Friday, 30 October, 2020
AFR: Why RBA’s QE will have a big impact
AFR: Why RBA’s QE will have a big impact
In the AFR today I write that sometimes bankers should really shut their well-fed mouths and focus on serving the community (or try the free Twitter link here). After delivering ordinary financial results, ANZ’s chief executive Shayne Elliott has bandied around the nonsense that the Reserve Bank of Australia has exhausted its monetary policy ammunition and should not bother trying to address its legislated objective of delivering full employment at a time when Australia’s effective unemployment rate – including people working zero hours on JobKeeper – is about 9.5 per cent (or 14 per cent in Victoria).
“People don’t want it, borrowers don’t want it, it becomes a burden for me because I end up having to buy government bonds or bank it with the RBA,” Elliott said. Excuse me? Is he seriously saying that the 5 to 10 per cent of Aussie borrowers who are still on repayment holidays do not want the RBA to reduce the interest rates they are currently having difficulty servicing?
Is Elliott suggesting the RBA should not help our exporters and import-competing businesses by countering the upward pressure on the Aussie dollar that results from all the other global central banks buying their government bonds, which makes our 10-year interest rates look unusually attractive to offshore investors (who bid up our exchange rate when they buy our government bonds)?
This is rich coming from a well-paid banker who is borrowing billions off the RBA at a record-low cost of just 0.25 per cent for three-year money, who does not pay a cent for the government’s guarantee of his bank deposits, and who has absurdly cheap access to a $243 billion bank bail-out fund called the Committed Liquidity Facility, amongst numerous other public subsidies.
While I have argued that Elliott is a fine banker, he has also repeatedly demonstrated he knows little about macroeconomics or public policy. He told me I was dead wrong in early 2019 when we correctly forecast that Australian house prices would appreciate by 10 per cent over the next year (they were falling at the time), which is exactly what they did. And he was equally erroneous when he advised parliament during the COVID-19 crisis that house prices would slump by up to 15 per cent. They have, in fact, declined by just 2.8 per cent from their April 2020 peak (as we projected), and are now gradually starting to recoup those losses. (Note there has been no net increase in Aussie house prices for four years.)
What we know from the AFR’s John Kehoe (aka “mini-McCrann”) is that next Tuesday the RBA will likely unveil an important suite of five new policy measures aimed at helping Australians get their jobs back. The first two changes will involve the RBA reducing its official cash rate from 0.25 per cent to 0.10 per cent while also lowering the interest rate banks earn on their deposits at the RBA from 0.10 per cent to 0.01 per cent. This is crucial because Australia has an excess savings problem.
Since the onset of the COVID-19 shock, households and businesses have hoarded excess cash, which has been materially boosted by the Commonwealth government’s aggressive fiscal stimulus. As a result, the household savings rate has jumped to 20 per cent, its highest level since 1974. By cutting these two key interest rates, the RBA will compel banks to further chisel deposit rates, which will encourage parsimonious savers to spend more of that money or invest it in higher-yielding debt and equity that will compress the cost of capital for companies.
Businesses will likewise have an incentive to pursue opportunities that will appear more attractive given the reduced returns on cash and lower long-term hurdle rates, which I will touch on later.
As a third measure, the RBA will trim the cost of the $200 billion funding facility it is directly offering banks from 0.25 per cent to 0.10 per cent. This unprecedented lending arrangement means that notwithstanding their much higher relative credit risks, Aussie banks can borrow at the same rate the Commonwealth government borrows at for 3-year money (poor old state governments have to pay much more). There is nothing stopping banks then passing this saving directly on to business and household borrowers in the form of cheaper loan rates. At the margin, this will contribute to lubricating sluggish credit growth, which will be directed towards much-needed additional investment.
The RBA’s fourth initiative will entail it easing its current 3-year government bond yield target from 0.25 per cent to 0.10 per cent. Historically, the RBA has focussed on controlling the short-term, or overnight, cost of borrowing since many Australians have variable-rate loans that price off this overnight benchmark. But an increasingly large number of borrowers have longer-term, fixed-rate loans of 3- or 5-years in term. These rates price off 3- and 5-year government bond yields, which are effectively longer-run versions of the RBA’s overnight cash rate.
Combined with the RBA’s “forward guidance” that the cash rate should remain near-zero until we get back to full employment, forcing government bond yields down to 0.10 per cent signals that the RBA is putting its money where its mouth is. This is important because financial markets have doubted the RBA’s convictions in the past. Put another way, it gives households and businesses confidence that they can bank on rates remaining low-for-long when they’re puzzling over their next investment opportunity. It should also directly decrease their 3- and 5-year fixed borrowing rates.
According to Kehoe, the final part of this powerful stimulus package will involve the RBA buying longer-dated federal and state government bonds of 5- to 10-years in term until it can get the jobless rate down towards its full employment level, which it estimated to be 4.5 per cent in 2019. This has a wide range of consequences.
First, as RBA governor Phil Lowe has pointed out, 10-year Australian government bond yields are among the highest in the world. This is primarily because his central banking peers have been buying their own government bonds to reduce long-term risk-free rates. Since the RBA has not matched their efforts, 10-year Aussie interest rates now stick-out like a proverbial bull’s balls. This makes them exceedingly attractive to overseas investors, who have been gobbling up federal and state government bonds like nobody’s business. To do so, they have to buy Aussie dollars and sell foreign currency, which puts upward pressure on our exchange rate. This hurts our exporters and important-competing companies, undermining jobs, income and growth.
The RBA has correctly concluded that as a small open economy, Australia must compete on a level playing field where the rules of the game are set by foreign actors (global central banks). So while one can criticise the theoretical merits of QE (as I have previously), that is an intellectually vainglorious exercise when the entire world is engaged in it. If the RBA does not expand its balance-sheet in the same way as other central banks, it will not be meeting its obligation to maximise employment. We’d be cutting off our noses despite our faces.
One silly counter-argument is that by reducing long-term government bond yields, the RBA will make federal and state government bonds less attractive to foreigners. Yet that is precisely the purpose of the policy: to moderate artificially high global demand for Aussie dollars that is inflating our exchange rate because we have not matched offshore QE. The RBA will be buying these bonds to supplant that demand until such a time as it is comfortable with those long-term interest rates rising again.
At a time when the RBA is asking state and federal governments to do everything possible to stimulate growth via productive long-term investments, it must do everything it can to ameliorate state and federal taxpayers’ borrowing costs such that they are no higher than what banks and their foreign counterparts are paying. In contrast to banks, which can borrow via the RBA for 3-year terms to fund loans on their balance-sheet that have a similar average 3-year life, the states and the federal government have to underwrite longer-dated investments (eg, infrastructure). This means they typically borrow over 5- to 15-year terms.
They currently face the bizarre situation where the AAA rated Victorian government has to pay 130 basis points to access 10 year money while an unrated building society pays less than one-tenth of that sum to borrow off the RBA. No wonder the Japanese have been falling over themselves to buy our state government bonds: hedged into yen they pay the highest yields in the developed world.
By way of comparison, Germany’s largest state (North Rhine-Westphalia), which accounts for one-fifth of its economy, benefits from a negative 0.29 per cent interest rate when it borrows 10-year money.
Beyond the fact that government bond yields are the risk-free benchmark that all interest rates price off, the public sector also makes-up one-quarter of the economy. So while the agencies that issue federal and state bonds might prefer dealing with global investors than Martin Place, their taxpayers will absolutely favour lower debt servicing burdens. Interestingly, so do the credit rating agencies. Standard & Poor’s and Moody’s have both recently said that the RBA buying state government bonds will directly reduce the risk of credit rating downgrades because this reinforces the fact that the states benefit from Commonwealth government support as an essential part of our federation.
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