Testing the Limits: Are we approaching a new era of Monetary Policy?

Predictions of a February RBA rate cut were gathering momentum last week, as world markets grappled with the fallout from a number of macro hits. On Wednesday, cash rate futures – bets on how the cash rate will change the next RBA meeting – indicated a 60% expectation that Reserve Bank Governor Philip Lowe will lower the official interbank lending rate to 0.5% next month, though it has since declined.

The current 0.75% rate is already the lowest cash rate Australia has known in the era of inflation targeting. The fact that it could now fall to 0.5% would have been unbelievable a few years ago. Even during the GFC, the cash rate bottomed out at a low point of 3%, and quickly turned around.

For many who have been watching Australia’s flagging growth statistics, reports of retail ruin, and the ongoing bushfire crisis, the question is less likely to be “why cut interest rates?” rather than “why not?” The answer feeds into much larger systemic questions about the role of monetary policy in the global economy.

Traditional Monetary Policy

Central bankers around the world are warning policy makers of the lack of wiggle room in official interest rates. While ultra-low interest rates are new in Australia, they have become common practice around the world for the past decade, as inflation has stayed at record lows in spite of falling unemployment. The US Federal Reserve targeted an interest rate of close to 0% for 7 years from 2008-2015, and it is now only marginally higher at 1.75%, and on its way back down. Those set by the European Central Bank have been near 0% for five years now.

Central banks around the world are scraping the proverbial barrel of what traditional monetary policy is capable of. For context, if you never took Macro 101, “monetary policy” is a tool of macroeconomic adjustment, generally executed by a country’s central bank manipulating the interest rate on very short-term assets. By injecting or withholding liquidity from certain financial markets, they can manage the effective interest rate in said market, which will theoretically have a trickle-on effect to other money markets. In a downturn, this hopefully looks like a reduction in interest charged on consumer financial products like credit cards and mortgage loans, boosting disposable income.

Limitations

The problem with interest rates is that, once you hit 0%, you’re basically at the end of your rope. It is possible to offer negative interest rates, in which the store of cash attracts fees and loans accrue interest instead. It’s a tactic that has been used in Japan since 2016 with apparent success. However, the difficulties with introducing negative rates here are likely to be more political than economic; how do you justify charging retirees to store their savings?

The limitations of traditional interest rate management have been highlighted by Governor of the Bank of England Mark Carney, who warns that a liquidity trap could undermine the future efforts of central banks to smooth out the lower end of the business cycle.

In a recent interview, Mr Carney said that central banks no longer had the ammunition to adequately prevent financial crises, in what he described as a situation that is likely to persist for some time.

Also this week, two former chairs of the US Federal Reserve told the American Economics Association’s 2020 meeting that lowering interest rates would not be enough to fight off a future recession in this monetary climate.

Janet Yellen warned that though monetary policy would have a role to play in future downturns, it was unlikely to be adequate for the foreseeable future. Ms Yellen and GFC chairman Ben Bernanke both emphasised the role that fiscal policy through government spending will need to play in the coming years, given that the Fed is hamstrung by low rates.

So, where does that leave central banks now? What other tools are in the monetary policy toolbox that can be used when traditional interest rate fixing is ineffective, or when banks want to do more?

Quantitative Easing.

Quantitative easing is entering more discussions as global recession fears grow in the public consciousness. Markets want to know what else central banks can do to prevent a possible recession.

Quantitative Easing is a relatively new method of managing the business cycle, that became popular during the Great Recession in those economies that had exhausted their capacity to lower interest rates early on.

Basically, the aim of quantitative easing (QE) is to target the other end of the yield curve to the cash rate. The yield curve is a way of thinking about rates of return on securities in terms of time to maturity. At one end, you have the very short maturity overnight cash market, which is the market that the RBA uses the cash rate to manage. Then at the other end, you have the long-term assets like 10-year Government Bonds.

The huge difference in the lengths of maturity here means that it can be hard for the overnight rate to have any impact on longer term assets. In applying QE, a central bank would enter the long-term market and effect yields directly by making large purchases of these long maturity assets. Such purchases push up the price and lower the yields on long-term bonds, supressing the far end of the yield curve.

This is now a tested method that appears to have been used successfully – Mr Bernanke recently presented research to support the success of the Fed’s QE regime from 2009-2014, during which time the Fed accumulated an estimated US$4.5 trillion in assets.

The RBA is yet to join the bevvy of central banks trying QE, as they have previously had sufficient interest rate flexibility to avoid it. But 2020 could be the year that all changes. In a November speech Philip Lowe stated that the RBA Board would consider engaging in QE once a cash rate of 0.25% had been reached, but not before. With as few as two board meetings needed to hit that lower boundary, QE is looking a lot closer than ever before.

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