Macro

We were the first to publicly canvass the near-term possibility of Aussie QE (actually, it was one our investors who encouraged us to dig into this), and an increasingly intense debate on the subject has since been unleashed with CBA publishing no less than 3 reports on QE within about 24 hours this week. 

The essential issue is that the RBA only has 2-3 cuts left before it hits its so-called terminal cash rate. The RBA and the banks think that is probably around 0.50% to 0.75%, below which the RBA will get effectively no pass-through to actual lending rates. That's the first problem. 

The second issue is that the RBA is probably only going to get about 15bps (maybe less) of pass-through of the next cut, which is expected by August. That, therefore, immediately puts a third cut on the table. 

If the RBA then pulls the trigger on a third cut, it might get only 10bps of pass-through. That means three RBA rate cuts will be needed to get less than 50bps of pass-through, or the equivalent of two standard RBA rate cuts (assuming they got 22bps in June, and get 25bps across the next two cuts). The bottom-line is that as the RBA approaches its zero per cent lower bound, the old target cash rate instrument becomes increasingly less effective. 

The third problem is that the RBA has quite radically revised its full-employment estimate. It used to be a jobless rate of 5 per cent. It now thinks that it is a jobless rate of less than 4.5 per cent. 

The fact that the RBA has missed its inflation target for 4 years is one thing (while blowing a big housing bubble). But it is quite another matter to also miss its full-employment target. 

Nobody really gives a rat's bum about 1.5 per cent or 2.5 per cent core inflation (at least in the near term). But getting to full employment is a serious policy objective. Now the challenge is that the RBA probably needs another 50bps of lower lending rates to get to full employment--maybe more. This brings me to the final problem. 

The target official cash rate is just a theoretical construct that is used by the RBA to adjust actual lending rates. Whether the RBA changes its official cash rate, or moves to target reducing a wider range of interest rates across the economy--such as, for example, the rate at which it will lend directly to banks on a secured basis over terms of 1-3 years, and/or the longer-term risk-free rate as represented by 3, 5 and 10 year government bond yields, and/or the spread that banks have to pay above the government bond yield to borrow money to lend to businesses and households--is neither here nor there. 

It is, in fact, quite silly for the RBA to restrict itself just to the overnight cash rate, when it can efficiently influence all these interest rates, and get much, much more powerful pass through. 

When you think through all of this logic, you arrive at the irresistible conclusion that the RBA should commence QE sooner rather than later to maximise the efficacy of its own policy decisions. Especially considering ScoJo are not going to budge from their budget surplus goals unless we are truly heading for a recession. All of this is outlined in more detail in my column, which you can read here, or AFR subs can click here. Excerpt enclosed:

A fissure is emerging between bankers who are worried about increasing regulatory interference and the costs associated with the RBA exercising influence over a greater range of interest rates than its overnight target cash rate, and the RBA that has a legislated obligation to reduce the jobless rate to its new “full-employment” level of 4.5 per cent, which is not likely possible with its remaining monetary policy ammunition...

The RBA believes it has used QE in the past by expanding its current short-term lending operations to banks (carried out by repurchase, or “repo”, arrangements), to 12 month terms during the 2008 crisis. (A repo is simply a secured form of lending where a bank posts collateral with the RBA and then borrows against it.)

The cost of this repo funding was miles below market interest rates for banks at the time and provided them with liquidity they might not have been able to access while alleviating pressures on their funding costs (and hence on savings and loan rates)...

CBA’s research confirms our original analysis that if the RBA were to extend its current monetary policy program, it would likely involve: longer-term lending operations via repo to further reduce bank funding costs, which the RBA could crucially insist are passed on to borrowers via cheaper borrowing rates; and/or direct asset purchases of government bonds to reduce the longer-term risk-free rate that banks borrow against combined with purchases of other related securities, including senior bank bonds and asset-backed securities, to cut their credit spreads, which are a core driver of funding costs and thus actual borrowing rates.

Although there is excitement that the RBA might focus its asset purchases on residential mortgage-backed securities, this would favour a very specific type of bank lending (ie, housing), which is not desirable given record levels of household leverage. The RBA is presumably motivated to reduce the cost of all bank loans, including those offered to companies, small businesses, and households, which can only be achieved by focussing on repo financing and/or generic senior bank bonds. (Aussie banks are also somewhat unusual globally because they have relatively low deposit funding and a relatively high reliance on sourcing capital via issuing senior debt.)

Some claim these measures should be reserved for a crisis. But it is really just about ensuring monetary policy continues to work effectively in an ultra-low interest rate world. Whether the RBA seeks to manipulate interest rates via its overnight cash rate, term repo lending, and/or bond purchases, all these actions are attempting to influence the cost of capital banks pay when they want to borrow money to lend locally.

Read the full column here.



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