Commentary |
25 March 2020

The government's bazooka is biggest, not the RBA's

Lowy Institute Nonresident Fellow Stephen Grenville evaluates the RBA's response to COVID-19. Originally published in the Australian Financial Review.

Stephen Grenville
Stephen Grenville

Further correspondence with Christopher Joye

Dear Christopher,

I see that the RBA is back in your good books again, after initially being slow to follow your insistent advice. They have largely acted as you instructed and we are saved.

Belatedly, you and I have found a point of agreement: the RBA has done a good job, given the current environment and the various pressures on the Bank. Their actions will help at the margin and there is not much downside.

It was inevitable that the policy interest rate would be reduced by another 25bp, even if this will make almost no difference, as borrowing costs were already abnormally low. This is not targeted at those most affected, but it should boost general demand.

The RBA will intervene as necessary along the yield curve, to keep interest rates down. Their focus is on the 3-year bond rate rather than the 10-year rate.

Again, this seems sensible. Bond markets have been volatile and the global norm is for central banks to be seen to be doing something. The RBA is doing a lot less than many central banks, which is appropriate.

We shouldn’t be surprised that markets have had second thoughts about their earlier ‘flight to safety’ into government bonds, which pushed 10-year yields well below 1%. Nor should we be surprised when yields make step-jumps when ‘news’ arrives. That is how they are supposed to operate, and news has certainly been fast-moving -- budgets will go heavily into deficit, more government bonds have to be sold and debt will increase. As well, S&P threatens to take away Australia’s AAA rating.

But even when yields momentary touched 2.5%, this was not anomalous: it’s not long ago that we regarded such yields as surprisingly low. And yields quickly retraced to 1 ½ %.

What are the RBA’s obligations to maintain this historically low rate and smooth out volatility?

The governor said the planned ‘yield-curve management’ was similar to the RBA’s intervention in the foreign exchange market. I remember this well. Occasionally, especially in the early days of the float, we did minor intervention just to steady shallow nervous markets. But substantial intervention was always motivated by a belief that the market had taken the dollar to levels which made no sense. For these interventions, we had a clear if inexact idea what ‘normality’ was, and intervention was aimed at pushing the rate towards this long-run equilibrium.

If the RBA buys long bonds to keep the rate from rising above, say, 1%, it would be like the RBA intervening to stop the dollar from rising from its recent low of 55 cents to its current level of 57. You don’t intervene to stop markets moving towards a more sensible price.

We have yet to see how ‘yield curve management’ will work in practice. If it is mainly at the three-year mark, it might be seen as largely about keeping bank borrowing costs low, as this tenor is more important than the 10-year bond.

What about the long end? While government bonds are always described as ‘riskless’, this just means that the holder gets paid in full on maturity. Of course, the market value changes as the yield changes and the longer the tenor, the bigger the change. Over the past decade, holders have made substantial capital gains from the downward trend in yields. These gains have compensated for the low running yield. But yields this low make future capital gains unlikely.

At some stage in the next decade, there is a strong probability that yields will move higher than at present. Whoever is holding long bonds will experience a substantial capital loss. Perhaps it was this thought that motivated some bond-holders to sell recently. Maybe there is a similar story in Germany: if your dealer friend was prepared to sell his bonds with a sensible positive yield (instead of the negative yields which have prevailed), he might find a buyer.

This suggests that the RBA should have only minimal responsibility for the price of long bonds. If they commit to keeping yield down, there is a good chance that they will make capital losses at the taxpayers’ expense.

What about the $90 billion-plus available to be lent to banks? This certainly sounds like a ‘big bazooka’ – that’s around 10% of business credit. It is cheap funding for banks so that they can on-lend, and might reduce business borrowing rates. But banks will be reluctant to lend to borrowers with serious cash-flow problems -- that is, the very ones we want to keep in business until good times return. And these businesses might be reluctant to borrow, even at low interest, unless they don’t expect to repay.

This measure is good for the banks, to the extent that they can replace their current funding with cheaper RBA money. This may be helpful to banks which will be squeezed by the lower policy rate, their forbearance for stretched borrowers and their increased bad loans. But the Reserve Bank can’t provide what is needed by those with no cash-flow – grants and guarantees. That is the job of governments, using the budget.

That said, the commercial banks’ offer to delay debt servicing is an excellent initiative. The banks have already judged that these were bankable customers, at least in the pre-crisis environment. Thus extending the loans is low risk, but a very present help in stressed times.

Perhaps the AOFM’s planned purchases of MBS and ABS responds to your call for ‘immediate offers to vouchsafe liquidity and funding to all parts of the financial sector’, although it falls short of meeting the need ‘to be full-spectrum, unrestricted QE across all sectors’ and is only $15 billion rather than the $50 billion-plus that you recommended. Further correspondence is needed.

The biggest difference between us is your exclusive focus on the needs of the self-absorbed financial sector. What the RBA has done is fine but peripheral to the main game which is the budget and the real economy. The RBA’s $90 billion funding can’t have the same bazooka impact provided by budget funds targeted to those most affected.

Lastly, while lauding the RBA team, you might offer a word of praise for those health-care workers who are facing the physical, not financial, risks of keeping the real world as safe as possible.

Kind regards

Stephen Grenville is a Nonresident Fellow at the Lowy Institute and former deputy governor at the Reserve Bank