Via the excellent Damien Boey at Credit Suisse:
Overnight, RBA Governor delivered a speech about unconventional monetary policy, as it might apply in Australia.
Key points were as follows:
- The Bank does not expect to get to quantitative easing, or negative interest rate policy in this cycle, because it expects gradual recovery towards its growth and inflation targets.
- If quantitative easing were to be considered, it would not be before rates hit 0.25% – the Fed’s lower bound on interest rates from the past cycle. Quantitative easing is not under consideration before this point.
- If quantitative easing were to be considered, it would not be in the form of private sector asset purchases. Rather, the Bank prefers purchases of government bonds.
- The Bank recognizes that quantitative easing can have some unintended, and unhelpful side effects, such as the perception of monetary financing of government spending – the blurring of the lines between fiscal and monetary policies. But equally, the Bank recognizes that rate cuts can be perverse near the lower bound. Officials frown on the use of negative interest rates, given mixed evidence about its effectiveness abroad. Also, they recognize that there is a “reversal interest rate”, where rate cuts become contractionary, although this could still be some distance away.
Some commentators might be surprised by Lowe’s claim that rates have to get near zero before quantitative easing is considered. We are not, for reasons we discuss below. That said, we find several things interesting about Lowe’s speech:
- What he did not spend much time on about current or future liquidity management operations, such as targeted long-term repo operations, funding for lending schemes or the committed liquidity facility.
- Vagaries about the exact way that the RBA actually finances government spending – even before the point of quantitative easing.
- What he did not mention about the unconventional policy options that might actually work.
On the first point about liquidity management, it is interesting to note that several commentators have talked about quantitative easing-lite in Australia, in the form of mortgage backed security purchases, before reaching the zero bound on interest rates. Note that Lowe has ruled out private sector asset purchases in the foreseeable future. Note also that quantitative easing involves the flooding of the interbank system with more reserves than it needs – mechanically driving the cash rate to zero. Therefore, it is not possible to conduct quantitative easing in the traditionalist sense with a positive interest rate, without serious restructuring of the plumbing of the system. What can be done however, is to conduct asset swaps between the RBA and selected banks in dire need of reserves. The RBA would only inject reserves to the extent necessary to keep interbank rates where they want them – not a “scorched earth” policy of flooding the system with reserves. Essentially, this is what the Bank is already doing through its committed liquidity facility – and the good news is that no bank is currently experiencing such severe “funding” stress that the Bank needs to do anything more.
On the second point, Lowe spends a lot of time talking about money-financed purchases of assets, and the “monetization” of government debt. To be sure, it is possible for quantitative easing to increase the deposit base, if the RBA were to purchase assets from the general public, rather than the banks. But the cost is that the short-term boost to deposits from such activity is counteracted over time by the net interest income drain that the private sector experiences from not owning (higher yielding) bonds. At some point, the net balance would become unfavourable, causing an effect akin to a “reversal interest rate”. And in any case, the RBA has not specified exactly who it would conduct quantitative easing with, should it so choose this option.
In the event that the RBA were to conduct quantitative easing by purchasing government bonds owned by the banks, all we would see in the system is an asset swap – the banks would get reserves, and the RBA would expand both sides of its balance sheet – its assets by the amount of bond purchases, and its liabilities by the amount of extra reserves it has created. There would be no new deposits created in this process. Nor would the RBA be “monetizing” government debt. In most economies bar Europe, fiscal deficit spending occurs in the first instance on overdraft like terms with the central bank – creating both deposits for the general public, and excess reserves for the interbank system. In this context, government bonds are used – not as a financing instrument, but rather as a sterilization instrument to mop up the excess reserves, and give the central bank control over the cash rate. Quantitative easing merely represents a reversal of the sterilization leg of these transactions – but the deposits have already been created by the initial act of government deficit spending, and quantitative easing does not change this fact one iota.
We do not think that RBA purchases of government bonds will be a particularly effective easing option. Indeed, the RBA notes that there are not many government bonds to buy, and quantitative easing could seriously disrupt the functioning of bond markets. Dropping long-term bond yields does little to influence borrowing costs in Australia, because most borrowing occurs at the short-end of the curve. Lower bond yields might help to boost valuations on rate-sensitive sectors – but we would also need to consider what the economic and earnings outlooks might be like by the time the RBA pulls the trigger on quantitative easing. Lower bond yields might help to weaken the AUD/USD – but we would also need to consider what the Fed might be doing to potentially counteract RBA policy.
This leads us to our final point – Lowe fails to mention several unconventional policy options that might actually work. These include:
- Outright foreign exchange intervention to weaken the AUD/USD.
- Making explicit that the RBA will fund state governments, rather than just the Federal government.
On outright foreign exchange intervention, we note that the Bank has long held the view that it has too small a balance sheet to manage the exchange rate like the BoJ. But the truth of the matter is that the RBA can always expand its balance sheet to be like that of the BoJ, if it really wanted to. It is not funding constrained in any way. In the event that the RBA were to engage in foreign exchange intervention to cap, or target the AUD/USD, it would gross up its assets, in the form of foreign exchange holdings, and gross up its liabilities in the form of interbank reserves. Foreigners would get more AUDs deposits, and give up their foreign currency units – but the banking system would see an expansion of its deposit base. The cost is that the flooding of the system with interbank reserves would drop interest rates down to zero. Alternatively, if it is not clear that the AUD/USD target is too high or too low, reserve fluctuations from a managed exchange rate would transfer foreign exchange volatility into interest rate markets. In other words, the RBA would take the banking system back to a bygone era – the pre-float days. Deep down, many bank officials believe that this represents going backwards on hard earned progress in monetary engineering over the past few decades, and we believe this normative view is what holds some back from advocating the option. Others we suspect a frightened by the risk of dropping interest rates down to zero immediately (as a by-product of foreign exchange intervention), without certainty about the results. Whatever the reason though, Bank officials are not thinking much about the intervention option, when they really should be.
Finally, on state government funding. As noted earlier, the Federal government has access to over-draft like spending facilities at the RBA. Officially, these are known as “exchange settlement accounts” , which are on par with bank reserve accounts at the RBA. But the state governments gave up their access to exchange settlement accounts by mid-1990, around the time when the rate, and inflation targeting regime began. Therefore, state governments have since had to raise AUDs before spending them, while the Federal government has had the privilege of spending AUDs before raising them. And recently, state governments have come under heavy funding pressure, because of deteriorating stamp duty revenues.
But the RBA could relax the funding constraint on the state governments, by either giving them back their exchange settlement accounts, or promising to be the buyer of last resort of their debt issuance, thereby making market funding a risk-free exercise. Indeed, the RBA already purchases semi-government debt, but has not made a blanket commitment to do so. If the RBA were to make the necessary plumbing tweaks, or commit explicitly to semi-government bond purchases, it would achieve an uplift to inflation expectations, and lower real interest rates. It would be like giving all the member states in Europe a blank cheque to engage in deficit spending … Arguably, when the RBA talks about government debt purchases, it may be thinking about state government debt purchases. But we suspect not, given the context of Lowe’s comments.
Overall, the tone and content of Lowe’s speech makes us think that the RBA is making up quantitative easing options on the run, because the market is telling them to. It is being very reactive, rather than creative. Ordinarily, we would be worried about such thinking, consistent with curve flattening on lost credibility alone. But we do think that we are on the cusp of good luck, rather than good management. Foreign property buying, combined with relaxation of credit standards has the potential to lift the economy out of the doldrums, yet again, saving the RBA from doing anything too drastic. There is credibility to Lowe’s view that quantitative easing may not be reached in this cycle. But the risk factor is that the sensitivity of the economy to global forces is now greater than it ever has been, and not necessarily in a pro-cyclical fashion.
We are not quite ready to call it quits on the economy just yet. But we also want to recognize the plethora of risk factors out there, driving defensive behaviour. From a factor investing perspective, we want to be exposed to cyclical earnings and economic recovery (from a very low base) through value factors. But we also want to be capturing near-term undershooting risk through momentum factors, and longer-term bubble bursting risks through quality factors. Right now, such a factor portfolio would give you a real mixture of A-REITs, domestic cyclicals and resources names, over many traditional defensive names and some financials.
Some detail but reaching for straws on foreign property buying and any rebound in residential construction. For that matter, housing wealth effects also look on the nose as income is crushed.
RBA to cut to 25bps then do QE next year as unemployment rises past 5.5%, as Capital Economics says :
“Taken together with falling inflation expectations, we think inflation will fall to 1.2pc by the middle of next year and remain well below the lower end of the RBA’s 2-3pc target band for the foreseeable future.”
“On that basis, we expect the RBA will begin purchasing government bonds in 2020.”