Last week the European Central Bank (ECB) cut its official deposit rate by 10bps to -0.5% and announced it would start buying bonds again, a return to quantitative easing (QE). This week the US Federal Reserve (Fed) meets and is widely expected to cut its funds rate by 25bps to 2.00%, the second cut this year from the cycle peak of 2.50%. The ECB’s policy easing reflects slowing in the pace of European economic growth plus concern about downside risks and annual inflation stuck in a low groove around 1% y-o-y. The Fed’s rate cut, if delivered this week, will be harder to rationalize given that domestic spending growth in the US is strong and the labour market is booming. It is potential downside risks to US growth largely from the trade dispute with China that is causing the Fed to ease policy.
In Australia, the RBA after cutting the cash rate in two 25bps tranches in June and July to 1.00% has held fire for two months but makes it plain that it is prepared to cut further in need. The RBA has also been thinking aloud about what style of unconventional monetary easing, or QE, might work in an Australian context. The RBA has also made it clear that there are limits to what monetary policy deployed in isolation can achieve in terms of priming stronger economic growth and lowering the unemployment rate to what might be considered full employment. The RBA would like to see the Government reinforcing monetary stimulus by spending (and borrowing) more to fund selected infrastructure projects capable of lifting productivity the surest method of promoting sustained higher growth.
ECB President Mario Draghi made a similar call for European Governments to boost spending after easing monetary policy last week. Interestingly, the possibility of Governments spending more is perhaps higher in Europe than elsewhere even though several European countries have experienced problems related to excessive levels of Government debt and borrowings over the past decade. The interest cost of servicing Government debt in Europe has fallen sharply over the past year and for some countries such as Germany were bond yields are still mostly negative there is a benefit to the budget from borrowing more.
In the topsy-turvy world of very low and in some cases negative bond yields borrowing more can improve a government’s budget position. Whether the improvement to the budget position lasts really depends upon how long very low or negative bond yields persist.
Over this past month or so, even with central banks still mostly cutting official rates, there are signs that buying demand is waning for government bonds at very low or negative interest rates. For example, the German 10-year bund yield at -0.45% is about 25bps higher than it was a month ago but is 90bps lower than it was this time last year. For the US 10-year Treasury the current yield of 1.90% is about 35bps higher over the past month but 110bps lower than this time last year and Australia’s 10-year bond yield at 1.18% currently is up around 30bps over the past month nut down more than 140bps compared with this time last year.
The quite sharp upward movement in government bond yields over the past month marks perhaps recognition in the bond market the risk of global economic recession is not imminent and as a result although central banks are cutting official interest rates, the extent of the cuts may prove to be more modest and over a more protracted period of time than previously expected.
There are still opportunities for Governments to borrow at low rates, but they may not last. As a result, there is more pressure on Governments to borrow more and spend more than there was a month ago making it more likely that countries break ranks with the orthodoxy over the past decade of restraining spending to try and balance the budget and contain growth in government debt.
If Governments start to spend and borrow more as central banks are requesting, there is a risk that higher government borrowings will add to upward pressure on bond yields. In effect, the upward pressure place on bond yields by more government spending would start to compromise the effectiveness of monetary policy. When central banks cut official interest rates one transmission mechanism to the broader economy is that longer term interest rates are lowered reducing term borrowing interest rates.
Term borrowing interest rates may not fall and could even rise if an official rate cut occurs when the Government is lifting spending and borrowing. Central banks may need to be careful what they wish for. If Governments do as central banks are asking and spend more, monetary stimulus may become less effective.
In Australia in the near-term there are no signs that the Government is bending to the RBA’s request for more government spending. That makes it more likely that the RBA may be tempted to cut the cash rate further although it will require a convincing trigger from a rising unemployment rate (still a doubtful call at this stage) for the RBA to consider another rate cut. What the RBA, or any other central bank, cannot be certain of is that cutting official rates means lower longer-term interest rates.