There have been times when Chris Joye has made good sense. As well as times when he becomes property bubble obsessed. Sadly we’re back to the latter as he pushes Frydenberg’s mad house price bubble plan today:
There is considerable value in the RBA demonstrating that QE means it has ample monetary policy ammunition left. At the same time, it is appropriate for Frydenberg to maintain his laser-like focus on building fiscal space through budget surpluses. History has shown that it is much easier to get central banks to normalise interest rates than it is to convince profligate politicians to balance their books.
Frydenberg’s inaugural budget surplus last financial year (on the net operating balance and fiscal balance measures), which we had long forecast, was an important first step along the road to meeting the government’s core electoral promise of repaying Australia’s record public debt.
So why is the current QE thinking so muddle-headed? First, buying government bonds is unlikely to do much good in Australia. The RBA’s former deputy governor, Stephen Grenville, explained why during the week, although he overlooked the alternative solutions. Because most Australian private debt is floating-rate, as opposed to fixed-rate, it prices off the short-term cash rate plus a credit spread, or risk premium, rather than long-term government bond yields. As a consequence, all Australian banks hedge their wholesale funding back to a spread above the cash rate or a proxy therein, such as the bank bill swap rate, which itself embeds a bank credit risk premium.
This means that the RBA buying long-term government bonds is not going to do much to influence domestic rates. It might put downward pressure on the Aussie dollar, which will be stimulatory. But even this outcome is uncertain because the exchange rate is determined by global forces over which the RBA has limited control. Indeed, restricting Aussie QE to government bonds exposes the RBA to non-trivial reputational risk if it is perceived as a failure.
Another concern with buying government bonds is that doing so could further reduce bank profitability in a climate where they already face a multiplicity of return-on-equity headwinds. APRA and the RBA require banks to hold up to one-third of all government bonds as part of their emergency liquidity books. If the RBA crushes the interest rates on these assets, it will crimp bank profits and reduce the probability that they improve product rates.
The one area where QE is likely to have a profound impact on savings and borrowing rates is if it compresses the risk premium above the cash rate that banks fund themselves at. As I have explained before, credit spreads on the banks’ senior bonds are some eight to 10 times wider than in 2007 and elevated by global standards, even though risk-weighted leverage has halved. It is well-known that Aussie banks have to pay materially more to raise money in global markets than similarly-rated peers. Our internal analysis shows that this is driven by the skinny pool of capital domestic super funds make available for investments in local fixed income given their huge equity biases (the latter is an artefact of super funds being judged based on their raw, not risk-adjusted, returns, which motivates them to chase the riskiest possible equity, not debt, investments).
The good news is that there are many ways the RBA can crush this intermediated cost of capital while also ensuring banks pass on the savings to customers. The first would involve lengthening out the term of the RBA’s current overnight lending operations via its repurchase (or “repo”) arrangements to much longer tenors of say one, two or three years. The Bank of England did something similar in 2016. The RBA could further require any banking tapping this liquidity to agree to pass on the savings to depositors and borrowers. This would contract funding risk premia while also reducing the quantum of wholesale bond issuance, which would reinforce the positive effects on a second-order basis.
A complementary solution would be for the RBA to commit some of its QE program to a similar form of lending via direct asset purchases of any securities that the RBA accepts as collateral under its repo operations. These include government bonds, senior bank bonds, and AAA-rated asset-backed securities.
The Fed, ECB and Bank of England customised their QE initiatives to their local peculiarities and the RBA should do likewise. We don’t really have a corporate bond market, so buying what little corporate paper is issued makes no sense. In contrast to the US and Europe, our banks are much more heavily reliant on wholesale funding, rather than deposits, to underwrite the loans they extend to businesses and households. Accordingly, targeting intermediated funding costs is crucial to ensuring the RBA’s monetary policy transmission mechanism works properly.
It is not widely appreciated that we have previously profited from both these forms of QE. During the 2008 crisis, the RBA extended its repo terms to 12 months at ultra-low-cost, expanding its balance sheet by 50 per cent. Those operations were about maintaining liquidity. This time around, QE would focus on enhancing the RBA’s transmission mechanism.
If buying bonds lowers the risk free rate in Australia it will also lower bank wholesale borrowing costs so it will do something for mortgage pricing though certainly it’s a law of diminishing returns. It will also make corporate borrowing cheaper, a good thing.
Joye’s other measures will only help make mortgages cheaper, and extend moral hazard even further into the banking system, which will lift the AUD.
Neither is not a good idea given mortgage mispricing and lost competitiveness is how we got to the need for QE in the first place.