Last update we had a detailed look into “conventional monetary policy”. Today our goal is to build on our understanding of “conventional monetary policy” transitioning into the world of “unconventional monetary policy” (“UMP”) – what is it, its history, its effectiveness and what it might look like if (or when) adopted in Australia.
Another term commonly used is “quantitative easing” (“QE”). It also often gets dumbed-down to “money printing” – as we learn the mechanics of it we will realise that this is not a fair description (at least based on the UMP strategies most likely to be pursued).
Firstly, let’s recap what “conventional monetary policy” is all about here in Australia. We ended last time with the following summary:
Monetary policy in Australia is about our central bank (the RBA) setting the interest rate applicable in the interbank market and then working closely with the banks to control liquidity in the interbank market in order to keep the interbank money market balanced at the desired interest rate.
The interest rate applicable to the interbank market closely resembles short-term interest rates in the broader economy and because deposit and lending rates are based off short term rates, the RBA can effectively influence interest rates in the broader economy.
So in essence, “conventional monetary policy” is really quite simple – the RBA sets the “price of money” in the interbank market and this spills over to the interest rates applicable to you and I on loans and deposits. Make money cheaper and you should stimulate borrowing activity which in turn stimulates economic activity as the borrowed money is spent in the economy.
If the economy isn’t performing very well and yet the interest rate set by the RBA is close to zero, the RBA has a problem. Their role in accordance with the legislation that created them is to use monetary policy to maintain full employment and for the economic prosperity and welfare of the people of Australia (“stability of the currency” is the third goal, but that’s a little less relevant here).
With the cash rate now at 1%, we’re approaching the point where “conventional monetary policy” is no longer effective. Rates cannot be cut much more in the attempt to spur lending/economic activity. At some point (even before 0%), cheap money has almost no impact. For example, is 0.5% really any different to 0.25%?
Cue calls from various observers for the RBA to start thinking about what else it can do with monetary policy in order to achieve its mandates…
A Brief History of “Unconventional Monetary Policy”:
The history of UMP is brief: It essentially originates from the USA after the global financial crisis a little more than a decade ago. The US Federal Reserve initially responded with “conventional monetary policy” – cutting rates to zero by late 2008 (where they stayed till late 2015). But the economy was still really struggling. The Fed had two choices; they could do nothing, or they could do something.
Not wanting to sit back and do nothing, the Fed chose to do something…
The US has basically the same monetary system as we do in Australia with the Fed performing the role of our RBA. As we covered last time, “conventional monetary policy” is all about the central bank closely working with commercial banks in monitoring liquidity in the banking system with the goal of keeping the interbank money market balanced at the prevailing set interest rate. They do this by injecting or extracting liquidity via transactions involving debt securities – largely government bonds. Buy securities from the banks, give them funds to use in the interbank market to settle transactions. Sell banks securities, give them an interest-bearing security in exchange for their excess reserves.
The Fed ended up implementing four UMP programs – some subtly different, but all basically the same. What the Fed ended up doing is buying around 3 trillion USD worth of securities, lifting their balance sheet from around 1 trillion pre-GFC to around 4 trillion at the end of their Quantitative Easing (QE).
Based on our knowledge of how “conventional monetary policy” is deployed, stop and think carefully about what the Fed was doing…
Conventional monetary policy is about working with the banks to carefully balance reserves in the system so that the interbank market is balanced at the desired interest rate.
The Fed deliberately flooded the interbank market with reserves!
As we know, banks will try and rid themselves of excess reserves as they earn no return. However, if the market is so flush with reserves that nobody is running low and needing to borrow some in the interbank market, the interest rate in the interbank market will fall to zero (assuming zero is not already the target rate set by the central bank).
This was very controversial at the time (and still is). It was basically un-tested and the ramifications were not clear at all. At least three other major central banks adopted some form of UMP – The European Central Bank (ECB), the Bank of England and Japan. Fast-forward to today – the key reason why UMP is a hot topic is because there doesn’t appear to have been any major negative ramifications of UMP. Given this, UMP is now considered a legitimate tool in the central banker’s very, very limited tool chest.
I want to digress for a moment to highlight an important point. It is critical to understand that bank reserves are a special kind of money. As we learned last time, here in Australia they are called “exchange settlement” (ES) funds. Banks are very restricted with what they can do with them. They can deposit them in their account at the central bank. They can lend them out to other commercial banks in the interbank market or they can buy debt securities from a very limited list of approved securities (most commonly government bonds).
Banks cannot and do not lend reserves to customers. Banks cannot and do not bid up the price of risk assets such as shares with all their excess reserves. This is why the term “money printing” is very misleading – I don’t know about you, but to me that phrase conjures up images of wads of cash (or the modern electronic equivalent of numbers in bank accounts) being pumped out into the economy. Increasing bank reserves in the banking system does not have any impact on the level of private sector assets. Its transmission mechanism to stimulate the economy if therefore questionable.
What’s UMP supposed to do?
Theoretically, in essence UMP is supposed to work to stimulate economic activity in basically the same way as conventional monetary policy.
By removing interest-bearing securities from the market and replacing them with zeroyielding bank reserves, interest rates should decline. One difference however is that unlike conventional monetary policy, which is concerned almost exclusively with short-term rates, UMP programs can be used to lower longer-term rates by acquiring longer-duration assets. This is a key feature of the Fed’s UMP programs – they bought substantial amounts of longer-duration government debt.
The drop in yields – both short and long term – should increase the demand for credit within the private sector.
UMP has been shown to have another effect. The yield on risk-free assets is of course your benchmark for assessing other investments. By suppressing risk-free rates, yieldhungry investors have bid up the price of anything with any yield or prospective return. You can say this is an unintended consequence of UMP. But I guess it’s seen as a pleasantly unintended consequence (at least for the moment). At some point investors may wonder if taking the risk for such a low yield was worth it.
To digress into this a little more for a moment, we now have somewhere around 13 trillion USD of negative-yielding debt globally. Corporate leverage is at records as companies have been taking advantage of low rates by frantically issuing debt and using the proceeds for stock buybacks. Share markets are near all-time highs…
A major outcome of zero interest rates and UMP is the investment landscape we’re now facing. Markets are incredibly fragile. Risk premia razor-thin. Prospective returns whittled down to near-zero, but with the same volatility risk as always.
This general climate has persisted for some time now and we therefore can’t say its “unsustainable”. The big question – when the next economic downturn occurs (and it’s a matter of “when” and not “if”), will the tidal wave of UMP and a craving for yield outstrip the demand for safety and keep asset markets buoyant? Or will the falls be even worse owing to extremely stretched valuations?
Personally, I don’t believe central bank actions will “save” markets in an environment where corporate profits fall, corporate debt defaults rise and fear is high…
Does UMP Work?
Well… That’s a good question…
The efficacy of UMP is a hot topic among academic economists. As many economists acknowledge, identifying causal relationships between UMP and economic outcomes is difficult – said another way, it’s really hard to prove that UMP has achieved any economic benefits. Here’s a snapshot of US GDP growth over the past 20 years encompassing the GFC and subsequent UMP period:
Depending on what you include, the US economy has had circa US$33 trillion in economic stimulus thrown at it since the GFC… and that’s the recovery? Just chopping around in “low-growth” mode?
I’ll say it again – academic economists cannot agree on whether the US’s foray into UMP actually achieved any tangible economic benefits. Economics is hard – economies are too vast and complex to track the effects of a specific monetary policy outcome through the economy. But the fact that economists cannot clearly demonstrate how UMP truly helped says volumes about its effectiveness.
Back to why UMP is now a bona-fide tool… There doesn’t appear to have been any real negative unintended consequences of UMP. Whether it really has benefits is therefore somewhat irrelevant – if the economy is struggling and conventional monetary policy tools all but exhausted, central bankers won’t sit by and do nothing – they will pursue some form of UMP…
What could UMP look like in Australia?
With basically the same monetary system, the USA has written the playbook for Australian UMP.
It’s probable that the RBA will look at a government bond buying program focused on longer duration bonds. In terms of efficacy, remember that the RBA itself notes that most interest rates on loans and deposits in Australia are floating or short-term and thus tied closely to short-term money market rates. Therefore, aside from robbing savers of risk-free return, there’s a real question mark over whether suppressing longer-term yields would do anything to help the economy.
If you recall from last time, the RBA pays banks interest on reserves they have on deposit at a rate 0.25% lower than the official cash rate. Depending on where the cash rate is at when a UMP strategy is implemented, abolishing this interest payment will be a good move – maybe even charging banks to hold deposits (i.e. negative rates). Again, banks don’t lend reserves but if the goal is to suppress short-term rates, this will work.
There is one UMP tactic that might actually do some serious good. However, the circumstances under which it would be effective are quite dire…
Remember that the RBA is very restricted as to which assets it can buy from banks as part of its open market operations. Highly rated mortgage securities are on the list.
If the economy performs really poorly – I mean really poorly – our bloated banks face the prospect of massive losses on their “assets” (being the loans they have made). Stress in the interbank market would be high. “Counterparty risk” – where banks are hesitant to lend to each for fear that they will not get the money back the next day – is a possibility. Their ability to extend credit to creditworthy borrowers (including rolling over existing debt) will be greatly impacted.
In such a scenario, the RBA can act to inject massive liquidity, taking mortgage securities (and thus “risk assets”) off the banks in the process, somewhat alleviating capital strains and freeing up capacity to make new loans.
This was the origins of UMP in the US – the GFC lead to this exact scenario and the Fed responded in this way. Somewhat controversially, the Fed bought wads of mortgagebacked securities from the banks, some of which weren’t exactly highly rated, thus allowing the banks to improve their balance sheets as they could park the reserves they received from the sales in more secure assets such as government debt.
In conclusion, I believe that “UMP”…QE…”money printing” – call it what you will – is coming to Australia. Maybe not this week or this year, but when conventional monetary policy is exhausted yet the economy spluttering, our central bankers will try something different.
When it does, please remember what it’s really all about and remember that in other nations to try it already the only tangible (and delayed) outcome has been the facilitation of bubbles in risk assets – a pleasant outcome… right up until it isn’t…
This document contains information which is the copyright of Aviator Capital Pty Ltd (AFSL 432803) or relevant third party. Any views expressed in this transmission are those of the individual, except where the individual specifically states them to be the views of Aviator Capital Pty Ltd. Except as required by law, Aviator Capital Pty Ltd does not represent, warrant and/or guarantee that the integrity of this document has been maintained nor is free of errors, interception or interference. You should not copy, disclose or distribute this document without the authority of Aviator Capital Pty Ltd. Aviator Capital Pty Ltd does not accept any liability for any investment decisions made on the basis of this information. This information is intended to provide general information only, without taking into account any particular person’s objectives, financial situation, taxation or needs. It does not constitute financial advice and should not be taken as such. Aviator Capital Pty Ltd urges you to obtain professional advice before proceeding with any financial investment.
Register your interest in this Fund
Lorem ipsum dolor sit amet, consectetur adipiscing elit. Ut elit tellus, luctus nec ullamcorper mattis, pulvinar dapibus leo.
Monetary Policy Pt2
Monetary Policy – Part 2
Last update we had a detailed look into “conventional monetary policy”. Today our goal is to build on our understanding of “conventional monetary policy” transitioning into the world of “unconventional monetary policy” (“UMP”) – what is it, its history, its effectiveness and what it might look like if (or when) adopted in Australia.
Another term commonly used is “quantitative easing” (“QE”). It also often gets dumbed-down to “money printing” – as we learn the mechanics of it we will realise that this is not a fair description (at least based on the UMP strategies most likely to be pursued).
Firstly, let’s recap what “conventional monetary policy” is all about here in Australia. We ended last time with the following summary:
Monetary policy in Australia is about our central bank (the RBA) setting the interest rate applicable in the interbank market and then working closely with the banks to control liquidity in the interbank market in order to keep the interbank money market balanced at the desired interest rate.
The interest rate applicable to the interbank market closely resembles short-term interest rates in the broader economy and because deposit and lending rates are based off short term rates, the RBA can effectively influence interest rates in the broader economy.
So in essence, “conventional monetary policy” is really quite simple – the RBA sets the “price of money” in the interbank market and this spills over to the interest rates applicable to you and I on loans and deposits. Make money cheaper and you should stimulate borrowing activity which in turn stimulates economic activity as the borrowed money is spent in the economy.
If the economy isn’t performing very well and yet the interest rate set by the RBA is close to zero, the RBA has a problem. Their role in accordance with the legislation that created them is to use monetary policy to maintain full employment and for the economic prosperity and welfare of the people of Australia (“stability of the currency” is the third goal, but that’s a little less relevant here).
With the cash rate now at 1%, we’re approaching the point where “conventional monetary policy” is no longer effective. Rates cannot be cut much more in the attempt to spur lending/economic activity. At some point (even before 0%), cheap money has almost no impact. For example, is 0.5% really any different to 0.25%?
Cue calls from various observers for the RBA to start thinking about what else it can do with monetary policy in order to achieve its mandates…
A Brief History of “Unconventional Monetary Policy”:
The history of UMP is brief: It essentially originates from the USA after the global financial crisis a little more than a decade ago. The US Federal Reserve initially responded with “conventional monetary policy” – cutting rates to zero by late 2008 (where they stayed till late 2015). But the economy was still really struggling. The Fed had two choices; they could do nothing, or they could do something.
Not wanting to sit back and do nothing, the Fed chose to do something…
The US has basically the same monetary system as we do in Australia with the Fed performing the role of our RBA. As we covered last time, “conventional monetary policy” is all about the central bank closely working with commercial banks in monitoring liquidity in the banking system with the goal of keeping the interbank money market balanced at the prevailing set interest rate. They do this by injecting or extracting liquidity via transactions involving debt securities – largely government bonds. Buy securities from the banks, give them funds to use in the interbank market to settle transactions. Sell banks securities, give them an interest-bearing security in exchange for their excess reserves.
The Fed ended up implementing four UMP programs – some subtly different, but all basically the same. What the Fed ended up doing is buying around 3 trillion USD worth of securities, lifting their balance sheet from around 1 trillion pre-GFC to around 4 trillion at the end of their Quantitative Easing (QE).
Based on our knowledge of how “conventional monetary policy” is deployed, stop and think carefully about what the Fed was doing…
Conventional monetary policy is about working with the banks to carefully balance reserves in the system so that the interbank market is balanced at the desired interest rate.
The Fed deliberately flooded the interbank market with reserves!
As we know, banks will try and rid themselves of excess reserves as they earn no return. However, if the market is so flush with reserves that nobody is running low and needing to borrow some in the interbank market, the interest rate in the interbank market will fall to zero (assuming zero is not already the target rate set by the central bank).
This was very controversial at the time (and still is). It was basically un-tested and the ramifications were not clear at all. At least three other major central banks adopted some form of UMP – The European Central Bank (ECB), the Bank of England and Japan. Fast-forward to today – the key reason why UMP is a hot topic is because there doesn’t appear to have been any major negative ramifications of UMP. Given this, UMP is now considered a legitimate tool in the central banker’s very, very limited tool chest.
I want to digress for a moment to highlight an important point. It is critical to understand that bank reserves are a special kind of money. As we learned last time, here in Australia they are called “exchange settlement” (ES) funds. Banks are very restricted with what they can do with them. They can deposit them in their account at the central bank. They can lend them out to other commercial banks in the interbank market or they can buy debt securities from a very limited list of approved securities (most commonly government bonds).
Banks cannot and do not lend reserves to customers. Banks cannot and do not bid up the price of risk assets such as shares with all their excess reserves. This is why the term “money printing” is very misleading – I don’t know about you, but to me that phrase conjures up images of wads of cash (or the modern electronic equivalent of numbers in bank accounts) being pumped out into the economy. Increasing bank reserves in the banking system does not have any impact on the level of private sector assets. Its transmission mechanism to stimulate the economy if therefore questionable.
What’s UMP supposed to do?
Theoretically, in essence UMP is supposed to work to stimulate economic activity in basically the same way as conventional monetary policy.
By removing interest-bearing securities from the market and replacing them with zeroyielding bank reserves, interest rates should decline. One difference however is that unlike conventional monetary policy, which is concerned almost exclusively with short-term rates, UMP programs can be used to lower longer-term rates by acquiring longer-duration assets. This is a key feature of the Fed’s UMP programs – they bought substantial amounts of longer-duration government debt.
The drop in yields – both short and long term – should increase the demand for credit within the private sector.
UMP has been shown to have another effect. The yield on risk-free assets is of course your benchmark for assessing other investments. By suppressing risk-free rates, yieldhungry investors have bid up the price of anything with any yield or prospective return. You can say this is an unintended consequence of UMP. But I guess it’s seen as a pleasantly unintended consequence (at least for the moment). At some point investors may wonder if taking the risk for such a low yield was worth it.
To digress into this a little more for a moment, we now have somewhere around 13 trillion USD of negative-yielding debt globally. Corporate leverage is at records as companies have been taking advantage of low rates by frantically issuing debt and using the proceeds for stock buybacks. Share markets are near all-time highs…
A major outcome of zero interest rates and UMP is the investment landscape we’re now facing. Markets are incredibly fragile. Risk premia razor-thin. Prospective returns whittled down to near-zero, but with the same volatility risk as always.
This general climate has persisted for some time now and we therefore can’t say its “unsustainable”. The big question – when the next economic downturn occurs (and it’s a matter of “when” and not “if”), will the tidal wave of UMP and a craving for yield outstrip the demand for safety and keep asset markets buoyant? Or will the falls be even worse owing to extremely stretched valuations?
Personally, I don’t believe central bank actions will “save” markets in an environment where corporate profits fall, corporate debt defaults rise and fear is high…
Does UMP Work?
Well… That’s a good question…
The efficacy of UMP is a hot topic among academic economists. As many economists acknowledge, identifying causal relationships between UMP and economic outcomes is difficult – said another way, it’s really hard to prove that UMP has achieved any economic benefits. Here’s a snapshot of US GDP growth over the past 20 years encompassing the GFC and subsequent UMP period:
Depending on what you include, the US economy has had circa US$33 trillion in economic stimulus thrown at it since the GFC… and that’s the recovery? Just chopping around in “low-growth” mode?
I’ll say it again – academic economists cannot agree on whether the US’s foray into UMP actually achieved any tangible economic benefits. Economics is hard – economies are too vast and complex to track the effects of a specific monetary policy outcome through the economy. But the fact that economists cannot clearly demonstrate how UMP truly helped says volumes about its effectiveness.
Back to why UMP is now a bona-fide tool… There doesn’t appear to have been any real negative unintended consequences of UMP. Whether it really has benefits is therefore somewhat irrelevant – if the economy is struggling and conventional monetary policy tools all but exhausted, central bankers won’t sit by and do nothing – they will pursue some form of UMP…
What could UMP look like in Australia?
With basically the same monetary system, the USA has written the playbook for Australian UMP.
It’s probable that the RBA will look at a government bond buying program focused on longer duration bonds. In terms of efficacy, remember that the RBA itself notes that most interest rates on loans and deposits in Australia are floating or short-term and thus tied closely to short-term money market rates. Therefore, aside from robbing savers of risk-free return, there’s a real question mark over whether suppressing longer-term yields would do anything to help the economy.
If you recall from last time, the RBA pays banks interest on reserves they have on deposit at a rate 0.25% lower than the official cash rate. Depending on where the cash rate is at when a UMP strategy is implemented, abolishing this interest payment will be a good move – maybe even charging banks to hold deposits (i.e. negative rates). Again, banks don’t lend reserves but if the goal is to suppress short-term rates, this will work.
There is one UMP tactic that might actually do some serious good. However, the circumstances under which it would be effective are quite dire…
Remember that the RBA is very restricted as to which assets it can buy from banks as part of its open market operations. Highly rated mortgage securities are on the list.
If the economy performs really poorly – I mean really poorly – our bloated banks face the prospect of massive losses on their “assets” (being the loans they have made). Stress in the interbank market would be high. “Counterparty risk” – where banks are hesitant to lend to each for fear that they will not get the money back the next day – is a possibility. Their ability to extend credit to creditworthy borrowers (including rolling over existing debt) will be greatly impacted.
In such a scenario, the RBA can act to inject massive liquidity, taking mortgage securities (and thus “risk assets”) off the banks in the process, somewhat alleviating capital strains and freeing up capacity to make new loans.
This was the origins of UMP in the US – the GFC lead to this exact scenario and the Fed responded in this way. Somewhat controversially, the Fed bought wads of mortgagebacked securities from the banks, some of which weren’t exactly highly rated, thus allowing the banks to improve their balance sheets as they could park the reserves they received from the sales in more secure assets such as government debt.
In conclusion, I believe that “UMP”…QE…”money printing” – call it what you will – is coming to Australia. Maybe not this week or this year, but when conventional monetary policy is exhausted yet the economy spluttering, our central bankers will try something different.
When it does, please remember what it’s really all about and remember that in other nations to try it already the only tangible (and delayed) outcome has been the facilitation of bubbles in risk assets – a pleasant outcome… right up until it isn’t…
This document contains information which is the copyright of Aviator Capital Pty Ltd (AFSL 432803) or relevant third party. Any views expressed in this transmission are those of the individual, except where the individual specifically states them to be the views of Aviator Capital Pty Ltd. Except as required by law, Aviator Capital Pty Ltd does not represent, warrant and/or guarantee that the integrity of this document has been maintained nor is free of errors, interception or interference. You should not copy, disclose or distribute this document without the authority of Aviator Capital Pty Ltd. Aviator Capital Pty Ltd does not accept any liability for any investment decisions made on the basis of this information. This information is intended to provide general information only, without taking into account any particular person’s objectives, financial situation, taxation or needs. It does not constitute financial advice and should not be taken as such. Aviator Capital Pty Ltd urges you to obtain professional advice before proceeding with any financial investment.
Register your interest in this Fund
Lorem ipsum dolor sit amet, consectetur adipiscing elit. Ut elit tellus, luctus nec ullamcorper mattis, pulvinar dapibus leo.