The Reserve Bank of Australia (RBA) has taken several complementary policy actions to support the Australian economy since the onset of COVID-19. The RBA has lowered its policy interest rate to near zero, set a target for the 3-year government bond yield, enhanced its forward guidance, commenced a program of purchasing government bonds, and provided long-term, low-cost funding to the banking system. I will explain each of these actions in more detail shortly.
The overall aim of all these monetary policy actions has been to support economic activity in Australia through several channels. The policy actions have underpinned record-low funding costs across the financial system and for governments. Lower borrowing costs free up cash flow for households and businesses, some of which are spent. The lower interest rates and the funding for the banking system support the flow of credit to firms and homes. Lower interest rates also keep asset prices, boosting balance sheets, consumption, and investment. Finally, a lower structure of interest rates leads to a lower Australian dollar value than would otherwise be the case. The result is a more robust Australian economy.
The policy response has evolved over the pandemic period as information about the extent of the pandemic and its economic impact has unfolded. The initial policy decisions were taken in March 2020, including an unscheduled meeting on March 18. Further measures were announced in September and November 2020 and in February 2021. In mid-March 2020, as the impact of the virus and the health policy actions on the Australian economy became evident, the Reserve Bank Board put in place a comprehensive package at an unscheduled meeting to support jobs, incomes, and businesses so that when the health crisis receded, the country was well placed to recover strongly. The package comprised:
- A reduction in the cash rate target (the policy interest rate) to 25 basis points, having already reduced the cash rate to 50 basis points at the earlier March Board meeting
- forward guidance that the Board will not increase the cash rate target until progress is being made towards full employment, and it is confident that inflation will be sustainably within the 2–3 percent target band
- reducing the interest rate paid on Exchange Settlement (ES) balances (the balances the banking system holds with the RBA) to 10 basis points
- The introduction of a target on the 3-year Australian Government bond yield of around 25 basis points
- the purchase of bonds to address the dysfunction in the Australian government bond market
- a Term Funding Facility (TFF) for the banking system under which funds equivalent to 3 percent of lending could be borrowed from the RBA for three years at 25 basis points (against eligible collateral) until the end of September 2020. The TFF provided additional incentives to support lending to businesses, tiny and medium-sized businesses, and the continued use of the RBA’s open market operations to ensure that the financial system had a high level of liquidity. The RBA had already expanded its liquidity provision before the mid-March Board meeting to address the growing dislocation in financial markets.
In September 2020, as the end-September deadline for the drawdown of funding under the TFF approach, the Board decided to expand the TFF to provide additional low-cost funding equivalent to 2 percent of lending in the banking system. It also decided to extend the drawdown period for this and the additional funding linked to business lending to June 2021. In October, the Board changed its forward guidance to focus on actual outcomes for inflation rather than expected results in guiding its future policy decisions. At the November 2020 Board meeting, the Board decided on a further package of measures to support the economy:
- a reduction in the cash rate target, the 3-year yield target, and the interest rate on new drawings under the TFF to 10 basis points from the previous rate of 25 basis points, a reduction in the interest rate on ES balances from 10 basis points to zero
- Introducing a government bond purchase program focuses on the yield curve’s 5 to 10-year segment. The RBA would buy $100 billion of government bonds in the secondary market over the following six months, purchasing bonds issued by the Australian Government (AGS) and the Australian states and territories (semis).
The Board took this decision given the assessment that Australia was facing a prolonged period of high unemployment, and inflation was unlikely to return sustainably to the target range of 2–3 percent for at least three years. In February 2021, the Board announced that it would purchase an additional $100 billion of government bonds after the first program was completed to support the Australian economy further as it recovered. Those purchases are underway now. The policy actions taken to deliver low funding costs have had several complementary elements and have been mutually reinforcing in underpinning low-interest rates across the economy. Next, I will explain each of these actions in detail.
Policy rate reduction
The first policy action I will discuss is reducing the cash rate target. This has been the primary lever of monetary policy for more than three decades. The effect of this reduction in the cash rate on financial markets and the economy has been similar to the experience over those three decades. The decrease in the cash rate provides stimulus to the economy through several channels. When the cash rate is lowered, it reduces funding costs for the banking system, which in turn flows through to lower borrowing rates for households and businesses. These lower borrowing rates stimulate borrowing and economic activity. The lower cash rate also boosts the cash flow of existing borrowers. It supports asset prices, including housing prices, promoting household wealth and spending. In addition, it puts downward pressure on the Australian dollar, which is stimulatory for the economy.
The Board has reduced the cash rate target to what it assesses to be the effective lower bound of 10 basis points. There has been an additional aspect of the cash rate reduction that is important to highlight in this episode. The ES rate is also reduced when the cash rate target is reduced. At the same time as the cash rate target declined in March and November 2020, the remuneration rate on ES balances was also reduced (Graph 1). The remuneration rate on ES balances is the RBA’s interest rate on deposits banks hold with the RBA (I will refer to it as the ES rate in the remainder of this speech). The ES rate is also reduced w
Graph 1:
Cash Market Rates
Normally, this is unimportant to anyone outside those who manage the banking system’sstem’snts at the RBA. But this time around, the ES rate has much more significance. In the past, the cash rate target set by the Board was the primary anchor for money market rates and, hence, the whole structure of interest rates in the Australian financial system. The actual cash rate, the overnight interest rate at which banks borrow and lend their balances at the RBA, almost always equals the cash rate target. The RBA conducted its daily market operations to keep the size of ES balances small, with minimal ‘excess’ liquidity in the t’e market, so demand and supply pressures in the market invariably ensured the cash rate traded at the cash rate target each day.
Because of the policy actions I will discuss shortly, particularly the bond purchases and the TFF, ES balances are now very large, around $200 billion. But, the banking system has a very large amount of deposits at the RBA. There is now a large amount of liquidity in the system. Some banks still need to borrow overnight in the market to ensure their balance with the RBA remains positive, but these amounts are very small. And there are a lot of banks with large ES balances who are willing to lend to them. The reduction in the cash rate target, the remuneration on ES balances, and the actual cash rate have seen all short-term interest rates in the Australian financial system decline to historically low levels, including the important interest rate benchmark, the Bank Bill Swap Rate (BBSW) (Graph 2). As the graph shows, the BBSW rate has fallen even further because of the availability of low-cost funding to the banking system. The lower BBSW rate translates directly to lower borrowing costs for the interest rates that reference it, particularly business borrowing rates.
Graph 2:
Money Market Rates
In turn, these short-term interest rates, along with the low-cost funding available through the TFF, have reduced the funding costs to the banking system, resulting in large declines in household and business borrowing rates (Graph 3).
Graph 3:
Variable Lending Rates
Forward guidance
The RBA’s announcements have enhanced forward guidance about the Board’s recommendations for the future path of monetary policy. The forward direction describes the economic conditions the Board would be looking to see before considering raising the cash rate. That is, the guidance is based on the state of the economy (in technical terms, the advice is state-based). At the May Board meeting earlier this week, the Board reiterated that in its central scenario, these conditions are unlikely to be met until 2024 at the earliest. This complements the 3-year government bond yield target and has helped underpin the low-interest rates across the economy. But I would highlight that the state of the economy is the key determinant of policy settings, not the calendar.
Bond purchases
Turning to government bond purchases have been comprised of three elements (Graph 4):
- assets to maintain the 3-year yield target since November 2020, the bond purchase program
- investments to address market dysfunction.
Graph 4:
RBA Bond Purchases
Face Value: Cumulative from March 20, 2020
I will explain each of these in more detail.
Three-year yield target
From March 2020, the RBA commenced purchasing government bonds focussed on the three-year point of the yield curve. This is because, in Australia, most borrowing is at variable rates that key off the front part of the yield curve. This contrasts with other markets, such as the US, where longer-term yields are more important benchmarks for borrowing rates. The 3-year yield target has helped anchor the Australian yield curve and has had significant traction in lowering borrowing rates for households and businesses, together with the other policy measures adopted. It has also helped reinforce the RBA’s RBA’srd guidance regarding the cash rate.
Graph 5:
Three-year Australian Government Bond Yield
In March 2021, the Board agreed that it would not consider removing the yield target completely or changing the target yield of 10 basis points when reviewing the yield target bond later in the year. Initially, the target was for the April 2023 bond maturity. Subsequently, the target was changed to the April 2024 maturity, which became the closest bond maturity to the 3-year horizon. If the Board were to maintain the April 2024 bond as the target bond rather than move to the next bond maturity that becomes closest to the 3-year horizon, the maturity of the target would gradually decline until the bond finally matured in April 2024. The Board will consider extending the target to the next maturity at the July meeting.
Bond purchase program
In November 2020, the Board announced a quantity-based bond purchase program complementary to the 3-year yield target. The Board decided to implement this policy for several reasons. Longer-term Australian Government bond yields were higher than those in other advanced countries. This provided evidence that the size of other central banks ‘ purchase programs affected longer-term Australian bond yields beyond the anchoring effect of the Bank’s yield target. This, in turn, contributed to a higher exchange rate, restraining the recovery of the Australian economy.
The bond purchase program announced in November 2020 was for the purchase of $100 billion in bonds of maturities of around 5 to 10 years over the following six months. It includes bonds of the Australian and state and territory governments, with $80 billion allocated to the Australian Government and $20 billion to the state and territory governments. In February 2021, the Board announced an additional $100 billion with the same composition and rate of purchase of $5 billion weekly. The bonds are purchased in the secondary market through transparent auctions. There remains a strong separation between monetary and fiscal policy. The RBA does not, and will not, directly finance governments. While the bond purchases are lowering the finance cost for governments – as is the case for all borrowers – the Bank is not providing direct finance.
Figure 1:
Stylized transmission mechanism
When the RBA buys a bond, it credits the account of the Bank it believes the bond is from. The RBA’s RBA’s sheet gets bigger: on the asset side, there is the government bond, and on the liability side, there is the deposit of the Bank in the form of a higher exchange settlement balance. The money supply has increased, though in electronic form rather than physical. When the bond matures, the Government repays the RBA, just like any other bondholder. The RBA RBA’s sheet shrinks: its bond-holdings decline, and a decline matches this in exchange settlement balances.
So bond purchases work through several channels to put downward pressure on interest rates for the Government, households, and businesses, as well as downlowssure on the exchange rate. The review highlighted that much of the research has focussed on the impact of QE on financial conditions, particularly bond yields and interest rates. It noted that there is much less research on the effects of QE on output and inflation. How should we think about the size of the bond purchase program? How stimulatory is it?
We assess that this estimate has turned out to be close to the mark. We have reached this assessment in several ways, but all arrive at a similar conclusion. Bond yields started to decline ahead of the actual announcement of the bond purchase program at the November RBA Board meeting as the market formed the expectation that such a program was increasingly likely. So, the estimate of the impact has to take this into account. The US yield provides a reference point for global developments affecting bond yields. Graph 6 shows the decline in the spread between Australian and US 10-year bond yields between September and November last year as market expectations of a bond purchase program increased and were then realized with the announcement at the November Board meeting. Again, this decline in the spread amounts to around 30 basis points.
Graph 6:
Government Bond Yields
To repeat, we assess that the bond purchase program announced in November reduced longer-term government bond yields by around 30 basis points. In turn, this led to a lower exchange rate and easier financial conditions than otherwise would have been the case. The impact of these easier economic conditions on output and inflation is harder to calibrate. Hence, the announcement effect of the program on bond yields and the exchange rate will include some impact from the market’s market’s market’s market’s market’srket’ssment on the whole size of the bond purchase program, not just the size of the first one that is announced.
Graph 7:
Central Bank Government Bond Holdings*
The RBA’s RBA’sase program started later but is on a faster upward trajectory than other central banks. The graph shows that by the end of the current bond program, the RBA will have purchased bonds equal to around 10 percent of GDP. The size of the government bond market is smaller in Australia than in nearly every other economy. This is not true in some other countries, especially the US. In recent months, the RBA has often been buying bonds at a faster weekly pace than the Australian Office of Financial Management (AOFM) has been issuing. Hence, the RBA’s RBA of the bond market is rising faster than in other economies.
In considering the impact of the bond purchase program, we need to be mindful that the Bank’s Bank’sBank’spurchases do not cause dysfunction in the market by the Bank holding too large a share. As I said earlier, government bond yields are a very important benchmark and anchor of the financial system. We do not think we are close to that point, but it is certainly something we are alert to. For example, we would not want our bond purchases to push bond yields higher (rather than lower) because of market dysfunction, which resulted in an illiquidity premium.
Graph 8:
AGS Bid-offer Spreads
These purchases also boost the system’s liquidity and put downward pressure on government bond yields. Even though their original motivation differed, they still achieved the same effect now as bond purchases under the bond purchase program. The initial borrowings were at 25 basis points, while from November 2020, the borrowing rate was lowered to 10 basis points for new drawdowns. This is materially below the cost of banks obtaining 3-year funding. In the program’s first phase, the bulk of the funds were drawn down in the weeks leading up to the end of September 2020 deadline (Graph 9). We expect borrowing under the TFF to ramp up in the coming weeks as the end-of-June deadline approaches.
Graph 9:
Term Funding Facility
The date for final drawings under the TFF is June 30, 2021. Given that financial markets in Australia are operating well, the Board announced earlier this week that it is not considering a further extension of the TFF. However, it is important to remember that the Term Funding Facility will provide stimulus while the funds borrowed by the banking system are outstanding. It will continue to provide low-cost funding to the banking system and keep downward pressure on borrowing rates for businesses and households throughout the next three years until the funds are repaid.
Conclusion
In Australia, the monetary policy response to the pandemic aims to ensure borrowing costs in the economy remain low for households, businesses, and governments and provide an environment that supports credit growth. The monetary response comprised several different but complementary actions. The monetary policy package has worked broadly as expected in supporting the economy. The recovery in the Australian economy has significantly exceeded earlier expectations, reflecting the sizeable fiscal and monetary policy support and favorable health outcomes. However, significant financial consent will be required for quite some time.
