Australian Financial Review
The Reserve Bank of Australia is approaching the limits of interest rate cuts, so financial market attention is turning to the possibility of it resorting to an unconventional stimulus known as quantitative easing.
Undoubtedly, this would be an extraordinary step for the RBA. It probably wouldn’t do so lightly, unless the economy was in trouble. Yet a fact overlooked by many outside the RBA is that quantitative easing would not be unprecedented in Australia. The RBA conducted a version of it during the 2008 global financial crisis.
The RBA’s balance sheet expanded 50 per cent to more than $150 billion in response to the crisis as Martin Place provided cheap funding to commercial banks to help credit flow to the economy. This is relevant today because it is likely commercial banks will not pass on in full future RBA cash rate cuts as their net interest margins (NIMs) are squeezed on the deposit side.
The margin squeeze will come from the near impossibility for banks to offer negative interest rates to depositors with low-interest, at-call accounts.
For this reason, senior commercial bankers believe the “lower bound” RBA cash rate is 0.5 per cent, or even as high as 0.75 per cent, because of the margin erosion lenders face.
Banks crying poor
The RBA has questioned the banks’ crying poor on margins. Governor Philip Lowe has emphasised banks’ wholesale funding costs have more than fully eased back to 2017 levels, after they pocketed 15-basis-point out-of-cycle rate rises last year and failed to hand this back when international funding costs normalised.
The RBA published a chart in May showing that only about 12 per cent of the value of bank deposits offer rates of 0.5 per cent or less, implying limited margin squeeze on the deposit side from a lower cash rate.
Banks may also be exaggerating their margin pressure. Interestingly, ANZ counted $175 million in customer remediation costs – linked to problems exposed by the banking royal commission – to reduce its reported NIM by 2 basis points in its half-year result.
Nevertheless, if banks repeat ANZ and Westpac’s refusal to fully pass through RBA cash rate cuts, the stimulatory of power of the cash rate will wane at 1 per cent or below.
Unorthodox monetary tools contemplated
Hence, unorthodox tools may be contemplated by the central bank. RBA deputy governor Guy Debelle in December left the door ajar to another QE experiment, noting in a speech that he had examined the experience of other central banks such as the US Federal Reserve.
“Hopefully, we won’t ever have to put that learning into practice,” Debelle said. “QE is a policy option in Australia, should it be required.
“There are less government bonds here, which may make QE more effective.
“But most of the traction in terms of borrowing rates in Australia is at the short end of the curve rather than the longer end of the curve, which might reduce the effectiveness of QE. The RBA’s balance sheet can also expand to help reduce upward pressure on funding, if necessary, as occurred in 2008.”
During the GFC, the RBA injected liquidity into banks, including by extending funding tenure to banks to six months and one year under its daily repurchase agreements. The “repos” are an agreement by the RBA to buy government bonds and other highly rated securities such as bank paper and residential mortgage-backed securities (RMBS) from counterparties, primarily local banks. The banks commit to buy back the securities at a later date.
During the crisis, the banks used the RBA funding line to lend to households and business. The RBA also expanded the collateral eligible for its market operations by accepting virtually all AAA-rated paper. It has since maintained that wider collateral pool. The RBA also accepts so-called self-securitised RMBS from the issuing institution, which by December 2008 accounted for almost half of the central bank’s repo collateral and has since declined to less than a quarter of the share.
The RBA’s quasi-QE crisis actions were less drastic than those of foreign counterparts, because it didn’t enter the financial market directly to buy extra government bonds and senior banks bonds to drive down yields. Debelle’s remarks suggest this is a future option.
Fed crisis actions
The US Fed acquired huge numbers of US Treasury bonds and mortgage-backed securities to drive down long-term interest rates, blowing out its balance sheet from $US870 billion ($1.25 trillion) in 2008 to $US4.5 trillion ($6.47 trillion) in 2014.
The ultra-low rates helped stoke a bull market in equities.
The Fed’s purchase of mortgage securities is not dissimilar to the Rudd government authorising buying up to $20 billion of local RMBS to try to keep funding lines open for non-bank lenders during the crisis.
Governments buying RMBS appears extreme. But the Morrison government recently instigated the purchase of $2 billion of securitised small-business loans via the Australian Office of Financial Management to stimulate small-business lending.
In the event of a serious economic downturn, interest rate cuts and, potentially, fiscal policy will be Australia’s first defences. Yet more extreme measures are on standby if traditional policy ammunition is exhausted. The RBA has experience using such tools.
Article appeared in The Australian Financial Review on 11 June 2019.
Article written by John Kehoe.