RBA leaves the bazooka on the table

While leaving open the option to do more, the RBA's efforts to date fall short

The Reserve Bank pulled its punches this week, leaving on the table powerful tools that could have been deployed to amplify the effect of monetary policy. The RBA should have followed the Fed’s lead by committing to open-ended purchases of government bonds across the yield curve. While the RBA has indicated a willingness to do more, its actions to date fall short of what will likely be required to stabilise an economy facing one of the worst shocks in its history.

The RBA lowered the target official cash rate to 0.25%, which it views as the effective lower bound on its main operating instrument. The reduction in the target cash rate was accompanied by a commitment not to raise the target “until progress is being made” to restoring full employment and returning inflation to target.

This is little different from the RBA’s previous guidance, which was already committed to keeping interest rates “low” until the economy moved in the direction of its full employment and price stability mandates.

The “progress being made” commitment is ambiguous. Any improvement in the economy going forward could be interpreted as “progress” and see markets pricing in a premature increase in the official cash rate.

The RBA has reinforced this commitment by undertaking to intervene in the bond market to keep the three-year bond yield close to 0.25%, compared to the 0.50% yield we have seen recently, an approach sometimes dubbed “yield curve control.”

By offering to buy government bonds at an implied target yield, the target will effectively become the market yield, although Governor Lowe has indicated the intervention won’t be a strong peg like that applied to the cash rate.

The aim is to lock-down the front and middle parts of the yield curve that serve as the risk-free benchmark for retail and wholesale lending rates.

If the RBA’s commitment to hold the cash rate at 0.25% “for some years” were fully credible, then intervention on the three-year bond would be largely unnecessary. The RBA no doubt prefers that such intervention is minimal.

Governor Lowe explicitly nominated three years as the likely time frame for keeping the cash rate at 0.25%, which will reinforce the loose peg on the three-year bond.

The RBA had previously announced intervention to support liquidity in the secondary bond market, which will leave longer-term interest rates to float and largely market-determined.

The RBA will also step up its repo operations, supporting the secured cash market which in normal time has often been left to fend for itself by the RBA because it tends to view monetary policy working mainly in terms of the unsecured cash market.

The term funding facility will also facilitate transmission of the low official cash rate to borrowers. The facility is well structured and calibrated and could always be expanded but will be slow to ramp up.

What the RBA left on the table was the option to supercharge monetary policy by engaging in outright purchases of government bonds and semi-government securities across the yield curve at a time when government bond yields at the long-end of the curve have seen considerable volatility. The RBA could have also tabled the option to buy non-government debt securities and even equities, if required.

These purchases would have had a dramatic impact on the term structure of interest rates, as well as the exchange rate. As thing stand, the Australian dollar showed little reaction to Thursday’s announcement.

The RBA wants to avoid having to expand its balance sheet, which it would then have to contract at some point in the future.

It is also mindful of competing with banks for the existing stock of high-quality liquid assets, although the supply of these assets is set to expand rapidly as the federal budget plunges into deficit.

The RBA’s unwillingness to follow the Fed down the quantitative easing route also reflects its inability to conceive of monetary policy as working through any instrument other than the risk-free interest rate structure and with a flow-on effect on the exchange rate.

This partly reflects greater uncertainty about how changes in the size and composition of the RBA’s balance sheet would be transmitted to the rest of the economy.

However, the Federal Reserve has shown that quantitative approaches to monetary policy can work effectively and should be used by the RBA, despite these uncertainties.

Indeed, the Fed’s experience with QE represents a lower bound on the effectiveness of quantitative policy instruments given its policy of paying interest on reserves, which crimped its transmission via broader monetary and credit aggregates.

Dr Stephen Kirchner is program director, Trade and Investment, at the United States Studies Centre at the University of Sydney. He is the author of Lessons from quantitative easing in the United States: A guide for Australian policymakers.