Welcome to Wonderland: it’s weird and we may be here a while

And through the looking glass we go … As if 2020 hasn’t been odd enough already, Australian monetary policy has just gone full Alice in Wonderland. Which is to say, the decisions taken by our independent central bank to influence the price of money in our economy have entered a new world entirely. We may never quite go back to how things were.

In a sense, we’re simply reverting to the mean. For some time, Australia has been the global oddity when it comes to interest rates. For one, ours have remained much higher than in other countries. At a fundamental level, this suggested Australia, as a nation, was generally thought to be a good place to invest. Money invested here was expected to yield a higher return, thanks perhaps to the inherent wit of our people, or perhaps just to the vast mineral riches buried beneath our sprawling landmass.

Reserve Bank Governor Philip Lowe on Tuesday.
Reserve Bank Governor Philip Lowe on Tuesday.Credit:Louie Douvis

That premium, however, has been significantly diminished. For now, at least. This week, our official cash rate was cut to 0.1 per cent while our Reserve Bank also unleashed an historic package of measures to drive down borrowing costs.

In addition to delivering a much-needed cash boost to mortgage holders and business borrowers, the RBA’s actions should also help the wider economy by taking some pressure off our currency. Demand for Aussie dollars was previously boosted by a desire from international investors to buy our high-yielding, Aussie dollar-denominated assets. Now that interest premium is diminished, there will be less demand, lowering our currency’s value and giving our exporters a helping hand.


So with the official cash rate within a whisker of zero, is our Reserve Bank now out of firepower? Far from it. While the RBA governor is not inclined, we could still go to a world of “negative interest rates” where depositors pay to stash their money at the bank, while borrowers are paid for the pleasure of borrowing – disincentivising the former and incentivising the latter.

Never say never. In the meantime, we are officially in a world where our central bank is engaging in “quantitative easing” – something other countries have trialled for years, with varying levels of success. In short, our central bank is printing money. Quite a lot of it. It will use this money to buy $100 billion worth of government bonds – both federal and state – in the coming six months.

The RBA's actions will deliver a much-needed cash boost to mortgage holders and business borrowers.
The RBA’s actions will deliver a much-needed cash boost to mortgage holders and business borrowers.Credit:Michel Bunn

How will buying government bonds help? Well, by boosting the demand for bonds into the market, the Reserve hopes to drive up their price and lower the yield that must be paid out to investors to buy them in the first place.

Why is that important? Because not only will it directly reduce the cost of funding for government, it will also reduce the cost of other lending priced directly off government bond yields, lowering the cost of money for households and businesses.

Why $100 billion? Well, because that’s the level our Reserve Bank governor, Philip Lowe, feels will have a noticeable impact, from his review of the international evidence. “If we need to do more, we can and we will,” Dr Lowe has declared.

Importantly, the Reserve won’t be buying bonds directly. Instead of turning up to bid at bond auctions, crowding out private investors, it will let private investors snap up the bonds and then on-sell them to the Reserve on secondary markets. Acting this way will still increase demand for bonds. But it’s an important discipline for government spending that private investors must still be visibly willing to lend directly to government.

Nor is this a blank cheque for government. On this point, Lowe was categorical this week: “The RBA is not providing finance to the government, but our actions are lowering the cost of government finance.”

“It is important to point out that the bonds purchased by the RBA will have to be repaid by the government at maturity. They will have to be repaid in exactly the same way as would occur if the bonds were held by others. The same is true for the ongoing coupon payments on the bonds. The fact that the RBA is holding some bonds makes no difference to the financial obligations of the government, other than through a lower cost of finance.”

With state budgets due to be handed down in coming weeks, however, the Reserve is hoping its bond buying spree will help incentivise these governments to spend up big to fuel economic recovery.

So, is the Reserve’s historic action an implicit verdict that the federal government has failed to spend enough to ensure our economic recovery? No. Lowe was also clear on this, describing the government’s fiscal strategy as “the right one”. Of course, another budget is just months away and cheaper debt lowers the hurdle to more fiscal action.

It might all seem a bit weird and wacky, but Australians should be assured that both the major tools of economic management are working in unison to speed our economic recovery.

Longer term, of course, if we want to re-establish our national premium for “brand Australia”, a more holistic reform agenda is needed. Difficult things like reforming taxes, getting business incentives right and investing in skills and human capital formation will be needed. In the meantime: welcome to Wonderland. We may be here a while.

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Source: Thanks smh.com