The RBA’s internal review of its bond purchase program
In 2019, QE was a problem for ‘future me.’ Then the RBA became ‘future me’
The RBA has released the internal review of its $281 billion bond purchase program (BPP, aka QE) of Australian, state and territory government bonds between November 2020 and February 2022. Deputy Governor Bullock summarised the main findings in a speech on Wednesday. This follows its previously released assessment of its yield curve target, which I discussed in this post.
The review largely reiterates the conclusions of earlier analyses in terms of the estimated impact on bond yields and the exchange rate, although contains additional analysis of the impact on funding costs.
The review also includes an extensive analysis of the implications of the BPP for the RBA’s balance sheet and its prospective contribution to the budget bottom line via its dividend to the government. The RBA will release its annual accounts next month and will report large accounting losses, as well as a negative equity position. This makes it unlikely the RBA will pay a dividend to the government anytime soon, although the Bank has flagged that it will not need a recapitalisation either.
Estimating the effect of QE on bond yields, the exchange rate and the economy is very difficult. As I noted in my pre-pandemic assessment of the lessons from the US experience with QE, bond purchases have a static liquidity effect, but also a dynamic income effect. The first lowers bond yields, but the second raises them. An efficient market will quickly price the dynamic effect. Strictly speaking, the effect of QE is at odds with an efficient market, but so are lots of other empirical regularities in asset pricing. As Bernanke famously said, QE works in practice, but not in theory.
These issues have led to some dubious analysis of QE, including by some very respected econometricians, claiming that QE has no effect on yields and, by implication, the economy. However, I think it is fair to say that recent research is leaning increasingly in the direction of finding larger rather than smaller effects from QE, especially when dynamic effects are considered.
Similarly, any assessment of the implications of QE for the government’s budget needs to take account of the dynamic implications of QE for the economy. If QE has significant positive effects in offsetting a negative demand shock, then its value in preserving the tax base will more than offset any realised losses on the RBA’s holdings of government bonds. It is also worth recalling that the valuation losses to the RBA from its holdings of government bonds are offset by valuation gains to the government as issuer of those bonds, although this may also lead to a fiscal transfer between the Commonwealth and the states in relation to purchases of semi-government securities. The static effects of QE enabled the government to issue debt a lower cost than would have otherwise been possible, although the dynamic effects will push the other way. Since we cannot be sure of the implications of QE for bond yields and the economy, it follows that it is very hard to assess its implications for the budget bottom line, but I have a hard time believing QE comes at a net economic cost to the government and taxpayer.
In the US, there are divided views on whether the pandemic QE episode will come at a cost to the budget bottom line. Brookings agrees with me that the dynamic effects of QE make the fiscal implications ambiguous at worst. Bill Nelson of the Bank Policy Institute has been insistent that there is a cost. I can’t fault his NPV analysis (circulated via his private email list), but I think this is more of an accounting treatment than an economic one.
The review includes a rather perfunctory analysis of QE from a quantity theory perspective, noting that ‘some commentators [can’t think who!] have pointed to an alternative approach considering the identity that links nominal spending to the quantity of money and the velocity of money.’ This view is dismissed on the basis that velocity in Australia has not been constant, but that is a misunderstanding of the monetarist view. The secular decline in velocity is unsurprising in an environment of declining interest rates, which lowers the opportunity cost of holding real money balances (which is not to suggest that this is a complete explanation of the decline in velocity). The increase in money demand implies that monetary policy needs to work harder, especially in the context of a big money demand shock such as the one we saw during the pandemic. As Friedman argued, monetary policy instruments are like a thermostat that needs to be adjusted to keep nominal income stable in response to changes in velocity. Velocity is the outside temperature in the thermostat analogy, nominal income the inside temperature.
The review also reiterates the conclusion of the review of yield targeting that bond purchases are to be preferred over yield targeting in the event the level of cash rate becomes a constraint on monetary policy in the future, an argument was I making in real-time in this space during the pandemic.
The point of my June 2019 review of the US experience was to urge the RBA to quickly adopt QE in the event it could not deliver against mandate via its usual operating framework. As I argued in my Agenda piece written in the middle of 2021, the RBA’s unwillingness to break with its usual neo-Wicksellian operating framework and conception of monetary policy transmission was responsible for delaying the introduction of QE until November 2020, leading to open economy crowding-out effects via the exchange rate due to a macro policy mix tilted in favour of fiscal policy. The review of BPP effectively concedes this point in its narrative, as did the RBA’s real-time narrative in support of the introduction of QE.
In late 2019, my USSC paper on QE became the subject of a conversation with a former very senior public servant. In his view, I was not telling the RBA anything it did not already know. As it turns out, the RBA has now effectively endorsed the conclusion I reached in June 2019, that in the event of a near-term negative shock, the RBA should ‘go early, go hard, go QE.’ It resisted that conclusion between March and November 2020. So it turns out that I really was telling the RBA something they didn’t know or at least did not appreciate.
In late 2019, most thought QE was still a hypothetical. It was clear to me that even a small negative shock would become a challenge for the Bank’s traditional operating framework, not least because the economy had already been weakened by leaning against the wind between 2016 and 2019. In February 2020, I warned in an op-ed in the AFR that the RBA Board had left us dangerously exposed by keeping rates unchanged at that month’s Board meeting on the basis of apprehended financial stability risks. It was the scenario Lars Svensson had warned us against, in which leaning against the wind increases vulnerability to a negative shock. The review of BPP concludes that QE should only be used in extreme circumstances, but on the eve of the pandemic, the RBA had already taken the cash rate down to 0.75% without the benefit of an exogenous shock. The zero bound loomed because of endogenous policy choices.
It will be interesting to see where the external RBA review lands on these issues. If it largely endorses the conclusions of the RBA’s internal reviews of yield targeting and its BPP, then that will sit just fine with me.
ICYMI
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