Australia’s Fake Quantitative Tightening Program

Australia’s Fake Quantitative Tightening Program

Australian policy makers now face the impossible task of reining in inflation and cost of living pressures at the same time trying to keep Australia’s debt bubble and financial system stability intact.

In the past two years, Australian economic policy makers have unleashed the most radical economic stimulus agenda in the history of Australia due to the COVID-19 pandemic which commenced in early 2020.

This economic stimulus agenda has led to:

• sharp rises in household and government spending funded by surging private sector credit growth and ballooning public sector debt;
• booming asset prices (especially real estate prices); and
• the highest levels of officially recorded inflation in two decades.

This agenda, coupled with the Russian invasion of Ukraine (which has led to higher oil and gas prices in particular) has resulted in cost-of-living pressures becoming the most pressing economic and political challenge facing Australia. This challenge was a major factor for the defeat of the Morrison Government in the Federal Election held on 21 May 2022.

In response, the Reserve Bank of Australia (RBA) has begun the process of attempting to rein in inflationary pressure through a campaign of contractionary monetary policy. This campaign has included to date:

• ending quantitative easing (QE) in February 2022;
• raising the official cash rate by 25 basis points to 0.35% in May 2022 – the first increase in the official cash rate since November 2010; and
• announcing the commencement of quantitative tightening (QT).

Extraordinary Monetary Stimulus

According to the RBA[1], the RBA’s COVID-19 monetary stimulus package included:

• lowering the official cash rate to from a pre-pandemic level of 1.5% in the first half of 2019 to 0.1% by November 2020;
• reducing the interest rate of Exchange Settlement balances to 0%;
• implementing the Term Funding Facility (TFF), which led to Australia’s commercial banks borrowing $AUD 188 billion at 0.1% from the RBA, as opposed to accessing financial capital from the domestic and international wholesale capital markets;
• the purchasing of Australian Government Securities (AGS) (i.e., federal government bonds) and State and Territory Government securities (STGS) to support market function which occurred between 20 March 2020 and 6 May 2020 to the tune of $AUD 51.3 billion;
• launching yield curve control (YCC) on 20 March 2020, which focused on controlling the yield on certain 3-year Australian Treasury bonds, namely on the April 2023 AGS until 20 October 2020 and then the April 2024 AGS thereafter to the tune of $AUD 29 billion (note that YCC between from 19 March 2020 to 3 November 2020 was targeted at 0.25% and from 3 November 2020 thereafter was targeted at 0.1%);
• QE (i.e., purchases of AGS and SGTS across the yield curve) in three tranches to the tune of $AUD 223.7 billion of AGS and $AUD 57.0 billion in STGS from November 2020 to February 2022.

It is these policies, coupled with extraordinary fiscal policy (by the Commonwealth and State/Territory governments) and the war in Ukraine, which have led to highest level of official recorded inflation at 5.1% which was released by the Australian Bureau of Statistics on 27 April 2022.

Monetary Contraction and Quantitative Tightening

In light of surging inflation, with the April 2022 unemployment rate recorded at 3.9% (the lowest level in seasonally adjusted terms since 1974[2]) and robust year-on-year growth of 3.3% to the end of March 2022, the RBA commenced its monetary contraction campaign in May 2022, as outlined above.

The RBA’s QT program, according to its Assistant Governor, Dr Chris Kent, commenced in May 2022 and will consist of:

• allowing Commonwealth and State/Territory government bonds that were purchased under the bond buying program (i.e., bonds purchased to support market function, YCC and QE) to mature and thus naturally run off the RBA’s balance sheet (as opposed to actively selling the bonds); and
• requiring Australia’s commercial banks to repay the financial capital lent under the TFF.

With respect to the:

• former, $AUD 2 billion worth of such AGS and STGS will mature in July and November 2022 respectively, $AUD 13 billion in 2023 and approximately $AUD 35 and $AUD 45 billion thereafter; and
• latter, approximately $AUD 85 billion is due for repayment in 2023, with the remaining $AUD 103 billion due in 2024, specifically by 30 June 2024.

The full extent of the RBA’s QT program is illustrated in Diagram 1[3].

Diagram 1: The RBA’s intended QT program

It is important to note that while the QT program is modest in 2022, the RBA has signalled that its monetary contractionary campaign will be conducted primarily through the raising of its official cash rate. At the time of writing, market analysts are expecting that the RBA Board will further raise its official cash rate at its June 2022 meeting between 0.25% and 0.4%.

Economic Effects of Monetary Contraction and Quantitative Tightening

The economic impact of the RBA’s proposed monetary contraction and QT program is to drive up the cost of capital for economic agents (including Australia’s Federal and State/Territory Governments) across the economy.

Specifically, the QT program will drive up the funding costs for Australia’s commercial banks, which would be required to pass these costs onto their customers through higher interest rates across their lending products.

The effects of these higher funding costs would dampen credit growth and slow the Australian economy, independent of the increases in the RBA’s official cash rate.

Given that the main components of economic growth in the March 2022 quarter were household and government spending, the total effect of the monetary contraction campaign (i.e., both the official cash rate and the QT program) will be to severely dampen household and government consumption through a higher cost of credit (provided governments offset their higher interest costs with recurrent expenditure cuts elsewhere).

It remains unclear as to how much the RBA will raise its official cash rate in 2022 - from record low levels - and by the RBA’s own admission[4], what the impact on households will be given record levels of household debt.

Nevertheless, according to the current monetary contraction campaign laid out by the RBA, while the market expects a number of increases in the official cash rate in 2022, it is arguable that the bulk of the monetary tightening campaign will hit in 2023 and 2024, with the repayment of $AUD 188 billion of TFF financial capital and the roll off of $AUD 51 billion in AGS and STGS from the RBA balance sheet.

These potential impacts and their timing will have profound ramifications as to how and when and to what extent, the Australian economy will adjust.

Anti-deflationists oppose Monetary Contraction

While the RBA’s monetary contractionary campaign is still in its infancy, anti-deflationist economists have already begun to warn, through the Australian mainstream media, of the dangers of such a campaign.

For example, Alex Joiner, chief economist at IFM Investors,published in the Australian Financial Review[5] on 29 May 2022 that a significantly tightened monetary policy from here is likely to lead to a fall in household consumption and thus lower aggregate demand and economic growth given that indebted households will be forced to use more of their disposable income to service debt rather than be able to consume (or save) as much.

This shift, Joiner argues, could be triggered as households fall into negative equity with falling real estate prices.

Given these set of dynamics, Joiner argues that the RBA must temper its monetary contractionary ambitions and give due consideration to economic growth and financial stability.

However, what neither Joiner nor the RBA have yet to accurately articulate is the extent to which a monetary contraction can be implemented before such a contraction becomes a major drag on the economy and threatens financial stability.

Given the uncertainty surrounding this question, forecasts and forward guidance offered by government officials (included by the RBA) should be taken with heavy qualification.

The Disingenuous QT Program

The ultimate question which economic agents across the Australian economy should consider is whether the RBA and the new Albanese Government have the resolve to fully implement their monetary contractionary campaign.

While the new Federal Treasurer, the Hon. Jim Chalmers MP, has confirmed the independence of the RBA, the Albanese Government has an important role to play in ensuring the viability of the RBA’s agenda.

Any major QT program, as foreshadowed, will drive bond yields higher as the supply of AGS and SGTS increases in the secondary market. This will raise interest costs payable by all governments within Australia, particularly the Commonwealth.

To mitigate this impact, a significant and material fiscal consolidation would be required to limit an increase in supply of government bonds. Ideally, delivering a budget surplus will give the Australian Government the ability to purchase AGS, which can roll-off the RBA’s balance sheet and thus mitigate the likely interest rate effects of the QT program.

While the new Federal Treasurer has committed to delivering a new budget in October 2022, major fiscal consolidation does not appear to be a likely feature.

Thus, given that financial stability remains the cornerstone of economic public policy, this column argues that the RBA’s monetary contractionary campaign is likely to face major headwinds as its impact is felt by households, small business and governments across Australia.

The likely adverse and material impact on these sectors will likely prevent the RBA fully executing on its program and thus requiring a pause and ultimate reversal. Such a capitulation would render, at the very least, the RBA’s current QT program to be disingenuous.

It is for these reasons that the RBA Assistant Governor Dr Kent foreshadowed the possibility of a new QE program into the future via his recent speech. Specifically, Dr Kent said (emphasis added):

“Third, should a bond buying program be needed in the future to provide support to the economy, it would be likely to be more effective if sales are avoided this time around. Setting a precedent of sales in the QT phase of the current program could reduce the effectiveness of a given value of any future bond purchases. That's because the effect of those purchases on bond yields and the exchange rate would arguably be lessened if the market anticipates a fast run down of holdings next time around. In short, the market would probably assume ‘once a seller, always a seller.”

Conclusion

After unleashing the largest and most extraordinary monetary stimulus campaign in Australian history, Australia’s economic policy makers are now faced with the impossible task of attempting to rein in surging inflation at the time they are attempting to prevent financial instability and Australia’s record debt bubble from collapsing.

To date, the RBA has ended its QE program and begun the task of raising its official cash rate at the same time as announcing their QT program.

While the QT program is of an insufficient size in 2022, it will be of a material size in 2023 and 2024, especially when Australia’s commercial banks have to pay back the financial capital that was borrowed under the TFF.

The effects of QT, coupled with rising official interest rates, will have a significant impact on market interest rates and on the real Australian economy – especially heavily indebted households. Left unchecked, this impact is likely to result in a deflationary spiral that could threaten financial stability and the solvency of Australia’s commercial banks.

Given that economic policy makers are not willing to accept this outcome, Australian economic agents can expect, at some point, a pause to the monetary contractionary campaign and ultimately see a reversal back to monetary easing, which will likely require or entail a recommencement of QE.

As such, the RBA’s QT program is both fake and disingenuous and will be ultimately proven to be so in the months and years ahead.

John Adams is the Chief Economist for As Good As Gold Australia

[1] https://www.rba.gov.au/publications/rdp/2022/pdf/rdp2022-02.pdf

[2] According to the original unemployment data series, unemployment also reached 3.9% in July 2007.

[3] This diagram was drawn from a speech given by the RBA’s Assistant Governor, Dr Chris Kent, on 23 March 2022 titled: “From QE to QT – The next phase in the Reserve Bank's Bond Purchase Program”. See link here: https://www.rba.gov.au/speeches/2022/sp-ag-2022-05-23.html

[4] See the May 2022 minutes for the RBA Board - https://www.rba.gov.au/monetary-policy/rba-board-minutes/2022/2022-05-03.html

[5] https://www.afr.com/policy/economy/aggressive-interest-rate-tightening-could-trigger-housing-crash-20220526-p5aor7