Philip Lowe: The year ahead
Address by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to the National Press
Club of Australia, Canberra, 3 February 2021.
* * *
Thank you for the invitation to address the National Press Club. This is the third time I have had
the privilege of doing so, but it is the first time here in Canberra.
The world has changed tremendously since my previous address in February last year: a
pandemic, the biggest contraction in output in generations, the closure of our borders, a very
large fiscal stimulus, near zero interest rates and quantitative easing. All that in just a year and
none of it was predicted. It was therefore with some trepidation that I titled my remarks today,
'The Year Ahead'. I did so, though, because at the start of a new year, I thought it important to
explain how we are thinking about the Australian economy and monetary policy over the year
ahead.
Before I do this, I would like to offer 3 observations on the year we have just been through.
The first is that Australians respond well in a crisis.
The second is that the economic downturn was not as deep as was initially feared and the
bounce-back has been earlier and stronger than we were expecting.
And the third is that as we start 2021, there is still quite a way to go before we reach our goals of
full employment and inflation consistent with the target.
I would like to elaborate on each of these observations as they are relevant to the future.
The national response
First, our national response. As a community, we have pulled together in the common good and
been prepared to do what has been necessary to contain the virus. Our public administration and
health systems have worked well in the public interest. Governments responded quickly to the
pandemic and decisive fiscal and monetary policy responses have helped many people. Our
banks also worked with their customers to help them meet their obligations. Because of these
collective efforts Australia is in a much better place than most other countries. This is true for
both the economy and the health situation.
An earlier and stronger bounce-back
My second observation is that despite the pandemic having very significant economic costs, the
downturn was not as deep as we had feared and the recovery has started earlier and has been
stronger than we were expecting. Employment growth has been strong, as have retail sales and
new house building. Across many indicators, including GDP, the outcomes have been better
than our central forecasts and often better than our upside scenarios as well.
As an illustration, in August our central forecast was that the unemployment rate would end 2020
at close to 10 per cent and still be above 7 per cent at the end of 2022 (Graph 1). In our upside
scenario, the unemployment rate was expected to end 2020 a little lower than 10 per cent, but
still be around 7 per cent later this year. Thankfully, the actual outcome for the unemployment
rate has been much better than this, with the peak now looking to be behind us and the
unemployment rate ending 2020 at 6.6 per cent.
It is reasonable to ask: what explains these better-than-expected outcomes?
There are 3 factors that I would like to point to.
The first is the success that Australia has had in containing the virus. That success has meant
that the restrictions on activity have been less disruptive than we feared. It has allowed more of
us to get back to work sooner and it has reduced some of the economic scarring from the
pandemic. As is increasingly clear from experience both here and overseas, the health of the
population and the health of the economy are inextricably linked.
The second factor is the very significant fiscal policy support in Australia, which as measured by
the change in the aggregate budget position is almost 15 per cent of GDP (Graph 2). Most of this
support has been delivered by the Australian Government, but the states and territories have also
played a role too. This support has been more substantial than was assumed in August and has
made a real difference. It has provided a welcome boost to incomes and jobs and helped front
load the recovery by creating incentives for people to bring forward spending. There has also
been a positive interaction with the better health outcomes, which have allowed the policy
support to gain more traction than would otherwise have been the case.
Graph 2
The third factor is that Australians adapted and innovated. When the virus first came to our
shores, many people hunkered down, but as the days wore on, households and businesses
adjusted and changed what they do and how they do it. This resilience has helped keep the
economy going and kept people in jobs.
Many firms changed their business models, moved online, used new technologies and
reconfigured their supply lines. Households adjusted too, with spending patterns changing very
significantly. Some of the spending that would normally have been done on travel and
entertainment has been redirected to other areas, including electrical goods, homewares and
home renovations. Online spending also surged, increasing by 70 per cent over the past year
(Graph 3). These changes in our spending patterns have been challenging for many businesses,
but the ability and willingness of Australians to keep spending has helped the overall economy.
Graph 3
Still quite a way to go
My third observation is that despite the positive economic news over recent months, we still have
quite a way to go.
There is still very substantial spare capacity in the Australian economy. The unemployment rate
is higher today than it has been for almost 2 decades and many people can't get the hours of
work they want. And in terms of output, we remain well behind where we thought we would be
when I spoke here in February last year (Graph 4). When the National Accounts are published for
the December quarter, they are likely to show that the level of GDP is 4 per cent lower than
where we thought it would be a year ago. This is a big gap.
On the nominal side of the economy, there is also a fair way to go. In underlying terms, inflation is
running at 11⁄4 per cent, well below the medium-term target of 2-3 per cent. And wage growth is
the lowest in decades, with the Wage Price Index increasing by just 1.4 per cent over the past
year (Graph 5). Given the spare capacity that currently exists, these low rates of inflation and
wage increases are likely to be with us for some time.
Graph 5
The year ahead
This brings me to the year ahead.
In my view, we can draw some comfort from the year just passed. Our ability to pull together and
the earlier-than-expected bounce-back are both positive developments and provide a basis for
confidence about the future. Yet even so, the path ahead is likely to be bumpy and uneven and it
will be some time before we are back to full employment and have inflation back to the target.
As was the case in 2020, much depends upon the path of the pandemic. The development of
vaccines in record time is clearly good news. It has reduced one of the big uncertainties and
could provide the foundation for a vigorous and sustainable recovery in the global economy. But
this outcome is not assured - the global rollout of the vaccines faces challenges and there are a
range of other uncertainties about the global economy, including trade tensions. We hope for the
best here, but we also need to be prepared for further setbacks in what remains a highly
uncertain world.
The RBA will be releasing a full set of updated economic forecasts on Friday. Today, I can
provide the key numbers. In preparing these forecasts we have assumed a rollout of the
vaccines in Australia in line with current government guidance and that international travel
remains highly restricted for the rest of this year.
Our central scenario is for the upswing in the Australian economy to continue, with above-trend
growth over the next couple of years (Graph 6). GDP is expected to increase by 31⁄2 per cent
over both this year and 2022. Given the recovery we have seen so far, we are expecting the level
of GDP to return to its end-2019 level by the middle of this year, which is 6 to 12 months earlier
than we previously expected.
Graph 6
Notwithstanding this recovery, we are not expecting the level of GDP to return to its previous
trend over our forecast period. This is largely because of lower population growth. When we
prepared the forecasts a year ago, we were expecting the population to grow by 1.6 per cent per
year over 2020 and 2021. The actual outcome is likely to be around 0.2 per cent in 2021, the
lowest since World War I (Graph 7). This slower population growth has a direct effect on the size
of our economy and means that we will not get back to the previous trend any time soon. In per
capita terms, we expect more, but not all, of the lost ground to be made up.
Graph 7
In the labour market, we are expecting the rate of unemployment to continue to decline. In the
central scenario, it is expected to reach 6 per cent by the end of this year and around
51⁄4 per cent by mid 2023 (Graph 8). Job vacancies, job ads and business hiring intentions are at
high levels, which suggests continuing solid employment growth over the next few months.
Beyond that, some slowing in employment growth is expected when the JobKeeper program
comes to an end in March.
Graph 8
Given this outlook, wages growth and inflation are forecast to remain subdued.
In the central scenario, wages growth is forecast to pick up from its current low rate, but to do so
only very gradually and still be below 2 per cent at the end of next year. Consistent with this, and
the ongoing spare capacity in the economy, inflation in underlying terms is also forecast to stay
below 2 per cent over the next couple of years: the central forecast for 2021 is 11⁄4 per cent and
for 2022 it is 11⁄2 per cent (Graph 9). In headline terms, inflation is expected to spike to around
3 per cent in the June quarter, largely reflecting swings in the prices of child care and some other
administered prices, but then to return to below 2 per cent by the end of this year.
Graph 9
So that is the broad outline of the central scenario. We will also be publishing downside and
upside scenarios, as we did last year.
The downside scenario is one in which there is a combination of further sporadic domestic
outbreaks, a delay in the rollout of vaccines and a worsening global outlook. The upside involves
further good news on the health front, with a strong pick-up in consumer and business
confidence propelling a stronger self-sustaining recovery, especially given the large amount of
monetary and fiscal stimulus that is in place. In the downside scenario, further progress in
reducing unemployment is delayed and there is a little pick-up wage growth and inflation from
current levels. In the upside scenario, the unemployment rate falls faster to be a bit below
5 per cent in the second half of next year.
I would like to highlight 2 specific issues that have a bearing on the forecasts.
The first is how households respond over coming months to the tapering of the fiscal and other
support measures.
Unusually for an economic downturn, growth in household income has been quite strong, largely
reflecting the support provided by fiscal policy (Graph 10). Much of this extra income has been
saved, with the household saving rate surging to 22 per cent in the June quarter. This largely
reflects the limited spending opportunities during the lockdowns, but it is also a response to the
uncertainty that people felt about the future. These extra savings have strengthened household
balance sheets and mean that many people now have bigger financial buffers than they had
previously.
Graph 10
The question is what comes next. Over the next 6 months, aggregate household income is
expected to decline as the pandemic support payments unwind. Normally, when income falls, so
too does consumption. But we are not in normal times. The extra savings over the past 6 months
and the bigger financial buffers can support future spending - people will have more freedom to
spend as restrictions are eased and be more willing to spend as uncertainty recedes. So we are
expecting the recovery in consumer spending to continue.
But there are risks to the forecasts in both directions here. On the downside, further bad news on
the health front could see additional restrictions on activity and a renewed desire to save. And on
the upside, positive news on health and jobs could see people seek to catch up on spending and
run down their extra saving buffers quickly. So we are watching this area carefully.
One other important factor bearing on household spending is the housing market. When I spoke
here last year I discussed how falling housing prices was one of the factors that had contributed
to sluggish growth in 2019. The dynamics in the housing market now look to be in a different
phase, with prices rising across most of the country recently (Graph 11). It remains to be seen
how long this will continue, but sustainable increases in asset prices support household balance
sheets and encourage spending through positive wealth effects. Higher housing prices can also
encourage additional residential construction. But as housing prices rise again, we will be
monitoring lending standards closely. We would be concerned if there were to be a deterioration
in these standards, but there are few signs of this at the moment.
Graph 11
The second specific issue I want to highlight is the outlook for investment.
Prior to the pandemic, there were concerns about the protracted period of low levels of
nonmining business investment (Graph 12). Not surprisingly, when the pandemic hit, investment fell
further. Faced with a more uncertain environment and a drop in demand, many firms deferred
investment plans and sought to de-risk their balance sheets. Spending on non-residential
construction has been particularly affected. On a more positive note, there has been a welcome
offsetting pick-up in public investment, which is playing a strong counter cyclical role.
We are yet to see the same signs of a recovery in private investment that we have witnessed in
household spending. Investment is nonetheless expected to pick up as uncertainty recedes and
demand increases. An increase in private business investment is not only needed to support the
economic recovery but also to build the productive capital stock that is needed for our future. So
this too is an issue we are watching carefully.
Graph 12
Monetary policy
I would now like to turn to monetary policy.
At our meeting yesterday, the Reserve Bank Board reviewed the monetary policy measures
announced last year and the outlook for the year ahead. I would like to share the conclusions of
this review with you.
The first conclusion is that last year's monetary policy package is working broadly as expected
and is supporting the economy. Together, the bond purchases, the Term Funding Facility, the
3year yield target and the record low cash rate have kept funding costs low for all borrowers and
helped ensure that the banking system is able to provide the credit that is needed for the
recovery. They have also resulted in a lower value of the Australian dollar than otherwise.
Combined, the various measures have resulted in the RBA's balance sheet increasing from
around $180 billion to $330 billion and a further substantial increase is in prospect (Graph 13).
Graph 13
The second conclusion is that very significant monetary support will need to be maintained for
some time to come. It is going to be some years before the goals for inflation and unemployment
are achieved. So it is premature to be considering withdrawal of the monetary stimulus.
The third conclusion is that we will continue to purchase bonds issued by the Australian
Government and the states and territories at the completion of the current $100 billion program in
mid April.
In reaching this conclusion, the Board considered 3 factors:
1. the effectiveness of the bond purchases;
2. the decisions of other central banks; and
3. most importantly, the outlook for inflation and jobs.
With 3 months experience now, it is clear that the bond purchase program has helped to lower
interest rates and has meant that the Australian dollar is lower than it otherwise would have been.
So, it has worked. Australia's government bond markets also continue to function well and the
available evidence is that further purchases would not be a source of market dysfunction.
In terms of other central banks, most have recently announced extensions of their bond
purchase programs, many running until at least the end of this year. Given this, if we were to
cease bond purchases in April, it is likely that there would be unwelcome upward pressure on the
exchange rate.
And, third, in terms of the most important consideration - the outlooks for inflation and jobs - we
remain well short of our goals, as I have already discussed.
Given these considerations and the fact that the cash rate is at its effective lower bound, the
Board decided to purchase an additional $100 billion of government bonds at the completion of
the current program in mid April. These additional purchases will be at the rate of $5 billion a
week, which is unchanged from the current program. They will ensure a continuation of the
RBA's monetary support for the Australian economy.
The fourth conclusion is that the Term Funding Facility will be maintained as it is. Banks are able
to draw on the facility up until end June, which means they will have the benefit of low-cost
funding out to mid 2024. The Board would consider extending this facility if there were a marked
deterioration in funding and credit conditions in the Australian financial system. At the moment,
there are no signs of this.
Fifth, the 3-year yield target for Australian Government bonds will be maintained. This target has
helped anchor the Australian yield curve and reinforced our forward guidance regarding the cash
rate.
Later in the year, the Board will need to consider whether to shift the focus of the yield target from
the April 2024 bond to November 2024 bond. In considering this issue the Board will be giving
close attention to the flow of economic data and the outlooks for inflation and jobs. It has made
no decision yet.
The final conclusion is that the cash rate will be maintained at 10 basis points for as long as is
necessary (Graph 14). The Board has no appetite to go into negative territory and has done as
much as it reasonably can with interest rates. Before increasing the cash rate, the Board wants
to see inflation sustainably within the 2 to 3 per cent target range. Meeting this condition will
require a tighter labour market and stronger wages growth than we are currently forecasting. It is
difficult to determine exactly when this condition might be met but, based on the outlook I have
discussed today, we do not expect it to be before 2024, and it is possible that it will be later than
this. So the message is: interest rates are going to be low for quite a while yet. The Reserve
Bank is committed to provide the support the economy needs as its recovers from the
pandemic.
Graph 14
On that note, I wish you all the best for the year ahead.
Thank you for listening and I look forward to answering your questions.