Over the past 18 months, the Reserve Bank of Australia (RBA) has changed tack from “the next move in interest rates is up” to a dovish bias. So much so, that this year they have cut the official cash rate from 1.5% to 0.75% (at the time of writing), with potentially more to come.
As Australian interest rates head toward zero, many market commentators are now speculating that the central bank will be forced to adopt “unconventional measures” to support the economy. This may include Quantitative Easing (QE).
QE can come in different forms, so if the RBA does follow this path it’s not entirely clear what it will look like. However, based on our understanding of the monetary system along with almost 20 years of international QE evidence, outside a domestic financial crisis it is almost certain that an ‘Aussie QE’ will do nothing.
To explore this further, we need to dispel a few myths.
QE is not money printing
In a broad sense, QE is a monetary operation where the central bank acquires certain assets (usually deemed ‘high quality’) from the private sector. The assets are usually local long-term government bonds.
The purchase of these assets is satisfied / settled with cash.
The use of QE is often referred to as ‘money printing’, but it can also be characterised as injecting cash into the economy. Both descriptions are false.
As described above, QE is nothing more than an asset swap between the central bank and the private sector. The swap is of one form of monetary instrument (bonds) for another (cash).
From the perspective of the private sector, no new financial assets are gained. Only the duration of the asset held is altered. It is akin to moving a term deposit to an ‘at call’ deposit.
QE does not inject new money into the system
The counter to this argument says individuals and companies cannot use bonds to purchase real goods and services. Therefore, selling bonds to the central bank and receiving cash increases private sector purchasing power.
But this is not true.
Under the universal laws of accounting, the total private sector net financial savings is equal to total government financial debt (to the cent). And under QE, total government debt does not change – therefore total private sector net financial saving does not change.
Holders of bonds (typically financial institutions, the wealthy and superannuation accounts) are by their nature savers or reflect savers. These savings simply mirror net government debt. Removing bonds via QE results in the non-government sector holding more of their savings in the form of cash.
QE does not force down interest rates
Proponents of QE argue that its implementation impacts the bond market such that it (artificially) lowers long-term bond yields. It follows this is stimulatory, since many private sector long-term investment decisions often reference long-term interest rates as the true cost of debt financing. In addition, long-term interest rates are a proxy for the risk free rate for investment decisions. The lower the rate, the more private projects will be approved.
Unfortunately, this argument ignores the evidence.
When tracking the movement in the US 10-year bond yield with the announcement of the commencement and completion of various quantitative easing programs, it is clear that:
- when QE commences, long-term interest rates rise; and
- when QE ends, long-term interest rates fall.
The evidence is counter to the argument that QE lowers long-term interest rates.
As we discussed in our article Negative bonds yields – what does it mean?, long-term government bond yields are nothing more than an indifference point relative to long-term cash expectations. This means when the central bank signals the beginning of QE, market participants (historically) view such a policy as stimulus. And stimulus means the economy will accelerate bringing forward future interest rates increases.
Conversely, the end of QE is seen as ‘removing the punch bowl’, and therefore reducing stimulus – pushing out the prospect of higher official cash rates.
Bond yields follow these expectations accordingly.
QE does not encourage banks to lend to the private sector
As discussed in our article Modern Monetary Theory (part 2), banks do not need deposits or reserves to lend. They simply need enough regulatory capital (from shareholders) and a sufficient supply of credit-worthy borrowers to create a loan. And the loan creates the deposit.
Therefore, the mechanics of QE, which adds deposits and reserves in exchange for bonds, do not impact banks’ ability or willingness to extend loans.
QE does not inflate asset prices nor create the so-called ‘wealth effect’
The introduction of US QE in 2009 corresponded with the beginning of the 10-year sharemarket recovery. The easy narrative was that this was a QE-based boom because the Fed was forcing investors out of bonds into riskier assets.
It is further argued that the economic benefit of the policy is to create a ‘wealth’ effect – spurring spending and in turn stimulating the real economy.
Again, the evidence does not support the reality.
As highlighted below, the relationship between Federal Reserve assets and the US equity market seems to hold firm until late 2012. One can argue the market simply lagged the ‘money printing’ and caught up in 2017 – however, since then the bank balance sheet and the market have headed in opposite directions. The relationship is, at best, tenuous. Further, the posterchild of QE (Bank of Japan) has yet to lift the Nikkei 225 Index to its previous 1989 peak despite 18 years of QE effort.
A more significant driver of long-term share market performance is profit (see below). And since the mechanics of QE are nothing more than an asset swap, its impact on profits is almost negligible. We say ‘almost’, because ultimately QE is really a private sector tax.
Mechanically, QE is a mild tax levied on the private sector
Up until this point, we have attempted to dispel the many myths of QE. Specifically:
- QE is not money printing
- QE does not inject new spending power into the economy
- QE does not lower long-term interest rates
- QE does not provide cash for banks to lend, and
- QE does not drive long-term share market performance.
More time. Really? After 20 years?
Since QE encourages the sale of low risk low yielding assets for even lower yielding cash, the result is lower net interest income to the private sector. Where does this income go? To the central bank on the other side of the trade, acquiring higher yielding bonds for the lower cost cash. In effect, the central bank is making an investment spread at the expense of the natural holders of bonds (including banks and superannuation accounts).
In Australia (and the US), excess capital (profits) are remitted to the treasury – in the same way as cash receipts from the tax office are remitted to the treasury.
For investors seeking Aussie QE, be careful what you wish for. You are asking for the wider economy to be taxed.
If QE does not work, why do it?
This is difficult to answer, as we do not have access to the inner thinking of central banks (or bankers). We know that Japan has used QE since 2001 for little or no inflationary or stimulatory effect. Further, there appears to be little evidence it worked in the US, Europe or the UK. We can only guess that the central bank’s tools are so limited they will try anything.
Having said that, we acknowledge that during extreme credit events, central bank (and treasury) intervention to buy assets can help. In 2008, as the US banking system was on the verge of collapse, the Treasury and Fed acquired risky assets (TARP), which stabilised member bank balance sheets. Until this time, banks were unwilling to lend to each other, causing a collapse in the payment system. Under this scenario (bad asset swapped for good cash), asset purchases helped stabilise the banking system.
However, outside of a banking crisis, QE is largely ineffective. It is not inflationary (because it is not money printing), and it is not stimulatory (it is functionally a tax). Investors expecting Aussie QE to provide economic salvation will be disappointed.
For the economy to turn the corner, what is needed is a significant federal government fiscal deficit (which is true money printing). However, based on the current political need to achieve a surplus, we hold out little hope.
The biggest problem is that very politicians understand how the economy actually works. We are constantly bombarded with the fallacy that "Government spending is limited by its ability to tax or borrow", where in actuality government spending is in no way constrained by the deficit or by how much tax it collects. Taxation only exists to regulate our spending power as consumers. This all comes back to your point about deficits Chris, you are right that a government deficit equals a net increase in financial assets (savings) for the rest of us down to the last cent, but for some reason the politicians have it backwards! And for every dollar of surplus, we will be one dollar poorer.
Hi Jerram, Thanks for the feedback and your interest.
Hi Harry, Thanks for your comment. I appreciate the feedback.
Another measure further reducing returns to savers. Not smart if you want to grow consumer demand. We had better hope the assets the RBA buys, mortgage backed securities, corporate bonds, don't blow up. The real answer is , stimulate demand. Deregulate, cut taxes, promote measures to achieve a return on investment.
Fantastic!!! After decades of QE and mainstream media reporting on the matter, I really didn't understand how QE "worked". This article clearly and concisely describes what it isn't and what it actually is. Thanks for sharing Chris, much appreciated.
Hi Charles, Thanks for your comment. And you are quite correct in your assessment regarding lower interest rates. Central Banks generally underestimate the loss of net interest income and impact on consumption as a consequence of their policies. QE only makes these issues worse.
hi Chris, Thank you for the feedback
Presuming that the QE is never unwound, can't the original Government defecit spending be seen as 'printing money' ?
Hi Keith. With or without QE, a fiscal deficit is the process of printing money. When the government spends, they "spend money into existence". When they tax, they "tax money out of existence". The net deficit creates the money to buy the bonds and pay taxes. That is why QE is so ineffective. It is essentially swapping one type of money already in existence (bonds) for other (cash). The net impact is zero except for a loss of net interest income from the private sector to the central bank.
With all respect, Chris, your understanding of QE is seriously screwed up. When central banks buy up government bonds to suppress longer term interest rates, of course they 'print money' to do so. They have not borrowed the money to purchase the assets, nor is there any asset swap. Neither has money been drained from the system to match their purchases. The Fed Reserve expanded it's Balance Sheet from under US$1 trillion to over US$4 trillion. Where did the money can from to do this? From fresh air - that's money printing! Your assertion that government deficits are 'money printing' is just nuts. Governments issue bonds to cover the excess of expenditure over income, or to fund capital expenditure. This is legitimate debt, absorbing existing liquidity in the market, not 'money printing'. Ironically, you may have got it right by accident. For if the bonds issued by a government to fund deficits are taken up by a central bank as part of QE, then it is 'money printing' - but by the central bank, not the government! To assert that QE has not caused super low to negative interest rates, nor boosted asset prices, is denying the facts. It's exactly what the central banks intended QE to do, and what it has done. Sadly, the expectation that this would lead to growth in business investment and employment, never materialised, as trickle down is the real myth, and companies just used the cheap money to fund buy backs and dividends.
QE definitely lowers long term interest rates. See Japan. When the Central Bank buys bonds, by definition that increases the price of bonds and lowers yield. The US appears to have experienced capital flight when they printed money to buy bonds. Australia will probably end up like Japan. If the cost of money is reduced to zero then the price of other assets must rise.
Hi Mark, Thanks for your feedback. As we approach Dec 31, I am reminded of the anniversary of the Nikkei 225 reaching 38,000 in 1989. Today it sits at 23,300. That's a 39% fall over 30 years. Real Estate returns have been a similar disaster. Meanwhile they have tried various forms of QE since 2001 (18 years) including buying listed companies. The consensus view QE boosts assets prices tends to ignore this inconvenience. The Fed expanding its balance sheet is not money printing because there is no direct transmission mechanism that takes reserves / ESA's (which is CB money) and converts into direct deposits accounts. The only impact balance sheet expansion can have is to acquire high quality assets from the private sector. So from a private sector perspective, they swap a low risk bond for low risk cash. So on the real economy there is no net change in financial position, no money printing, and therefore no inflation. As yes, actual money printing is when the Treasury runs a deficit which is why bond auctions never fail. Please refer to the appendix of our research where we detail the step-by-step process of government spending via the legal and institutional arrangement between the RBA / Treasury / Member banks. Link below. https://www.bennelongfunds.com/insights/175/investment-pe...
Hi Lloyd, Thanks for your comments. As discussed above, bond yields reflect investors expectations for long the term cash rate. The BOJ have made it clear their intentions are to hold the cash rate at zero (or below) for the foreseeable future. Hence the low bond yields. Note Aussie bond yields currently at or near all time record lows. Yet we have had no QE. But we have had a very sharp change in expectations of the long term official cash rate.
Hi Chris Thanks for your comments. You failed to answer my key question. Where did the money come from to add over US$3 trillion in assets to the Fed's balance sheet? I say it comes from money printing, you need to explain where it comes from. If not created by the Fed from nothing, it must be borrowed from someone, for we can both agree that no assets were sold to fund the purchases. SO WHO PROVIDED THE MONEY? Regarding Japan, without QE the Nikkei and property prices would undoubtedly be lower than they currently are. The fact that they have not exceeded prior highs does not mean QE has not boosted these prices. For years the Japanese have used their cheap money to invest in global assets with a superior yield, boosting asset prices outside of Japan. This also explains why the yield on the Aussie 10 year bond is so low. Foreign buyers are happy to earn 1% risk free if they can borrow at zero or negative, which they can do THANKS TO QE MONEY PRINTING. You commented to Lloyd that bond rates reflect investors expectations for the long term cash rate. This is dead wrong. Investors do not buy a bond based on what they think the cash rate will be when the bond matures. The interest rate they will accept is based on inflation expectations for the duration of the bond, plus a risk premium based on the credit worthiness of the issuer. Central banks set the cash rate, but the market sets the longer term rates, based on supply and demand, the 10 year bond being the benchmark. The only way central banks could manipulate this key rate lower (to make all long term debt cheaper) was to buy huge amounts of government bonds on the market at high prices (with money created at the push of a button). The only reason investors continue to buy these bonds is not because they are happy with the low or negative yield, but because they expect central banks to continue using QE to buy bonds which will support the price.
You state that QE swaps cash for other low yield low risk gov bonds. However, at the end you state that QE could be used to purchase Mortgage Bonds! Huge difference. One is monetising sovereign gov bonds, the other private sector household mortgage debt. Of course the latter would underwrite distressed mortgage debt, ave therefore represent a huge transfer of national wealth from creditors to debtors, from renters to home owners. It is immoral as it penalises prudent savers and rewards profligate savers. Do you agree?