QE: How much; Why now; And how will it help?

Chief Economist's View

Download the PDF version including our economic update by region here: QE: How much; Why now; And how will it help?

This week was full of potentially market-moving information, dominated by the US Presidential election, which overshadowed a relatively tame US FOMC meeting. Closer to home, the Board of the Reserve Bank of Australia (RBA) met in their monthly monetary policy meeting to make the historic decision to initiate a program of quantitative easing (QE), while also cutting the cash rate to an historically low 0.1%.

Before we get onto the RBA decision, a couple of words on the US election. Last week, we summarised five scenarios around the Presidential election. By the end of this week, those scenarios have been whittled down to two: a Biden win, but without Democrat control of the Senate (the Switch scenario); or a Trump win, but without Republican control of the House of Representatives (the Status Quo scenario). While it is theoretically possible that Democrats (with 2 independents) could still achieve 50 Senate Seats and then use the Vice President tie-breaker vote, this is far from a Blue Wave.

In either scenario, economic policy initiatives of either eventual Presidents will be constrained by a contested Congress. But this is not the case for foreign policy, which doesn’t need to pass through Congress to be brought into law.

How would US foreign policy change under a Biden administration? The answer is “quite a bit”.

We’ll see the US re-join the Paris Agreement on Climate Change and, quite possibly, the Iran Nuclear Deal. On foreign trade, Biden will work to restore harmonious relations with the US’ traditional trading partners and work towards establishing multi-lateral trading blocs, rather than using tariff threats in unilateral trade negotiations.

To this end, he will re-engage the US in the World Trade Organisation (WTO) and end the US’ blocking of the appointment of a WTO Chief and judges. These changes will have significant ramifications for US’ relationship with China, with Biden seeking to unify trade partners and use the WTO to force China into alignment with fair-trade practices, rather than going it alone relying on tariff wars as Trump has done.

Back to the RBA, on Tuesday, our central bank announced its intent to purchase $100 billion of government bonds over the next six months. In the press conference following the Board’s decision, Governor Lowe said that the RBA had chosen that amount as research showed evidence that QE had a "noticeable and meaningful" impact on the economy with a size equal to about 5% of GDP (i.e; 100/2000).

The RBA will purchase around $5 billion of bonds each week in the secondary market and not directly from the government. They will be purchasing bonds with maturities of between 5 and 10 years and they will buy a total of $80 billion of Federal Government bonds and $20 billion of State government bonds.

The RBA is expecting QE to boost demand and employment through three main channels. First, they hope lower interest rates will allow Federal and State governments to take on more debt to fund more government expenditure. Also, as government interest rates underpin private sector interest rates, they expect lower rates will allow households and businesses to carry more debt and hence allow more private sector spending.

Second, they hope that lower interest rates will slow foreign investor demand for Australian government bonds. This would slow the demand for the Australian dollar and relieve upward pressure on the currency. A lower currency should boost foreign demand for our exports and local demand for our import-competing industries.

Third, they hope that driving down the yields on bonds will lead investors to shift into alternative higher yielding assets, thereby driving up the prices of assets such as equities and property. This makes fund raising easier for businesses and reduces their cost of capital. It also boosts the wealth of asset owners, for example superannuants, who see the value of the super going up. As households see their super accounts grow, this tends to boost confidence, which tends to slow the rate of household saving and increase the rate of spending.

What happens next, if more monetary stimulus is required? The RBA could extend its QE program if the yield curve continues to have a positive slope. But if the yield curve flattens along the length of the curve so that rates are close to zero, the next move in the central bank playbook is to move to negative interest rates.

But the RBA has been firm in its resistance to conceding to negative rates. The other option is to buy private sector assets.

Table 1: Financial market movements: 29 October - 5 November 2020

Source: Bloomberg