What is quantitative easing

What is quantitative easing? And what’s helicopter money? - SMH - Shane Wright November 4, 2020

As the world moves deeper into the coronavirus pandemic, an already flailing world economy is being pushed to its very limits. But before anyone had learnt about a new disease in the Chinese city of Wuhan, the concept of quantitative easing was being floated as a possibility.

Reserve Bank governor Philip Lowe, in the immediate wake of last year's May election, had signalled his desire to see the economy grow much faster so as to drive down unemployment and lift wages.

In June, official interest rates were cut to 1.25 per cent. By the end of 2019, they were at 0.75 per cent with Dr Lowe revealing the RBA was starting to war-game other policies to get the economy moving. On Melbourne Cup Day, the bank took official interest rates to 0.1 per cent and cut another rate it offers commercial banks to zero while it embarked on plans to buy $100 billion of federal and state government debt.

These latest moves are all part of a suite of policies known as quantitative easing, or QE, but more broadly as "unconventional monetary policy", to protect the economy from the growing financial disaster.

So what is quantitative easing? And does it work?

It's not for the faint-hearted but it's now being used around the world. What is unconventional monetary policy, and what is "QE"?

Aren't low interest rates enough to help the economy?

The Reserve Bank's number one weapon to manage the economy is via interest rates. Cuts (to get it growing faster, and which are a form of "easing") or increases (to stop inflation getting out of hand) are what most people know as monetary policy.

With interest rates at their current level, ordinarily the Australian economy would be flying along with unemployment at near record lows, wages soaring and inflation through the roof.

But that's not what is happening. Before the coronavirus recession, there were close to 2 million people out of work or who wanted to work more hours while the RBA had noted that a small upward trend in wages growth appeared to have "stalled".

That was what was happening with official interest rates at just 0.75 per cent – with the RBA having made it clear it would go lower if necessary.

The situation is now even more dire. The country is in its first recession in 30 years, there are more than 2.5 million people without work or who want more hours while at least another 150,000 have disappeared from the workforce entirely.

The global economy is going through its biggest downturn since the 1930s with the coronavirus picking up speed, again, through Europe and the United States.

In the face of such headwinds, low interest rates are just not enough for the Reserve to meet its own charter, which is to deliver full employment and price stability (keeping inflation between 2 and 3 per cent).

Unconventional monetary policies, on top of very low interest rates, are the only ways the RBA can boost the economy.

What is quantitative easing?

Quantitative easing falls into the category of "unconventional monetary policies", and there are several that the RBA can deploy.

The bank can lower the official cash rate to zero or even take it negative as some central banks overseas have done.

It can engage in something called "explicit forward guidance", stating publicly it is going to keep interest rates very low for a set number of months or years or until it sees unemployment at a particular level.

Quantitative easing, as used by the US and Europe during the global financial crisis, is another tactic where a central bank effectively prints money that it uses to buy government bonds.

Bonds are debts issued by the government (for instance, the federal government currently owes about $820 billion to investors who have bought Australian bonds over the years). They are considered the safest form of investment because governments don't have a habit of going bankrupt.

As the interest rate on government bonds fall, a demand for them goes up. By the RBA buying as many government bonds as possible, it would hope to push down interest rates to such a low level that banks are better off lending money to businesses and households than holding on to it. In other words, it is spending large quantities of new cash to ease monetary policy.

A twist on this is that a central bank can offer low-interest loans direct to commercial banks (which, effectively, happened in Australia during the global financial crisis) or buy private debt such as mortgage-backed bonds. Even shares, in extreme cases, could be on the central bank's shopping list.

One option for the bank dealing with the coronavirus is to offer low-interest loans to banks on the proviso they pass that cash on directly to businesses. The RBA has offered $200 billion in a credit line to banks to loan to small- and medium-sized businesses.

What's helicopter money?

A final part of the unconventional policy suite involves the central bank printing money and giving it to the federal government so it can send out cheques to the nation's taxpayers.

This "helicopter drop" of money idea was first raised by noted economist Milton Friedman in 1969 in a famous paper about ways a central bank could quickly boost a sagging economy. Friedman suggested a chopper dropping $1000 notes from the sky, which would be collected by consumers. His idea rested on the notion that it would be a "unique event" that would never be repeated. Hence, consumers would go out and spend their windfall gain, boosting a struggling economy. The helicopters would be flying only if interest rates had already fallen to zero. Friedman also argued the cash drop would work much quicker than anything a government might provide.

Ben Bernanke, chairman of the US Federal Reserve during the global financial crisis, was known as "helicopter Ben" after using Friedman's metaphor in a 2002 speech about ways to prevent deflation.

It's slightly different to the way the Rudd government sent cheques out to millions of Australians during the GFC and the money the Morrison government is now handing out to people. In both of these cases, the money is raised by borrowing on debt markets.

Pure helicopter money is actually the central bank creating the cash out of thin air. They don't even need a printing press – just a few key strokes on a computer generates the money.

Some economists, over the years, worried that helicopter cash may be put into bank accounts or under the mattress, have advocated an even more exotic concept: cash would be issued to people with an expiration date. You might have six or nine months in which to spend the money. After a set period, any cash sitting in a person's bank account with an expiration date would simply cease to be legal tender.

But don't get excited if you hear a helicopter pass overhead. Given the huge injections of cash seen in Australia in schemes such as JobKeeper, the chances of the government using this tactic are just about zero.

Why are we talking about quantitative easing now?

There are three reasons why the RBA and others are talking about quantitative easing, and they are all related.

Firstly, inflation has not been near the bank's own 2 to 3 per cent target in years.

Secondly, even before the coronavirus outbreak, global economic clouds were gathering and central banks around the world had taken their interest rates lower (or beefed up their quantitative easing policies). The coronavirus outbreak has become an economic existential threat. The virus, and its economic impact, is spreading faster than treasury departments can model the financial fallout.

And finally, the RBA has run out of interest-rate ammunition to boost the local economy and take unemployment lower.

With official interest rates at 0.1 per cent, cutting rates even further has little effect as commercial banks have to reduce both lending and deposit rates. While low lending rates are great for those who want to borrow money, zero or (as has occurred overseas) negative deposit rates hurt those with money. Average saving account interest rates are already between zero and 0.1 per cent.

How does it work?

We are now well into seeing the impact of unconventional monetary policy. The RBA has made clear low interest rates are going to be with us for a long period, saying it believes inflation won't start increasing until the jobless rate gets down to at least 5 per cent. Governor Philip Lowe believes the new cash rate of 0.1 per cent will be in place for at least three years.

That's pretty close to "explicit guidance".

That's why the RBA is going to create $100 billion, which it will use to buy government bonds that won't have to be repaid for between five and 10 years.

It will effectively flood the market for this debt, driving down the interest rate on them. The bank will have also pumped $100 billion into the pockets of investors, enabling them to use that cash in other ways such as establishing new businesses.

Governor Philip Lowe believes the new cash rate of 0.1 per cent will be in place for at least three years.

It would be unlikely the bank would try to deliberately drive down the Australian dollar – partly because of the immense cost and because if other central banks did the same then the dollar may go nowhere.

But driving down the interest rates on government bonds is aimed at taking pressure off the Australian dollar. Overseas investors won't be as interested in buying Australian government bonds if they can get better interest rates elsewhere.

The Morrison government's original coronavirus stimulus package contained almost $5 billion in cash handouts to welfare recipients. It followed that up with $2.6 billion in so-called "economic support payments" to many welfare recipients in the October budget.

That leaves the purchase of government and corporate debt – quantitative easing – as the most likely path for the RBA.

But experienced economist Stephen Kirchner, in a research paper on the issue for the United States Studies Centre at the University of Sydney, has noted that the quantitative easing path is not for the faint-hearted.

He found if the RBA's scheme was to be of the same size put in place by the US Federal Reserve it would have to buy bonds worth about 1.5 per cent of GDP to achieve the equivalent of a 0.25 percentage point in interest rates.

Dr Kirchner estimated that, in dollar terms, it would mean buying up to $550 billion worth of debt.

The total value of federal and state government debt at the moment is just short of $800 billion so trying to find enough bonds to buy would be difficult.

That might force the bank into every corporate nook and cranny looking for business debt to buy. Unlike governments, businesses do have a track record of going under, potentially leaving the RBA with corporate bonds that may never be repaid.

But Kirchner found that QE in an Australian context was likely to be much more effective than in the US, especially if it did not make some of the mistakes the Federal Reserve made during its five-year debt-buying program.

Does QE work?

The avalanche of money thrown at the world's economies in the wake of the global financial crisis certainly avoided a repeat of the Great Depression. But there's also been criticism of how quantitative easing appears to have benefited high-income earners who have been able to borrow money more cheaply, pumping up property and share markets.

If the RBA ends up in an unconventional monetary policy space one thing is clear – the economy won’t be in a good way.

The rise of political populism and extremists on both the left and the right has been aided and abetted by some of the economic policies – including ones such as quantitative easing – used over recent years.

In the wake of the banking royal commission, tighter lending standards and risk aversion may make it more difficult for lenders to use really low interest rates to throw cash at everyone who wanted it.

The coronavirus outbreak is something else. It has destroyed supply chains and depressed demand.Public health measures mean the economy could be months away from operating in a way approaching normal.

With the the RBA now in the unconventional monetary policy space one thing is clear – the economy is not in a good way.

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Shane Wright – Shane is a senior economics correspondent for The Age and The Sydney Morning Herald.Connect via Twitter or email.