The Reserve Bank pulled its punches last week, leaving on the table powerful tools that could have been deployed to amplify the effectiveness of monetary policy. The RBA should have followed the Fed’s lead by committing to massive open-ended outright purchases of government bonds across the yield curve. While the RBA has indicated a willingness to do more, its actions to date fall short of what will likely be required to stabilise an economy facing one of the worst shocks in its history.
The RBA lowered the target official cash rate to 0.25 per cent, which it views as the effective lower bound on its main operating instrument. The reduction in the target cash rate was accompanied by a commitment not to raise the target “until progress is being made” to restoring full employment and returning inflation to target.
This is little different from the RBA’s previous guidance, which was already committed to keeping interest rates “low” until the economy moved back in the direction of its full employment and price stability mandates.
The “progress being made” commitment is ambiguous. Any improvement in the economy going forward could be interpreted as “progress” and see markets prematurely pricing future increases in the cash rate.
The RBA has reinforced this commitment by undertaking to intervene in the bond market to keep the three-year bond yield close to 0.25 per cent, compared to the 0.50 per cent yield we have seen recently, an approach sometimes dubbed “yield curve control.”
By offering to buy government bonds at an implied target yield, the target will effectively become the market yield, although Governor Lowe has indicated the intervention won’t be a strong peg like that applied to the cash rate.
The aim is to lock-down the front and middle parts of the yield curve that serve as the risk-free benchmark for retail and wholesale lending rates.
If the RBA’s commitment to hold the cash rate at 0.25 per cent “for some years” were fully credible, then intervention on the three-year bond would be largely unnecessary. The RBA no doubt prefers to keep intervention to a minimum.
Governor Lowe explicitly nominated three years as the likely time frame for keeping the cash rate at 0.25 per cent, which will reinforce the loose peg on the three-year bond.
The RBA had previously announced intervention to support liquidity in the secondary bond market, which will leave longer-term interest rates largely market-determined.
The RBA will also step up its repo operations, supporting the secured cash market which in normal times has often been left to fend for itself because the RBA tends to view monetary policy working mainly in terms of the unsecured cash market.
The term funding facility will also facilitate transmission of the low official cash rate to borrowers. The facility is well structured and calibrated and could always be expanded but will be slow to ramp up.
What the RBA left on the table was the option to supercharge monetary policy by engaging in outright purchases of government bonds and semi-government securities across the yield curve at a time when long bonds have seen considerable volatility. The RBA could have also explicitly tabled the option to buy non-government debt securities and even equities, if required. The European Central Bank’s new QE program includes private sector securities.
Such purchases could have an immediate and dramatic impact on the term structure of interest rates, as well as the exchange rate. As thing stand, the Australian dollar showed little reaction to Thursday’s announcement.
The RBA wants to avoid having to dramatically expand its balance sheet, which it would then have to contract at some point in the future.
It is also mindful of competing with banks for the existing stock of high-quality liquid assets, although the supply of these assets is set to expand rapidly as the federal budget plunges into deficit.
The RBA’s reluctance to follow the Fed down the quantitative easing route also reflects its inability to conceive of monetary policy as working through any instrument other than the risk-free interest rate structure, with a flow-on effect on the exchange rate.
This partly reflects greater uncertainty about how changes in the size and composition of the RBA’s balance sheet would be transmitted to the rest of the economy.
However, the Federal Reserve has shown that quantitative approaches to monetary policy can work effectively and should be used by the RBA, despite these uncertainties.
Indeed, the Fed’s experience with QE represents a lower bound on the effectiveness of quantitative policy instruments given its policy of paying interest on reserves, which crimped its transmission to the economy via broader monetary and credit aggregates.