A lot can change in 6 months
Early this year we wrote about Quantitative Tightening or QT. Back in February, before fears of trade wars and low inflation became the market focus, commentators were looking for interest rates to rise. However, the world is a very different place today. Expectations are that interest rates in Australia and the USA could approach zero. Therefore, we are now back to talking about Quantitative Easing or QE.
So, what is QE?
Since 2007, Europe, Japan and the US have been conducting an expansionary monetary policy known as quantitative easing (QE). Central banks add liquidity to capital markets by buying assets – namely bonds – on a large scale from their own governments, banks and private institutions. This in effect creates money. QE increases money supply and creates demand for bonds which lowers their yield and raises the prices of other financial assets.
Normally, central bank monetary policy consists of dealing with banks to reach a desired target for the interbank interest rate, which in Australia is the RBA Cash Rate. However, when interest rates are low and approaching zero the central bank needs more unconventional tools to stimulate the economy. Enacting QE means the central bank continues to buy financial assets regardless of interest rates and applies these expansionary monetary policy tools. Therefore the central bank is manipulating policy by adjusting the amount of money available in the system.
How does QE work?
Central banks create money by buying securities from banks. The objective is for banks to buy new assets with the money they received from the sale of old assets to the central bank. The end result is rising prices and falling interest rates which boosts investment.
How effective is QE?
There are mixed views as to how effective QE actually is. While there has been an increase in economic activity, the flood of money has encouraged reckless behaviour. In England much of the newly created money was reinvested into financial markets, increasing bond and shares prices. But with 40% of the share market owned by 5% of the population, most households did not benefit from QE. There are also fears that the funds created under QE benefit banks and corporations over savers and pensioners, creating a large inequality between the top 1% of wealth holders and everyone else.
How do central banks ensure new money is benefitting the economy?
In 2016 and 2017 the European Central Bank (ECB) introduced targeted longer-term financing operations (TLTROs) to keep credit flowing to companies. The objective was to keep money flowing into the real economy and not being used by banks to buy government bonds to keep on their own balance sheets.
With TLTROs, as long as banks lent money to companies, they could get cash back rather than pay interest on it as the facility would be reimbursed at the ECB’s negative deposit rate. TLTROs are a 4 year loan and are considered to be very generous. There is talk of new loans being introduced with shorter maturities (2 – 3 years) and floating rate. The floating interest rate which will be initially set at the ECB’s main rate which is currently zero.
Once enacted difficult to stop
QE was introduced after the global financial crisis in 2008/2009 as a temporary measure, but 10 years on there is no sign of rates normalising. Once a reliance on cheap money is created it is very hard to take it away. Nearly 25% of sovereign and corporate bonds globally are trading with an implied yield below zero.
Cheap credit hurts economies by removing the Darwinian controls which keep them healthy. Cheap money allows failing companies to keep operating irrespective of how profitable they are. As a result, they contribute little to income and employment growth. It also makes it harder for successful businesses to expand and create new jobs.
Ordinary savers are hurt by low to zero interest rates as they are no longer being rewarded for depositing their money with banks. Many European banks are now charging customers to keep their money.
Interest rates reflect the value of money over time. Zero interest rates signal that the time value of money is zero which suggests a stagnant economy ahead. Positive interest rates result in money being used productively. A weak economy needs cheap money.
Will the RBA implement QE?
As with the effectiveness of QE, the question of whether Australia will adopt it is also disputed.
Those who believe Australia will adopt a program of asset purchasing argue that deflation, excessive household debt and slowing economic growth combined with low interest rates leave the central bank with few options. Low long term bond yields which are very difficult to reverse, means that QE, once put in place, will have to continue for quite some time. The fact that the RBA has already started lowering rates means that it has set in motion a course that could lead to QE at some point.
Those in the will not camp point out that when the US started QE the country was in a serious economic downturn, with the financial sector on the verge of collapse. QE was put in place to restore the mortgage-backed securities market which had effectively froze. It also lowered yields on long term government bonds, which directly affect US mortgage rates. In the USA a large percentage of mortgages are fixed rate. It was successful in rescuing the housing market and encouraging consumer spending.
In Australia, a policy of QE would most certainly lower the long end of the yield curve. This would inflate asset prices and encourage financial risk-taking. Higher asset prices benefit the wealthy, but also widens the economic divide. And once QE is instituted it is hard to reverse.
If more stimulus is needed, other policies — such as fiscal policy — may do more.