May Statement. The largest moves have been in the United States where recent inflation and labour market data have been weaker than expected (Graph 1.1).

Advanced economy central banks are running down their asset holdings. The Fed has started to slow its balance sheet reduction by reinvesting a larger proportion of maturing assets. This is intended to reduce the risk of stress in money markets as reserves approach the level desired by the Fed. By contrast, the ECB has increased the pace of its balance sheet reduction, in line with previously announced plans that will see reserves decline more quickly to the level required to support its updated operating framework for monetary policy. The BoJ is still buying bonds, but it announced that it will gradually reduce its holdings of Japanese Government bonds by progressively tapering its purchases so that they only partly offset maturing holdings. This gradual approach is designed to reduce the potential for negative impacts on market functioning compared with a more rapid decline in bond holdings.

Central banks have emphasised that policy rates remain their primary monetary policy tool. The reduction of asset holdings is estimated to have had only a minor effect on financial conditions (relative to changes in policy rates in recent years), in part due to the gradual and well-signalled pace of reduction.

Market participants’ expected path for the policy rate in Australia has shifted down materially since the May Statement.

Although markets have been volatile recently, market pricing currently implies an expectation that lowering of the cash rate will begin from around the turn of the year and continue gradually through 2025 (Graph 1.2). The expected rate path has moved substantially since May. It decreased following the May policy decision but retraced this decline following monthly inflation and labour force data released after the June meeting. Most recently, June quarter CPI data was weaker than market participants had expected. Coupled with a reassessment of the outlook for the policy rate in the United States, these developments have led the expected policy rate path in Australia to fall below that seen prior to the May Statement. That said, market participants expect that the policy rate will be cut later and by less than most other advanced economies, where policy rates were increased earlier and to a higher level than in Australia (Graph 1.2). As a result, the policy rate in Australia is expected to be a little above those in several other advanced economies towards the end of 2025.

The cash rate is above the RBA’s range of estimates of the neutral rate, consistent with other information suggesting that Australian financial conditions remain restrictive.

One way to gauge the stance of monetary policy is to compare the cash rate with estimates of the nominal neutral interest rate. Definitions of the neutral rate vary, but in essence it is the level of the cash rate that would neither stimulate nor restrain demand, such that inflation is in line with the midpoint of the target. Accordingly, the cash rate being above estimates of the neutral rate implies that policy is restrictive.

Estimates of the nominal neutral rate in Australia have increased a little since the pandemic (Graph 1.3). This reflects both slightly higher estimates of the real neutral rate and a small increase in trend inflation expectations (see Box A: Are Inflation Expectations Anchored?). However, estimates of the neutral rate are subject to considerable uncertainty, and different models and assumptions can produce different results.^[1] Different horizons and measures of inflation expectations also give different estimates of the nominal neutral rate. For example, a rise in the measure of inflation expectations – other things equal – would imply a higher neutral rate. Internationally, evidence is mixed as to whether real neutral rates have increased since the pandemic.^[2]

Currently, the cash rate is above the RBA’s range of estimates of the nominal neutral rate. The cash rate is also above most estimates of the nominal neutral rate provided by market economists surveyed by the RBA. While these estimates are inherently uncertain, they are consistent with other information suggesting that Australian financial conditions remain restrictive. This includes a comparison of key financial indicators against historical averages, as shown in Graph 1.4, with conditions faced by many households (shown in orange) tighter than those faced by businesses (shown in purple). The Board, in making its policy decision, reviews a broad set of economic data and the outlook in order to determine whether financial conditions are restrictive enough to return inflation to target in a timely manner.

Government bond yields in most advanced economies have declined since the May Statement as expectations for central bank policy rates have moderated, although Australian yields have declined by less.

Yields in most advanced economies have fallen well below their peaks from October last year but remain above their pre-pandemic levels (Graph 1.5). An exception is Japan, where yields have continued to increase in line with expectations that the BoJ will increase its policy rate further. The smaller decline in Australian bond yields relative to most other advanced economies largely reflects differences in monetary policy expectations. As a result of the smaller decline in Australian bond yields, the spread between Australian and US long-term yields has increased to be positive for the first time since January.

Consistent with the moderation in global inflationary pressures, estimates of long-term inflation expectations implied by inflation-linked government bonds and inflation swaps (which include a premium to cover both inflation and liquidity risk) have declined across most economies, including Australia (Graph 1.6). Movements in long-term real yields have differed across economies, with declines in North America and modest increases elsewhere, while Australian real yields declined in response to the June quarter inflation data. Meanwhile, term premia are little changed since the May Statement, suggesting that investors have not changed the amount of compensation they require for holding nominal interest rate risk.

While financial market measures of long-term inflation expectations in Australia have eased a little in recent months, they remain around the midpoint of the target band after a period of being below that during the pandemic. (See Box A: Are Inflation Expectations Anchored?, which concludes that long-term inflation expectations remain anchored and consistent with the inflation target.)

1.2 Other measures of financial conditions

The prices of riskier assets increased further in May and June, though there has been some retracement of late.

US equity markets rose particularly strongly before pulling back in recent weeks following lower-than-expected earnings for some large technology companies and the weak employment report in July. Australian equities have performed better than most other markets over recent months (Graph 1.7). The rise in equity prices since late 2022 has been driven by investors being willing to pay more for a given expectation of future earnings and, in the United States and euro area, expectations of strong earnings growth (Graph 1.8). Higher equity prices had not been associated with a material increase in equity raisings in the public market.

Corporate bond yields have decreased over the past few months in the United States and euro area. Spreads on most corporate bonds remain at relatively low levels (Graph 1.9), though there have been modest increases of late in some markets. The low level of spreads occurred despite a rise in default rates on US and European sub-investment grade debt, particularly for floating rate leveraged loans. In Australia, non-financial corporate spreads narrowed over recent months, supported by strong demand from domestic and offshore investors. Corporate bond issuance has been above average in Australia and has increased in the United States and Europe. Companies have been seeking to take advantage of favourable conditions, while market reports suggest US companies have brought forward issuance to avoid potential market volatility around the upcoming Presidential election.

In China, authorities have eased monetary policy modestly amid weak demand for credit, slowing economic activity and an uncertain economic outlook.

The People’s Bank of China (PBC) reduced its key policy rates and some banks lowered lending and deposit rates by up to 20 basis points in July. Chinese Government bond (CGB) yields have declined to historical lows, although in real terms are above the post-GFC average (Graph 1.10). The PBC has indicated that longer term CGB yields are not consistent with their assessment of China’s economic outlook and have signalled that they may intervene in the CGB market to increase long-term yields; this may assist with some of the PBC’s other objectives such as currency and financial stability. The Chinese renminbi has depreciated by around 0.3 per cent in the past three months and remains close to the weak end of the daily trading band as authorities maintain a strong CNY fix.

Credit demand has eased further, particularly from households, as the protracted property sector contraction continues to weigh on consumer and home buyer sentiment. Property developers remain under severe financial stress despite further support measures from authorities, including a relending facility to help state-owned enterprises purchase unsold properties from developers. The measures could provide some support to developer cash flows, but the scale of funding is small relative to unsold inventory. The authorities have continued to direct lending towards priority sectors – such as science, technology and manufacturing – which has helped to offset some of the impact of the property sector contraction on commodity prices.^[3] However, aggregate business financing has eased further, which is likely to reflect weak profitability. This is consistent with broad-based declines in equity prices, particularly for property developers (Graph 1.11).

The Australian dollar trade-weighted index (TWI) remains within the range observed since early 2022, despite some sizeable moves in recent months.

The Australian dollar has depreciated a little on a TWI basis since the May Statement. A widening of interest rate differentials between Australia and other major advanced economies initially provided support to the Australian dollar. However, the appreciation was unwound amid a deterioration in risk sentiment, a liquidation of some Australian dollar carry trades against the Japanese yen – which are intended to take advantage of the higher interest rates on offer in Australia relative to Japan – and a decline in some key commodity prices over July. The significant volatility in the Japanese yen – in part driven by changing expectations of policy tightening by the BoJ – has also contributed to volatility in the Australian dollar over recent months. Nonetheless, the Australian dollar remains around early-2022 levels in trade-weighted terms, which is when major advanced economy central banks began tightening policy (Graph 1.12).

In real terms, the Australian dollar TWI has appreciated during the September quarter to end-July and was higher than the model estimate implied by long-run historical relationships with the forecast terms of trade and real yield differentials (Graph 1.13).

1.3 Australian banking and credit markets

The Term Funding Facility (TFF) ended smoothly, though short-term funding rates have tightened modestly since around the end of the financial year.

The TFF has ended with the remaining $34 billion of funding repaid since the June Board meeting. This process contributed to a large decline in Exchange Settlement (ES) balances at the end of the financial year (Graph 1.14).^[4] The seasonal accumulation of government balances associated with tax payments also contributed to declines in ES balances.

Despite this sharp reduction, banks’ short-term funding markets and money markets have functioned well. Even so, Australian dollar short-term funding rates increased a little, including the cash rate trading closer to the target, and remained elevated in August. Volumes in the private repo market and at the RBA’s market operations have also picked up. In liaison, market participants noted increases in the cost of short-dated repo funding and in the cost of borrowing Australian dollars in the FX swap market. The increases have been exacerbated by technical factors in these markets. For example, collateral and balance sheet limits are binding on some repo market participants, and in FX swap markets the liquidation of some major currency positions, including the Australian dollar against the Japanese yen, has also added to increases in short-dated Australian dollar borrowing costs. These increases are comparable with periods following previous financial year-ends, but market participants remain unsure of their likely persistence, resulting in an ongoing tighter level of short-term funding conditions (Graph 1.15).

Banks funding costs have been little changed recently, and wholesale funding market conditions remain favourable for financial institutions. Bank bond spreads relative to the swap rate – a reference rate for the pricing of securities – have recently narrowed further and are at their tightest since early 2022 (Graph 1.16). Conditions in the asset-backed securities market, a key source of funding for non-bank lenders, continue to be favourable for issuers.

Financial conditions for households remain restrictive but may be a little less restrictive than previously assessed.

Scheduled payments are high as a share of household disposable income, which is one channel through which the tightening in monetary policy has contributed to weaker consumption growth (see Chapter 2: Economic Conditions). As expected, the average outstanding mortgage rate has increased by around 15 basis points over the year so far, as fixed-rate loans established at low rates in the pandemic continue to expire (Graph 1.17). Most of the pandemic-era fixed-rate loans will expire by the end of 2024, which is expected to increase the average outstanding mortgage rate by around a further 15 basis points. Total scheduled debt payments will therefore increase a little (Graph 1.18). Although housing and personal loans arrears have increased since late 2022, they remain around pre-pandemic levels and nearly all borrowers are expected to be able to service their debts even if budget pressures remain elevated for an extended period.^[5]

Payments into mortgage offset and redraw accounts had increased from mid-2023 to the March quarter of this year but declined in the June quarter (Graph 1.19). Mortgagors have strong incentives to save in offset and redraw accounts, and the share of borrowers with offset accounts has increased in recent years. In aggregate, households are saving at a lower rate than before the pandemic (see Chapter 2: Economic Conditions). At the same time, household net wealth has been supported by higher housing and other asset prices; all else equal, an increase in wealth tends to be associated with stronger consumption.

Household credit growth has gradually increased over the past year to be around its average following the global financial crisis (Graph 1.20). While high interest rates reduce the incentives for households to take on additional debt, growth of nominal disposable incomes are supporting households’ ability to service those debts. The increase in household credit growth has been mostly driven by growth in mortgage debt, which makes up around 95 per cent of household credit. This growth has been accompanied by rising housing prices. Household credit growth net of payments into offset accounts also increased recently. Overall, the continued increase in both housing credit growth and household net wealth may suggest households’ financial conditions, on average, are a little less restrictive than previously judged.

New housing loan commitments have increased further but loan discharges associated with property sales have also risen (Graph 1.21). The rise in discharges may reflect the effect of the rise in interest rates, which increases the incentive to reduce or limit debt. Higher discharges by themselves weigh on the growth of credit. Over the past year, loan discharges have increased by more than the increase in commitments. This is consistent with home buyers on average taking on less leverage by using larger deposits, as well as with the possibility that investors with higher leverage are exiting the market and being replaced by other investors with less leverage. It may also reflect owner-occupiers taking on less new debt than otherwise.

Financial conditions have tightened for businesses over the tightening phase, though wholesale funding conditions have been favourable for larger non-financial firms.

The cost for businesses to borrow from banks and issue corporate bonds has increased substantially since April 2022 (Graph 1.22). Tighter monetary policy since May 2022 has passed through to higher rates on new and variable-rate debt for businesses. However, yields on corporate bonds have risen by less than the risk-free rate, and issuance has been above average (see discussion above). Also, the median interest coverage ratio of listed companies (earnings divided by interest expenses) was around its post-GFC average as at December 2023, partly supported by steady nominal earnings.

The growth of business debt has remained above its post-GFC average, supported by corporate bond issuance (Graph 1.23). This has contributed to an increase in net external funding (which includes debt and equity issuance) for non-financial corporations, although internal funding (i.e. retained profits) remains the primary source of funding for private businesses in aggregate. Financial conditions for smaller businesses and businesses with higher leverage has remained more challenging.

Endnotes

RBA staff use three main types of models for estimating the neutral rate. The first type is a semi-structural model that infers the neutral rate as the cash rate that would prevail in the economy if output was at potential, inflation was at target and employment was full. The second type infers the neutral rate from financial market pricing for government bonds. The third type infers it from a statistical model that attempts to forecast the future level of the cash rate once all cyclical influences have dissipated. The neutral rate is generally modelled as a real interest rate (i.e. adjusted for inflation) while the cash rate is a nominal rate (i.e. includes inflation expectations). To compare the two, the neutral rate can be converted into a nominal interest rate by adding some measure of inflation expectations. See Ellis L (2022), ‘The Neutral Rate: The Pole-star Casts Faint Light’, Keynote Address to Citi Australia & New Zealand Investment Conference, Sydney, 12 October. [1]

Overall, there is no clear international consensus as to whether post-pandemic economic trends (such as increases in public debt globally) are offsetting longer term structural trends that have weighed on neutral rates for many years (such as ageing populations and relatively weak productivity growth). See Benigno G, B Hofmann, G Nuño Barrau and D Sandri (2024), ‘Quo Vadis, r*? The Natural Rate of Interest After the Pandemic’, BIS Quarterly Review, March. [2]

Baird A (2024), ‘Urban Residential Construction and Steel Demand in China’, RBA Bulletin, April. [3]

For more information about the Term Funding Facility, see Black S, B Jackman and C Schwartz (2021), ‘An Assessment of the Term Funding Facility’, RBA Bulletin, September. [4]

For more information on household balance sheets, see RBA (2024), ‘Chapter 2: Resilience of Australian Households and Businesses’, Financial Stability Review, March. [5]