Pulling the ripcord: the RBA and quantitative easing

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We live in unconventional times. The Australian economy has borne the fallout of the pandemic spread of Covid-19. And in response, the Reserve Bank has made an out-of-schedule cut in interest rates to a record low 0.25 per cent, as well as making significant steps towards implementing a program of quantitative easing.

“Before the coronavirus hit, we were expecting to make progress towards full employment and the inflation target, although that progress was expected to be only very gradual,” Reserve Bank governor Philip Lowe said while announcing the emergency cut..

“Recent events have obviously changed the situation.”

As part of Thursday’s speech, Lowe revealed that the RBA are setting up a three-year funding facility aimed at providing loans for Australian banks – so they can in turn supply $90 billion worth of cheap credit to affected small and medium-sized businesses.

And the RBA have also begun buying Government bonds in an attempt to sure up a spiralling economy. But Lowe was careful not to refer to this as QE because:

“Our emphasis is not on the quantities – we are not setting objectives for the quantity and timing of bonds that we will buy, as some other central banks have done.”

But this is starting to resemble QE programs implemented by other central banks around the world during other times of crisis. So let’s look at what the RBA taking steps towards QE means for our economy, and what they could be hoping it achieves.

A license to print money?

In 2008, the world faced the worst economic crisis since the Great Depression. And just like during that depression, central banks found themselves resorting to an unconventional method to ease the burden on their economies – quantitative easing.

Put simply, QE is a way for central banks to increase the supply of money into the economy without printing new banknotes. Primarily, a country’s central bank will use its existing cash reserves to buy government bonds or assets from commercial banks and other financial institutions to kick-start a cycle of spending.

“While QE can be used to target certain sectors of the economy – buying bonds in the home loans sector to push mortgage rates lower, for example, the RBA is focused on purchasing bonds from the government, not other banks.”

The seller of these bonds or assets then has more money they can give or loan to people to spend and help the economy start to grow. In the case of the government, this is often in the form of tax cuts designed to increase spending. For banks, it’s money that can be lent to people so they can buy a house or a car, or to start or grow a business.

In response to the financial crisis, the US Federal Reserve undertook three rounds of QE between 2008 and 2010 – buying US$2.1 trillion of treasury bonds and mortgage-backed securities – until there were signs economic conditions had improved. Post-2008, QE has also been a tactic employed by central banks of the United Kingdom, the Eurozone, Switzerland, Sweden and Japan.

While QE can be used to target certain sectors of the economy – buying bonds in the home loans sector to push mortgage rates lower, for example, the RBA is focused on purchasing bonds from the government, not other banks.

“Our focus is very much on the price of money and credit. Our objective here is to provide support for low funding costs across the entire economy,” Dr Lowe said.

If the RBA was to buy government bonds, their value would rise. As they continued to buy, that value would keep going up. Interest rates on bonds move inversely to their price, so if the price rises, their interest rates fall.

And changing the interest rates of government bonds has a ripple effect – If their rate falls, interest rates on home loans, business loans and corporate bonds would fall too.

 

Has Quantitative Easing worked in other countries?

If the answer is found in the fact the world didn’t spiral into another Great Depression following the 2000s financial crisis, then it could be said that QE was a massive success. It was also heralded for stabilising the US job market and boosting economic activity.

“There is substantial evidence that the Federal Reserve’s asset purchases have lowered longer-term yields and eased broader financial conditions,” then-Federal Reserve chairman Ben Bernanke said in 2012 following the US programs.

It did the same in the UK and other countries, but QE is not without potential negatives. The strategy runs the risk of driving inflation above desired levels – pushing the prices of goods higher than increases in what people earn – if too much stimulus is applied.

It has also been charged with increasing income inequality as money can be redistributed to those already engaged in the financial sector and housing market. This means those who already own assets find themselves better off because their repayments drop in value. While those with savings accounts could see themselves struggling to enter a market in which house prices have risen substantially but the interest on their savings hasn’t.

Now that the RBA has chosen to make an unconventional first step into the world of quantitative easing, will we see them expand the program to purchase bonds directly from the Government, not just through the secondary market? And if they do, it bears thinking about how long their program could last, and if we’ll see a return to more conventional monetary policy decisions when it’s done.

Source: Your Loan Hub

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