Quantitative Appeasing

What is quantitative easing? Why would the RBA want to use it?

”First, do no harm”. Many medical students still take a revised version of the Hippocratic Oath upon graduation, a reminder to weigh the potential for unintended harm against the benefits of treatment. Central banks should heed this advice. Increasingly, the ability to use traditional policy instruments has been depleted, forcing central banks to consider increasingly bold and diverse prescriptions for the ailing economy. These tools, categorised broadly as unconventional monetary policy tools, have become increasingly popular despite harbouring heightened economic risks.

By far the most widely adopted unconventional monetary policy tool has become quantitative easing, having experienced near ubiquitous growth worldwide. The RBA noted in 2019 that “Before the financial crisis (GFC), the major central banks owned securities equivalent to around 5 percent of GDP. In recent years, this has risen to nearly 30 per cent.”

While long-term government bonds are responsible for most of this growth, agency securities and private securities have experienced unsettling levels of expansion, even before the COVID-19 pandemic. This is primarily due to the lack of policy instruments available to major central banks internationally, and broadcasts weakness in private credit markets.

This is exemplified by the $700 billion worth of mortgage backed securities purchases by the Federal Reserve since March 2020, 30% of the entire US market for MBSs. This level of Fed support indicates the level of vulnerability in the housing market, implying adequate steps since the GFC were not taken to shore up the residential sector.

Central banks are reticent to adopt this form of targeted support due to the distortionary impacts this has on the economy. Businesses can become reliant on low interest credit lines materialized by central banks rather than adequately preparing for a downturn. As a result, winding down QE programs can be economically painful. In 2013, the US 10-year treasury yield increased by 1.5% after the Fed announced it would taper its QE program in an event now known as the ‘tapering tantrum’.

Determining how to distribute liquidity into the economy can also be a source of contention. Extending credit to struggling businesses is undesirable as it generates the moral hazard discussed above. As a result, most central banks limit the scope of these programs to larger, sturdier institutions. This can restrict the economic impact of this tool and can perpetuate inequality. Under the EU’s corporate sector purchase program (CSPP), bond purchases are restricted to issuances worth over 10 million euros and credit scores between AA and BBB. This diverts liquidity to the institutions and labourers that are in least need of funds. This self-selection bias has meant over half the CSPP funding has been funneled to France and Germany over less affluent nations in the EU.

These weaknesses led RBA Governor Phillip Lowe to state that he has “no appetite to undertake outright purchases of private sector assets as part of a QE program” prior to the pandemic. He instead advocated for the purchase of longer term government bonds, noting that it “gets into all the corners of the financial system, unlike interventions in just one specific private asset market.” He also signaled that the direct involvement of the RBA in the allocation of goods in the economy is not the prerogative of the central bank. Fortunately the Australian economy has been in a position such that there has been no need to abandon this promise. Let's hope it stays that way.

By Finnegan Collins - 2nd Year Bachelor of Science and Bachelor of Advanced Studies (Financial Mathematics and Statistics & Economics)