Think Big: How monetary and fiscal policy work together in a post-Covid world
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Few would argue that stock investors who’ve made good post-Covid returns in 2020 owe at least some thanks to ‘Team Australia’.
Policy makers most likely aren’t done yet, with most analysts predicting the RBA will trim the official cash rate even closer to zero on Tuesday – from 0.25 per cent to 0.10pc.
While the RBA has implemented other support measures such as a controlled bond-buying program, governor Philip Lowe has also made clear his preference for government spending to lead the recovery.
So far the government hasn’t been shy, with a projected $5bn surplus in FY20 now looking more like a >$200 deficit in FY21.
And ASX markets got a boost at the government’s budget announcement in early October, when it committed to tax cuts and more infrastructure spending to support growth.
While government spending may be the primary support driver, a research note this week from Commonwealth Bank chief economist Stephen Halmarick illustrates how both sides of the policy response are connected.
Starting with the monetary policy side, Halmarick highlighted that the RBA is now more openly committed to ‘lower for longer’ rate settings.
Maintaining low rates of interest on government debt will be of primary importance in the years ahead, with government debt now forecast to climb to $966.2bn in 2024, “representing a peak of 43.8 per cent of GDP”, Halmarick said.
However, due to accommodative monetary policy settings, the interest cost on that debt is only expected to amount to around $13bn – less than one per cent of GDP.
“This decline in public debt interest costs represents the nexus between fiscal and monetary policy,” he said.
One factor stopping the RBA from cutting rates further in recent years was its concern around fostering further imbalances in the housing market.
But a recent speech from governor Lowe included a notable shift in language, where he said that to the extent low rates help boost employment, that will also help reduce the number of problem home loans.
In addition, Halmarick highlighted the central bank has judged that although its pretty much tapped out in what it can do rates-wise, it will get a better bang for its proverbial buck by keeping rates low as they economy opens up.
And lastly, while it supports the economy at home, the RBA has to keep on eye overseas. If other central banks globally are engaged in ultra-easy monetary policy – which they are – then choosing not to follow the crowd will put unwanted upward pressure on the Aussie dollar.
Importantly, the low-rates outlook also acts as a key support mechanism for government debt issuance.
After all, if the government is going to lead the way on spending, it will also need to issue more bonds to finance it.
But the RBA also helps in another way – as a purchaser of some of the bonds the government issues.
As part of the flow of funds in Australia’s financial system, the central bank also makes an annual dividend payment to the government each year, which is recorded in the budget.
Usually, the dividend is between $1-$2bn, Halmarick said. But as the buyer of additional government bonds, the RBA also receives a coupon payment on those bonds – leaving it with more funds to pay as a dividend.
Sure enough, the bank’s annual dividend rose to $2.57bn in 2019/20, up from $1.68bn in 2018/19.
As the RBA’s balance sheet expands and it buys more bonds, Halmarick expects dividend payments to increase in the years ahead.
An arrangement which will “help facilitate the very large increase in Commonwealth government debt at a very low net interest cost”, he said.
So while government spending will help drive the economic recovery, monetary policy is still set to play a key role in making that spending possible.
In a recent speech, governor Lowe said the ideal conditions for increased fiscal spending are in place, with strong demand for government bonds combined with record low rates.
“All this reinforces our strongly held view that the economic return of the increase in government debt will far exceed the interest costs,” Halmarick said.