Quantifying quantitative easing

In late 2019, ANZ Research provided a description of quantitative easing (QE) and what it might achieve in Australia. We also set out how we thought the Reserve Bank of Australia (RBA) might approach QE.

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There were two conclusions to that analysis. First, the hurdle for QE was high. Second, the RBA was likely to confine its initial foray into QE to the purchase of government bonds.

"ANZ Research expects the RBA to prepare on the basis QE may be required quite soon.”

RBA Governor Philip Lowe’s speech in late November confirmed those conclusions.

But the economic consequences of the novel coronavirus (COVID-19) suggest the hurdle for QE might be cleared sooner than ANZ Research thought.

We shouldn’t rule out the RBA considering asset purchases beyond government bonds. However, ANZ Research thinks the RBA will be reluctant to consider that unless evidence emerges that markets are in widespread dysfunction.

ANZ Research doesn’t think the RBA will follow an April official cash rate (OCR) cut with a move to QE as early as May. Fiscal stimulus will shortly add to rate cuts in trying to offset the impact of COVID-19, with the Government announcing its package on 12 March. Additional fiscal stimulus may also be delivered in the Federal Budget announced in May. Depending on its extent and impact and the spread of the virus, a move to QE may be delayed or avoided.

But ANZ Research expects the RBA to prepare on the basis QE may be required quite soon. The initial steps will be to set out its intentions. To some extent, discussion around QE may, in itself, deliver some of the benefits the RBA is seeking.

Indeed, ANZ Research thinks some of the recent rally in global rates reflects expectations that central banks will deploy sizable QE if required. The prospect of RBA QE hasn’t been reflected in outperformance by Australian Government Bonds (ACGB) because expectations about Fed policy had more scope to adjust than those for the RBA.

Still, if the potential for RBA QE hadn’t been on the table, we may have seen more AUD rates underperformance.

Different target, different issues

Typically, the form of QE is for a central bank to target a specific quantity of bonds to purchase. This quantity is usually specified well in advance, with the central bank buying the bonds in the secondary market – usually in the form of a reverse tender.

But this is not the only option. Recent commentary has raised the possibility the RBA might choose to target the price (yield) rather than the quantity of bonds. This is a legitimate choice.

The Bank of Japan (BoJ), for instance, introduced its Yield Curve Control (YCC) policy in 2016. This aimed at targeting a level of 0 per cent for the 10-year JGB, with the policy to be in place until the 2 per cent inflation target was achieved.

A yield target requires an unconditional commitment to purchase whatever level of bonds is required. Without that commitment, the target lacks credibility. So one of the drawbacks of yield targeting is the central bank may lose control over the size of its balance sheet.

If, however, the central bank’s actions have credibility, it is possible that the yield curve target can be achieved with minimal bond purchases. This 2018 paper notes the BoJ has been able to achieve an outcome close to its stated target with fewer purchases of JGBs over time. This may have partly been due to the BoJ’s long history of significant bond purchases.

A central bank that makes its initial move into QE with a yield target may face initial credibility issues about its willingness to buy bonds. Hence its resolve may be ‘tested’ quite early.

Liquidity impacts and exit

A key advantage of yield targeting is that it might be more effective than quantity targeting in achieving a particular outcome, in terms of bond yields. But under yield targeting the negative impact on market liquidity might be much greater, with adverse implications for other market participants.

Related to this, yield targeting might also see a much smaller increase in the money supply than a quantity target. This might mean less downward pressure on the currency, offset by the fact that it might be more successful in lowering relative interest rates.

There is also the problem the yield target might act as a floor as much as a ceiling, requiring adjustment of the target, with implications for the credibility of the target. Explicitly communicating the target is a ceiling may diminish this concern; although, if other central banks are aggressively purchasing bonds regardless of the level of yields, then an RBA policy aimed at targeting a yield level may see ACGBs left behind. The recent rally in bonds is a reminder of how quickly markets can move.

A final issue with yield targeting is the problem of exit. While quantity targeting also faces an exit problem, the fact there is no set price for bonds means that tapering is likely to be easier as economic conditions improve. The rise in yields that is likely to take place under such circumstances poses less of a challenge for a quantity target than it does for a yield target.

With a yield target, the RBA could find that if global yields start to rise on signs of economic improvement, it faces a wave of selling that needs soaking up to maintain its target. While strictly speaking the RBA has little constraint on the size of its balance sheet, it (and the Government) may become concerned about the size of the capital loss it could face when the yield target is removed.

Where to target?

The RBA must consider a range of options for setting the target yield. It can specify a particular part of the yield curve, such as X basis points (bp) for the 10-year bond, or a range of yields across a certain duration. (For example, yields of X to Y for bonds out to 5 years in duration.)

The decision of what part of the curve to target is important and would impact the extent and nature of the market impact:

  • Too short a target (3 years or less) would be ineffective, given that markets aren’t expecting any move higher in the cash rate for around two years.
  • Targeting the belly of the curve (around the 5-year point) would have some advantages. The weighted average time to maturity of Australian bank AUD bonds is around six years. By lowering (or keeping a cap on) rates in this point in the curve, the RBA would be providing some reassurance about what bank funding costs are likely to be (which would be further compressed by the asset appreciation channel of QE).
  • Targeting the 10-year part of the curve could have the most impact in terms of flattening the curve (or at least preventing future steepening). This may then have the largest currency impact. It may also be the option that requires the most intervention for the RBA to maintain, given the long-end’s tendency to be driven by moves in USD rates.

Of course, if the RBA decides to go with a quantity target, as the majority of central banks have, it still faces the question of what part of the curve to buy. When the Fed initially undertook QE, its purchases were concentrated in the 2.5 to 10-year part of the curve (more than 80 per cent). Then for QE3, it increased the average tenor of its purchases, trying to flatten the curve (as it had already started doing with Operation Twist).

The RBA’s decision is more limited, given the 11-year+ part of the curve is not particularly liquid. So it would be more likely to focus purchases in the 3 to 10-year part of the curve (the upside of buying sub-2-year debt would be limited, since the Australian Office of Financial Management already conducts regular buybacks of short-dated ACGBs).

David Plank is Head of Australian Economics at ANZ

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.

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