The RBA has begun ‘quantitative easing’. What is it, and how does it work?
The Reserve Bank has announced a $100 billion “quantitative easing” program.
What does that mean, and why did they do it?
“Quantitative easing” is one of those economic terms that is too abstract, so it’s difficult to know what it means.
But essentially, it’s all about manipulating interest rates.
Historically, quantitative easing is considered unconventional policy, but these days it’s becoming more conventional because a growing number of central banks have exhausted their traditional policy toolkits and they’re being forced to improvise.
The Reserve Bank of Australia is one of them.
It has just reduced its cash rate target to 0.1 per cent, which is the lowest in history — so it’s running out of traditional ammunition.
That’s why it’s decided to dramatically increase its purchases of Australian government bonds.
A government bond is a “debt security” that guarantees regular interest payments (say, every six months) from the government to whoever buys them, which continue for the life the bond.
What does the RBA want to achieve?
It wants the whole structure of interest rates in Australia to be lower, to make it cheaper for governments, businesses and households to borrow and invest, and to keep the value of Australia’s dollar down, to support economic growth.
It plans to do that by buying $100 billion of government bonds over the next six months.
Specifically, it will focus on buying government bonds with maturities of around “five to 10 years,” but it may also buy bonds outside that time range, depending on market conditions.
A “maturity” is simply the length of a bond’s life.
For example, if Treasury issues a five-year bond, that bond will expire in five years.
Roughly $80 billion of the QE program will be spent purchasing Australian Government bonds, and $20 billion will be spent purchasing state and territory government bonds.
At completion of the $100 billion bond-buying program, the RBA will hold around 15 per cent of Australian government bonds on issue.
How will it work in practice?
The RBA will be buying bonds from the “secondary market”.
What does that mean?
Well, the Australian Office of Financial Management (AOFM) sells bonds on behalf of the Federal Government (via Treasury).
The bonds are sold to institutional investors (large foreign and local banks) with the promise of making regular interest payments to whoever buys them, along with a repayment of the principal at a set future date.
Those institutional investors then create their own markets for those bonds (called “secondary markets”), by on-selling them to other investors such as pension funds and super funds, hedge funds, insurance companies, private banks and central banks, which want to hold interest-bearing assets in their portfolios.
When the RBA buys Australian Government bonds, it buys them from that secondary market.
Is this a form of money printing?
According to Sean Callow, a senior currency strategist at Westpac, you can think of it like money printing.
Mr Callow said extra debt will be issued by Treasury in the form of bonds, and authorised investors (ie large banks) will buy the debt with full knowledge that the RBA will be keen to buy it from them — so they can be confident they won’t be stuck holding debt they don’t really want.
“That means the banks will sell the bonds to the RBA, and the RBA will just credit the accounts that those banks have at the RBA,” Mr Callow said.
“The basic mechanics of it is the RBA says, ‘We’ll buy that bond from you. And here you are, we’ve just nudged up your account by the value of that bond — $100 million or whatever.’
“Now, that money is just created.
“Remember what Ben Bernanke [a former chairman of the US Federal Reserve] told 60 Minutes about 10 years ago.
“When he was asked, ‘So are you printing money?’ he said, ‘Well, effectively. We’re electronically printing it. Their accounts used to have this much and now they have an extra $100 million and we’ve got the bond.’
“So in terms of the RBA’s balance sheet, you’ve got the RBA’s liability of cash, which is the deposits it owes to banks as the banks want it, and the asset is the increased debt [on its balance sheet], which is the bonds.”
How often will it buy bonds?
The RBA plans to hold auctions for government bonds three times a week: on Mondays, Wednesdays and Thursdays, with the first auction being held this Thursday.
On Mondays and Thursdays it will purchase bonds issued by the Australian Government, and on Wednesdays it will purchase bonds issued by the states and territories.
It plans to purchase around $5 billion of bonds a week from the secondary market.
How will these bond purchases lower interest rates?
By significantly increasing demand for Government bonds in the five-year to ten-year range, the interest rates on those bonds will fall.
And when the interest rates on those bonds are lower, Governments will be able to borrow at cheaper rates over longer time periods.
RBA governor Phil Lowe said when the range of interest rates are lower across the economy it will lower the cost of finance for all borrowers.
“Whether they are a household buying a home or a business wanting to expand,” he said on Tuesday.
“This lower cost of finance for everybody is supporting the recovery from the pandemic.”
Since the RBA is buying Australian government bonds, will the Federal Government have to repay the money?
“It is important to point out that the bond purchases by the RBA will have to be repaid by the Government at maturity,” Dr Lowe said.
“They will have to be repaid in exactly the same way as would occur if the bonds were held by others.
“The fact that the RBA is holding some bonds makes no difference to the financial obligations of the government, other than through a lower cost of finance,” he said.
What’s different about this week’s announcement?
Earlier this year, the RBA began targeting the interest rate on three-year government bonds — to keep it hovering around 0.25 per cent.
To achieve that goal, it told everyone it was targeting that specific rate and it would purchase however many government bonds were necessary to ensure it.
But this week’s announcement is different.
Instead of announcing targets for the interest rates on five-year, seven-year, and 10-year government bonds, the Government has announced the “quantity” of bonds it plans to purchase — $100 billion worth of bonds in the next six months.
It has also reduced the target on three-year government bonds from 0.25 per cent to 0.1 per cent.
It means the RBA’s bond buying program has combined a price-based target at the shorter part of the yield curve (for three-year government bonds) with a quantity target at the longer part of the yield curve (for five-year to ten-year government bonds).
It is also doing some other things, such as lowering the interest rate on new drawings from its Term Funding Facility from 0.25 per cent to 0.1 per cent.
How will QE put downward pressure on the Australian dollar?
When interest rates in Australia are higher than in other countries, foreign investors are encouraged to invest more in Australia to get higher returns.
But to invest in Australia they first need Australian dollars, and that means demand for our currency increases, and if there’s an increase in demand for Australian dollars, relative to other currencies, the value of Australia’s dollar increases.
The RBA doesn’t want the value of Australia’s currency to strengthen relative to other currencies.
Why? Because a higher Australian dollar is not good for our exporters (although our importers prefer it).
However, by putting downward pressure on interest rates, the RBA is making it less attractive for foreign investors to want to invest in Australia, and that will keep demand for Australian dollars lower than it otherwise would be, and that should keep the value of the dollar lower.