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Anyone keeping a close eye on Reserve Bank’s website may have noticed something new in recent months. From the 19th of March 2020, Australia”s central bank began targeting the yields of three-year government bond yields, a first in the institution’s 60-year history.
Traditionally the Reserve Bank has focused on targeting the overnight cash rate, controlling this through managing the money supply and by controlling the rate commercial banks receive on funds stored with the RBA. The Global Financial Crisis of 2007-09 led many central banks across the globe to begin dealing in unconventional monetary policy, most notably asset purchases referred to as ‘Quantitative Easing’ (QE).
Globally QE got a lot of media coverage, being described as everything from a magical economic panacea, to the rebirth of trickle-down economics, with neither characterisation being particularly true. At its core QE is simply the government buying up risk-free assets in order to lower yields, which by extension lowers interest rates in an economy.
A combination of factors, particularly the size of the fiscal response, meant that in the GFC the RBA was able to achieve its aims exclusively through conventional monetary policy, but the prevalence of QE in Europe and America’s responses to the Great Recession, brought the formally unfavored central banking practice into the mainstream.
Now, with the world facing the most significant economic crisis in almost a century Australia and with the overnight cash rate at its lowest ever level at 0.25% p.a. the RBA has made its first foray into QE, buying three-year government bonds, targeting a three-year yield also at 0.25% p.a.
So, what does this actually mean for the economy and interest rates?
On the most fundamental level, driving down the three-year bond rate is another way for the central bank to engage in expansionary monetary policy while operating within the constraints of the liquidity trap. Lowering the three-year bond yield should lower the interest rate that investors and entrepreneurs face, and therefore encouraging investment.
Looking at the policy at a slightly deeper level, the RBA purchasing assets means that cash is being moved from the Central Bank’s balance sheet onto the balance sheet of financial institutions. This helps ensure the liquidity of those institutions, prevents the economy from seizing up, and ensures that lenders are in a position to loan out funds to those who want them.
Lastly, we need to look at the signal that Philip Lowe and his board are sending by targeting the three-year yield at near-zero rates, which is that they are committing to being ‘irresponsible’ in the medium-term.
One of the benefits of having Phillip Lowe PhD as the governor of Australia’s central bank is that we are able to look at his academic career, and his academic influences to predict and explain his decisions and his views on monetary policy. If we want to look at Lowe’s academic influences then a good place to start is his supervisor from his doctorate at MIT, who was Nobel laureate, Paul Krugman.
In his 1998 paper, Japan’s Trap Krugman outlines a problem with conventional monetary policy in a liquidity trap. This is that in a recession the central bank engages in expansionary monetary policy in an attempt to spur growth, but rational investors know that long-run price stability is a core aim of the central bank, and will return to inflation targeting at the end of the recession. This means that the expansionary monetary policy does not have the desired effects, because investors are evaluating projects against a real interest rate (that is the interest rate less inflation) of about zero.
However, Krugman suggests that if the central bank is willing to commit to not flight inflation for an extended period beyond the economic recovery. That they can
“credibly promise to be irresponsible – to make a persuasive case that it will permit inflation to occur”Paul Krugman
Promising to allow inflation in the future allows the current real interest rate to drop below zero and gives the economy the expansionary boost of negative interest rates, without the technical issues that arise with negative nominal rates.
This analysis from Krugman provides us with a good explanation of what the RBA board is currently doing. In Philip Lowe’s speech on the day the central bank announced the start of the asset purchasing program Lowe stated his commitment to this kind of irresponsibility
“We are likely to be at this level of interest rates for an extended period”Phillip Lowe
And for the board, the strongest commitment way they can make to maintaining low-interest rates is to target multi-year bond yields. This asset purchasing program is a promise to investors that rates will stay low for years to come, even if inflation rises above the bank’s normal target range.
So, what does this mean for regular investors?
It means that we are not likely to see a rise in the Reserve Bank’s official overnight rate any time soon, and investors should feel safe in that knowledge. And that when you are looking to hedge against risk in your portfolio, interest rate risk is not something to be overly concerned about in the next few years.
Disclaimer: The views expressed in this article are solely that of the author’s, and do not necessarily reflect the position of UNIT nor the University of Melbourne. The advice given is general in nature and does not consider an individual’s personal financial circumstance. Transacting off this information is done so at one’s own risk, and individuals are encouraged to consult a finance professional before making investment decisions based off of this article.