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What is quantitative easing?

Just before Christmas, the Reserve Bank board held its final meeting of 2018. The view, shared around the bank’s board members and senior staff, was that the next move in official interest rates would likely be up.

Six months later – and just days after the May election – board governor Phil Lowe used a speech in Brisbane to effectively promise that the bank was about to start cutting interest rates.

The economy had slowed, inflation was well short of where the RBA wanted it and, as Dr Lowe noted, the country needed to cut unemployment.

While other nations with really low interest rates had jobless rates of between 3 and 4 per cent, Australia was at 5 per cent (and now sits at 5.3 per cent).

It would be the first cut in official rates in almost three years and was followed five weeks later with another.

At 1 per cent, official rates had never been lower. And then the RBA revealed it was starting to war-game other policies to boost the economy.

Those policies, known by some as quantitative easing, or QE, but more broadly as “unconventional monetary policy”, are now on the agenda.


So what is quantitative easing? And does it work?

Aren’t low interest rates enough to help the economy?

The Reserve Bank’s number one weapon to manage the economy is via interest rates. Cuts (to get it growing faster, and which are a form of “easing”) or increases (to stop inflation getting out of hand) are what most people know as monetary policy.

With interest rates at their current level, ordinarily the Australian economy would be flying along with unemployment at near record lows, wages soaring and inflation through the roof.

But that’s not what is happening. Australia has just experienced its slowest 12-month period of economic growth in a decade and there are close to 2 million people out of work, or who want to work more hours, while the RBA has noted that a small upward trend in wages growth now appears “stalled”.


That’s happening with official interest rates at just 1 per cent – with the RBA making it clear it will go lower if necessary.

If low interest rates won’t do it, then the RBA has to consider other ways to get the economy motoring.

It’s doing this because it wants businesses to put on more staff (to drive down the unemployment rate), which should put upward pressure on wages (which are not growing as fast as the bank wants), which offers a higher inflation rate (the RBA wants inflation back in its 2-3 per cent target band).

But if low interest rates won’t do it, then the RBA has to consider other ways to get the economy motoring.

It has said a new round of economic reforms is necessary, while calling on all governments to bring forward infrastructure spending in what would be a co-ordinated effort to drive down the unemployment rate by creating jobs.

Unconventional monetary policies, on top of very low interest rates, are the only ways the RBA can boost the economy.


What is quantitative easing?

Quantitative easing falls into the category of “unconventional monetary policies”, and there are several that the RBA could deploy.

The bank may lower the official cash rate to zero or even take it negative as some central banks overseas have done.

It may engage in something called “explicit forward guidance”, stating publicly it is going to keep interest rates very low for a set number of months or years or until it sees unemployment at a particular level.

Quantitative easing, as used by the US and Europe during the global financial crisis, is another tactic where a central bank effectively prints money that it uses to buy government bonds.

Bonds are debts issued by the government (for instance, the federal government currently owes about $550 billion to investors who have bought Australian bonds over the years). They are considered the safest form of investment because governments don’t have a habit of going bankrupt.

As the interest rate on government bonds fall a demand for them goes up. By the RBA buying as many government bonds as possible, it would hope to push down interest rates to such a low level that banks are better off lending money to businesses and households than holding on to it. In other words, it is spending large quantities of new cash to ease monetary policy.


A twist on this is that a central bank could offer low-interest loans direct to commercial banks (which, effectively, happened in Australia during the global financial crisis) or buy private debt such as mortgage-backed bonds. Even shares, in extreme cases, could be on the central bank’s shopping list.

The RBA, which wouldn’t mind seeing a lower Australian dollar, could buy and sell the currency.

A final part of the unconventional policy suite involves the central bank printing money and giving it to the federal government so it can send out cheques to the nation’s taxpayers.

This “helicopter drop” of money idea was first raised by noted economist Milton Friedman in 1969 in a famous paper about ways a central bank could quickly boost a sagging economy.



Why are we talking about quantitative easing now?

There are three reasons why the RBA and others are talking about quantitative easing, and they are all related.

Firstly, inflation has not been near the bank’s own 2 to 3 per cent target in  years.

Secondly, global economic clouds are gathering and central banks around the world are taking their interest rates lower (or beefing up their quantitative easing policies).

And finally, the RBA is starting to run out of interest rate ammunition to boost the local economy and take unemployment lower.

At such low levels, cutting rates even further has little effect as commercial banks have to reduce both lending and deposit rates.

Financial markets believe there’s a four in five chance the RBA will cut official rates to 0.75 per cent at its October 1 meeting and then go to 0.5 per cent early next year.

At such low levels, cutting rates even further has little effect as commercial banks have to reduce both lending and deposit rates. While low lending rates are great for those who want to borrow money, zero or (as has occurred overseas) negative deposit rates hurt those with money.

Average saving account interest rates are already between zero and 0.1 per cent.

The RBA would have to start outlining its unconventional monetary policy plans once it has the official cash rate at about 0.5 per cent. In theory, that could occur by Christmas.


How would it work?

We’ve already seen some elements of the unconventional monetary policy battle plan put in place.

The RBA has made clear low interest rates are going to be with us for a long period, saying it believes inflation won’t start increasing until the jobless rate gets down to at least 4.5 per cent. That’s pretty close to “explicit guidance”.

It would be unlikely the bank would try to deliberately drive down the Australian dollar – partly because of the immense cost and because if other central banks did the same then the dollar may go nowhere.

And the Morrison government has shown no inclination that it would entertain a “helicopter drop” of cash into the bank accounts of Australians.

That leaves the purchase of government and corporate debt – quantitative easing – as the most likely path for the RBA.

If the Reserve Bank went down the quantitative easing path it would not be for the faint-hearted.

But experienced economist Stephen Kirchner, in a research paper on the issue for the United States Studies Centre at the University of Sydney, has noted that if the Reserve Bank went down the quantitative easing path it would not be for the faint-hearted.

He found if the RBA’s scheme was to be of the same size put in place by the US Federal Reserve it would have to buy bonds worth about 1.5 per cent of GDP to achieve the equivalent of a 0.25 percentage point in interest rates.

Dr Kirchner estimated that, in dollar terms, it would mean buying up to $550 billion worth of debt.

The total value of federal and state government debt at the moment is just short of $800 billion so trying to find enough bonds to buy would be difficult.

That might force the bank into every corporate nook and cranny looking for  business debt to buy. Unlike governments, businesses do have a track record of going under, potentially leaving the RBA with corporate bonds that may never be repaid.

But Kirchner found that QE in an Australian context was likely to be much more effective than in the US, especially if it did not make some of the mistakes the Federal Reserve made during its five-year debt-buying program.


Would it work?

The avalanche of money thrown at the world’s economies in the wake of the global financial crisis certainly avoided a repeat of the Great Depression.

Unemployment rates in Europe and the US have fallen and there are signs of upward pressure on wages (particularly in America and Britain).

But there’s also been criticism of how quantitative easing appears to have benefited high income earners who have been able to borrow money more cheaply, pumping up property and share markets.

If the RBA ends up in an unconventional monetary policy space one thing is clear – the economy won’t be in a good way.

The rise of political populism and extremists on both the left and the right has been aided and abetted by some of the economic policies – including ones such as quantitative easing – used over recent years.

In the wake of the banking royal commission, tighter lending standards and risk aversion may make it more difficult for lenders to use really low interest rates to throw cash at everyone who wanted it.

If the RBA ends up in an unconventional monetary policy space one thing is clear – the economy won’t be in a good way.

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