RBA review of its yield target
Yield curve control lived dangerously and died young, but that’s what monetary policy victory looks like
The RBA has released its review of its yield curve target (YCT) on the 3-year bond that was in operation between March 2020 and November 2021. The main conclusion of the review effectively endorses this newsletter’s long-standing preference for QE over yield curve targeting:
Now that the Board has more experience with bond purchase programs, it is likely that, in the future, bond purchases would be preferred to a bond yield target. While a bond purchase program may not be as effective in achieving a specific risk-free yield, bond purchases put downward pressure on yields and the exchange rate.
The review argues that a YCT was initially preferred over QE as a more ‘direct’ way of lowering funding costs, while also reinforcing the forward guidance on the cash rate. In March 2020, the RBA initially committed to holding the cash rate steady at 0.25% for three years, while the 3-yr bond was also pegged at 0.25% (both targeted yields were subsequently lowered to 0.10%).
However, as I argued in my review of the RBA’s pandemic response in Agenda, there were two other motivations for going down the yield curve control route. The RBA remained wedded to its traditional operating framework, but could not deliver sufficient easing within that framework without taking rates negative. The forward guidance on the cash rate, reinforced by the yield curve target, was intended to substitute the expected duration of easing for its magnitude given this self-imposed constraint on the level of the cash rate.
The second motivation was to avoid excessive balance sheet expansion. So long as the RBA’s forward guidance was credible, it would not need to purchase a significant quantity of bonds to defend the target. At the time, this was portrayed by some of the RBA’s media cheerleaders as a smarter alternative to QE. As the following chart from the review shows, the intervention in support of the target was indeed mostly pretty light, amounting to only 10% of overall bond purchases, including longer duration QE and the liquidity operations in March 2020.
But as I argued in my Agenda piece, the March 2020 monetary policy framework, coupled with a sizeable fiscal policy response, left Australia with a sub-optimal macro policy mix for a small open economy, with immediate open economy crowding-out effects. The AUD outperformed its G10 peers for much of 2020 and long bond yields were the highest in the AAA-rated sovereign credit space. Oddly, the review suggests that one of the benefits of the announcement of the yield curve target was that ‘the Australian dollar stabilised in response.’ Indeed it did, but not in a good way. The RBA ultimately had to resort to longer duration QE in November 2020 under pressure from other central banks that implemented larger balance sheet expansions that put upward pressure on the Australian dollar.
The other observation I made was that yield curve targeting ultimately led to more balance sheet expansion rather than less. The RBA’s aggressive catch-up QE program from November 2020 led to a balance sheet expansion as large as the Fed’s on a relative-to-economy basis, delivered much later. The delay in implementing longer duration QE is one of the reasons Australia now has had a somewhat lower inflation rate relative to much of the rest of the world. That might be viewed as fortuitous now, but wasn’t then. YCT was also pro-cyclical, necessitating more bond purchases just at the point that the market started saying that the stance of monetary policy was wrong. Many of these problems with yield curve targeting were anticipated in a FOMC Secretariat note from 2010 (released in 2016) making the case for large-scale asset purchases (QE) over YCT.
One of the early observations I made about the yield curve target was that the exit would inevitably be messy if the market came to take a different view of the outlook to the RBA. The review notes that with the benefit of hindsight, the RBA persisted with the target for too long and that the yield curve target did not give them the flexibility to address shifts in the economic outlook. The review also suggests that the RBA’s credibility took a hit from the ‘disorderly’ exit from YCT.
My view is that while the lack of flexibility is a legitimate criticism (and a reason to prefer QE), the demise of the yield curve target, the retreat from the forward guidance and the earlier than forecast increase in the cash rate were symptoms of the success of monetary policy, even if it was QE from November 2020 that did much of the heavy lifting.
The macroeconomic scenario in which the yield curve target was maintained and the cash rate held steady into 2024 was much less favourable that the one we actually got. As Adam Posen might say, this is what monetary policy victory looks like. This was a good outcome for the credibility of monetary policy and the RBA. The RBA’s credibility should be assessed against macroeconomic outcomes, not against the stance of its policy instruments.
The review notes that on two occasions, the RBA increased its stock lending fee on the targeted bond lines to make them more expensive to short as part of its effort to maintain its yield target. But throwing sand into the gears of the market was to ignore an important price signal that the stance of monetary was wrong. In Q&A following his AmCham speech, Governor Lowe conceded the market had been a better judge of the direction of interest rates than the Bank. Of course, he then went on to take issue with market pricing of the terminal cash rate this cycle!
The RBA is also conducting a review of its longer duration QE program, which will be released later in 2022. Hopefully, the lesson from both reviews will be that, in the event of a future shock that cannot be addressed adequately through changes in the cash rate, the RBA will do what it didn’t do in March 2020, which is to go big and go QE.
The review of the RBA takes shape
The RBA has been getting more than its usual share of flak for falling behind the curve on inflation, including from former Treasurer Peter Costello. It is noteworthy that we heard very little criticism from many of these individuals during the seven years when the RBA presided over an inflation rate below target and an unemployment rate above what is now considered to its full employment level.
This criticism is now colouring commentary on a prospective review of the RBA, with the implication that the review should mainly be about the recent overshoot on inflation. Some commentary even seems to suggest that the RBA’s tightening of policy is driven by the review itself.
As argued above, the worst you can say about the overshoot of the inflation target is that policy worked too well. That is a far cry from where we were pre-pandemic, when Governor Lowe maintained helplessness in relation to low inflation and forecast below target inflation into the never-never. Too many commentators acquiesced in that view.
The recent overshoot on inflation, by contrast, is the product of factors mostly outside the RBA’s control. The pandemic resolved itself into something more benign and manageable, which caught the supply-side of the global and domestic economy well and truly short as demand rebounded. The Russian invasion of Ukraine exacerbated many of those shortages. Shocks by definition are not forecastable. By contrast, low inflation pre-pandemic was mostly a policy choice.
John Kehoe had a story saying that the Treasurer has settled on an external rather than a Treasury and RBA-led review, with a panel of experts including a foreigner. The review is to be completed by June next year. According to Kehoe, ‘the review is likely to consider the composition of the RBA board members, the appointment processes, the 2 per cent to 3 per cent inflation target and the joint statement on the conduct of monetary policy between the treasurer and governor.’ This suggests fairly broad terms of reference.
Separately, the Richard Guylas story linked above mentions Sir Paul Tucker as a potential reviewer. Sir Paul would be a particularly good choice in evaluating the RBA’s governance and accountability arrangements. These arrangements are particularly important in conditioning the incentives faced by monetary policy decisionmakers.
Grant Wilson had a piece noting the RBA’s negative equity position given what he estimates to be $50 billion in mark-to-market losses on its bond holdings. While this suggests the need for a recapitalisation, according to Wilson, ‘we are told that the incoming ALP government does not want to go there, given the broader pressures on the budget.’ This is not a problem from the standpoint of monetary policy implementation, but over the longer-term, a strong capital position is desirable from the standpoint of ensuring the Bank’s operational and budgetary independence. If the RBA is to make greater use of QE in future, it will be important that it does not have to look over its shoulder at the implications for its capital position, lest it pull its future punches.