By Matthew Haupt
The Reserve Bank of Australia has signalled its intention to more meaningfully utilise the unconventional and controversial monetary policy tool known as quantitative easing. While the effectiveness of QE in stimulating the economy is questionable, the impact to financial markets will be significant. We believe the RBA will announce an extended QE program shortly, perhaps alongside the near-certain cash rate reduction on November. The RBA has long-held reservations about QE and conducted very limited bond-buying at the onset of the coronavirus, preferring targeted support through the Term Funding Facility and cash rate reductions. But the RBA now appears to believe it is approaching the threshold to pull this lever, with recent justifications from deputy governor Guy Debelle and positive notes from staffers.
On September 22, Debelle effectively ranked the bank’s remaining interventionist options: ramp up QE; reduce rates closer to zero; intervene in the foreign exchange market; enter negative rates. The RBA is overtly concerned about negative rates, with mixed evidence internationally and a wide range of adverse unintended consequences. It is the central bank’s measure of last resort.
The Australian dollar trades near its fundamental value, lifted by strong iron ore prices and relative economic strength, so the RBA is right to view currency intervention as futile despite its growing concerns about the economic impact of a strong currency. This leaves only lower rates and QE. The former is almost certain, and the latter has been defended ex-ante by Debelle in a recent speech and by RBA staff members in an article that argues the equivalency of quantitative easing to cash rate cuts at the zero lower bound.
Economic impacts of QE
Historically it was thought that a QE program would lead to economic growth while also increasing inflation across the economy, however recent examples have only shown evidence of asset price inflation.
Japan was the first country to implement QE, in 2001, following the Asian financial crisis of 1997 and a long period of low growth. Despite these efforts, it failed to create any tangible growth and Japanese gross domestic product fell from $US5.45 trillion ($7.5 trillion) to $US4.52 trillion between 1995 and 2007.
After the 2008 global financial crisis, several other countries began employing QE such as the US, UK and some European countries. The US Federal Reserve increased the money supply by $US4 trillion, but banks held on to much of it as excess reserves instead. The direct relationship between the recovery of the US economy and the policy of QE is unclear and difficult to quantify. What is clear is that it caused asset prices to rise significantly.
In response to the coronavirus, the US Fed embarked on significant balance sheet expansion, purchasing both corporate and government debt. By acting later than its peers, the RBA is afforded these lessons and has been clear about the limitations of QE in Australia: it will purchase government debt from secondary markets. This avoids “printing money” to buy new debt while maintaining the public/private distinction.
Winners and losers
While the impact of QE on the underlying economy is questionable given international evidence, financial markets will be affected: the yield curve will be flattened, and equities will rally.
The victims of the RBA’s plan are the banks, whose profit margins theoretically resemble the slope of the yield curve. The banks are already suffering low net interest margins, so the impact will be sentiment driven.
It is possible that lower rates lead to credit growth from both household and business, but at this stage evidence is inconclusive at best. In the medium term, QE combined with a closing output gap, rise in employment levels and low interest rates will allow the financial sector to improve. As a result, negative market reaction to QE may provide opportunities.
In the short term, sectors with long duration assets – such as infrastructure, property and utilities – stand to benefit. These companies’ valuations are determined significantly by the yield curve and will benefit considerably as the slope changes. We believe toll road operator Transurban and utilities companies Ausnet and APA Group will see capital flow as rates drop and QE is enacted. We have already seen REITs outperform on talks of potential rate cuts: Stockland, Scentre Group, GPT Group and Mirvac Group are just some names which we believe will perform well as monetary policy advances.
By materially engaging in QE, the RBA is set to pull one of the last remaining levers despite long-held reservations about its effectiveness. As with all policy measures, the devil will be in the details, so the RBA’s characteristically late action may be beneficial.