As the Reserve Bank edges the cash rate down towards zero and the prospect of an Australian version of quantitative easing draws closer, there is a worthwhile debate developing about whether that is the right path for Australia to take.
The RBA’s conventional policy tool is the cash rate, which impacts short-term interest rates. Quantitative easing – the purchases of bonds and other fixed interest securities -- lowers interest rates across the entire yield curve.
Zero policy - or even negative policy rates - and quantitative easing (QE) programs have had a mixed record offshore, where they have been in place for most of the period since the financial crisis and, in the case of Japan, for several decades.
There is a consensus that in the US the first bout of QE, in the immediate aftermath of the crisis, was effective. Bond and mortgage markets had seized up in response to the crisis and the US Federal Reserve’s interventions, initially via what was effectively a federal funds rate of zero and then bond and mortgage purchases, injected liquidity into those markets and they began functioning again.
Subsequent bouts of QE had little, if any, further positive impact in the US although the combination of ultra-low interest rates, QE and a massive injection of financial stimulus did result in consistent, if relatively modest, economic growth and a steady decline in unemployment to today’s record low levels.
Europe and Japan are stuck in environments with negative rates and QE, with minimal growth to show for it more than a decade after the crisis. The Europeans, after a brief hiatus, have re-started bond purchases and pushed their policy rate further into negative territory in response to a global slowdown that has pushed the eurozone to the brink of recession.
Thus the record of QE, which unlike Australia was introduced in economies whose financial systems were directly and severely compromised by the financial crisis and which experienced very severe flow-on effects to their real economies, isn’t one of unambiguous success.
Also, as noted earlier this week there are potential downsides to QE for the banking system, for the pricing of risk, for the functioning of markets, for the allocation of capital and for its encouraging of a build-up of debt in households and companies.
A former Reserve Bank board member and leading academic economist, Warwick McKibbin, told the Australian Financial Review this week that ultra-low rates and unconventional monetary policies would wreck the Australian financial system’s allocation of capital and undermine capitalism.
Separately, former RBA deputy governor Stephen Grenville wrote in the AFR that it would be a bad idea for the RBA to undertake QE; that it was likely to be ineffective in Australia and would do little to stimulate the economy. It would also weaken the exchange rate and boost asset prices, particularly housing, neither of which he believed was desirable.
The RBA’s stated ambition in lowering rates towards zero and even beyond is to reduce unemployment and under-employment to the point where there is full employment. That is ambitious but it's unclear how a zero or negative cash rate and QE get us there.
Low rates – and QE means rates are low for borrowings of up to a decade or more – are supposed to encourage or coerce banks to lend rather than maintain excess reserves with their central bank, and borrowers to borrow for productive investments.
The experience is that the banks, whose net interest margins are crimped by their inability to lower deposit rates to zero or less without losing their deposit bases, maintain excess reserves.
There’s a prudential influence – the post-crisis regulatory reforms requires them to hold more deposits and high-quality liquidity – but also a reluctance to engage in activity that generates sub-optimal returns on their capital.
Another dimension of the post-crisis experience of ultra-low rates and QE is that business investment has been weak but the low cost of debt has inflated house prices and the prices of financial assets as investors have been forced into increased risk-taking in search of returns.
Business investment is weak, partly because the existence of low rates and/or QE generate uncertainty and concern among businesses and consumers -- unconventional policies point to the severity of the economic and financial challenges and risks.
It also becomes difficult to price the risk of potential investments and calculate risk-weighted returns when central banks are effectively setting risk-free rates at close to zero.
Given the direction in which monetary policies are heading offshore, the RBA probably feels it has no choice but to track them towards unconventional territory. The alternative would see the exchange rate strengthen, with a depressing effect on the economy.
At the moment the RBA is playing a lone hand with only the limited tools available to monetary policy in trying to keep the economy afloat in the face of the global slowdown, and more particularly the slowdown in China, caused largely by the Trump administration’s trade policies.
That explains its consistent urging, so far ignored, that the federal government should add fiscal policy – which would be a more conventional and probably a more effective way to respond to the economic slowdown – to the effort.
There might be doubts about the effectiveness of ultra-low or even negative rates and QE programs and there might be undesirable side effects from these unconventional monetary policies. But in the absence of fiscal stimulus, the RBA has presumably concluded that they are the lesser of the unpleasant choices it faces while it’s left to battle the slowdown alone.