Australia's Central Bank Would Mix Stimulus Tools in Extreme Scenario

Incoming RBA Governor Philip Lowe

Philip Lowe.

Photographer: Sergio Dionisio/Bloomberg
  • Australia central bank seen cutting to 1% by some analysts
  • Incoming RBA chief has signaled that near 1%, QE is possible

Australia’s central bank has studied the examples of unorthodox policy conducted by its peers, and would favor a multi-pronged stimulus if economic conditions unexpectedly deteriorated to the point where it had to head into uncharted territory.

The Reserve Bank of Australia currently still has room for traditional interest-rate cuts, with its benchmark at 1.75 percent. However, economists anticipate another reduction as soon as next month, and Deputy Governor Philip Lowe -- who will take the RBA’s helm in September -- has indicated that lowering the rate on its own would lose effectiveness as it approaches 1 percent.

That explains the studies conducted by RBA staff. One advantage Australia has is learning from the experience of counterparts in Japan, Europe and the U.S. over the past several years in deploying monetary stimulus beyond rate cuts.

“As you would expect, we have considered what lessons can be drawn for
Australia by looking at the experience of other central banks that have adopted
various unconventional measures,” RBA Assistant Governor Christopher Kent, who is responsible for economic analysis and research, said in an interview. He said the likelihood of the bank having to consider using such measures is “very remote.”

‘More Effective’

Kent said three main lessons have been drawn from the experiences of other central banks:

  • “Policies should be tailored to individual country circumstances, including the nature of their financial systems.”
  • “Different unconventional policies could be used at the same time, and such a combination may be more effective than any one type of policy in isolation.”
  • “There’s evidence that unconventional policies have provided a measure of stimulus, although it appears that there are diminishing returns, which is true of most things.”

While the emergence of an extreme scenario in Australia remains unlikely, JPMorgan Chase & Co., Morgan Stanley and Macquarie Bank Ltd. anticipate Glenn Stevens, the current governor, and Lowe will need to cut the cash rate to 1 percent by the third quarter of next year.

Key Takeaways

Among the conclusions understood to be drawn from the RBA’s studies:

  • The key is to use the tools in unison, have a coherent narrative and a credible target -- and don’t try to achieve too much. Forward guidance, for instance, is a tool that can present problems if there isn’t a strong, consistent narrative.
  • Unorthodox policies probably wouldn’t be adopted on a pre-emptive basis, but only after some symptoms of economic stress had materialized that warranted a reaction.
  • Balance-sheet expansion, through purchases of assets such as government bonds or through long-term repurchase agreements -- potentially including asset-backed securities and mortgage securities -- would be one tool to consider.
  • Australia’s government bond market isn’t large. But buying assets such as corporate bonds involves non-trivial risks. That means the central bank would want some government backing to ensure it wasn’t taking the risks on its own, if it decided to go ahead with risk-asset buying.
  • Negative interest rates aren’t an attractive option, because of the problems they pose for the banking system and the prospect of putting the money market fund industry at risk.
  • Purchases of foreign assets would be perceived internationally as an exchange-rate targeting measure. Exchange-rate intervention in some form wouldn’t be ruled out in an extreme scenario. In the case of any buying of overseas assets, government backing would be important given the risk of losses.
  • True helicopter money -- direct financing of government spending -- is a tricky proposition. Experience in Africa and Latin America shows this can generate inflation, but these cases are associated with negative outcomes; direct financing can become addictive for politicians. In any case, if the central bank is expanding its balance sheet through asset purchases, and the government is offering the economy fiscal support, the result can be similar to what helicopter money is aiming to achieve.
  • While pulling down longer-term yields through asset purchases might have a limited impact on Australian corporate and homeowner borrowing costs, the RBA could get bang for its buck through the exchange rate falling -- if foreign investors shifted out of Australian fixed income.
  • The balance sheet could be expanded at the same time as cutting the benchmark rate, it need not happen after rate cuts had been exhausted.

“While the RBA is right to say that Australia’s government bond market is not large, we think that another crisis would see large budget deficits and a large increase in the supply of bonds,” Australia & New Zealand Banking Group Ltd. analysts wrote in a research note on Friday. “For example, the stock of commonwealth bonds increased by 10 percent of GDP during the early 1990s recession, while the stock of state bonds rose by the same amount.”

Australia’s central bank is currently contending with an economy with a good side and a bad side. Growth is solid and the jobs market is holding up as a mining boom unwinds. At the same time, wage gains and core inflation are at record lows, which prompted a rate cut in May. Indeed, Australia has some parallels to Sweden’s economy, which grew an annual 4.2 percent in the first quarter, with the central bank running a negative-rate policy and a bond-buying program to revive inflation.

Small Benefit

“Once you get below some certain level of very low interest rates,” the “incremental benefit from lowering them further is quite small,” Deputy Governor Lowe said at a December 2012 event, answering a question about when the RBA might consider quantitative easing.

Speaking at a time when the benchmark rate was at 3 percent, Lowe said that “somewhere around 1 percent plus or minus a bit -- I think once you get there, other options of unconventional monetary policy become more viable. Until you get there I don’t really see a strong case for doing these other unconventional things.”

The year after Lowe spoke, Japan achieved a big effect when it unveiled a new inflation target, a new quantitative-easing program and a new agreement with the government on achieving reflation. The narrative shifted this year, however, when Bank of Japan Governor Haruhiko Kuroda unveiled a negative interest-rate policy after repeatedly saying no such option was under consideration. The move has fed a perception of the BOJ running out of usable tools, and the yen has moved against policy makers this year.

U.K., Europe

In the case of the U.K., the government’s policy served to counteract what the central bank was doing, with fiscal tightening occurring as the Bank of England embraced quantitative easing. The European Central Bank has faced political resistance in some countries to its QE program, and set guidelines on the amounts of national government bonds it can buy.

The Federal Reserve did well in combining its policy tools and forward guidance, before running into challenges in the process of exiting from unorthodox policy. The Fed set guidelines for the unemployment rate that would spur higher rates, then didn’t follow through with rate hikes.

“We do have the advantage of being able to learn from the successes and failures of the various forms of QE that have been deployed in other countries,” said Saul Eslake, an independent economist who has worked in Australian financial markets for more than a quarter century and wrote a 2013 report mooting the possibility of QE in the country. “The most effective thing the RBA could do in the event that it reached the limits of conventional monetary policy” would be to pursue currency depreciation, he said.

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