Cabinet considers QE amid rate warnings

Federal cabinet has discussed Treasury advice about the Reserve Bank launching an unprecedented program of quantitative easing.

(AAP Image/Dan Himbrechts)

Federal cabinet has discussed Treasury advice about the Reserve Bank launching an unprecedented program of quantitative easing as the government’s key economic department privately warns Australia is “closer than we have been previously” to requiring unconventional monetary policy.

Senior Treasury economists warned the Morrison government in July there was a “material prospect” the RBA could soon reach the “effective lower bound” where further reductions in the cash rate have little or no effect in stimulating the economy, which recently logged its worst annual growth since the global financial crisis.

According to a cache of documents submitted to Josh Frydenberg’s office by the Department of Treasury — obtained by The Weekend Australian under Freedom of Information laws — economic bureaucrats advised that the RBA’s likely course of action, should it need to launch unconventional monetary policy, would be a quantitative easing program of buying residential mortgage-backed bonds.

This would lower bank funding costs and allow borrowers to access cheaper credit.

Treasury believed this was more appropriate than a US-style bond-buying program as the Australian government would be unlikely to borrow to spend more even if its funding costs were lower, while most home loans were not linked to Treasury bond yields.

With economists expecting interest rates to be cut further below already record low levels, Treasury said the RBA’s ability to lower borrowing costs by cutting official interest rates would soon become “impaired” as lenders protect their profit margins by withholding the central bank rate reductions from home loan customers.

At the time Treasury documents were produced in July, the official cash rate was 1 per cent. Following this month’s RBA cut the cash rate has since fallen to a new low of 0.75 per cent in a bid to reverse rising unemployment, stoke wage growth and reignite a slowing economy.

“When short-term interest rates approach their effective lower bound, unconventional monetary policies or the use of fiscal policy may be called for,” Treasury said in the documents obtained by The Weekend Australian.

“Australia is not currently in these circumstances but we are closer than we have been previously.

“With the RBA’s cash rate now at 1 per cent, there is a material prospect that Australia could reach the effective lower bound at some point and the RBA may need to consider unconventional policies.

“It is prudent to consider options.”

In its submission to Mr Frydenberg, Treasury also warned against the RBA embarking on a policy of negative interest rates, noting it would have damaging flow-on effects for superannuation funds and the life insurance industry and would likely spark a wave of bank customers withdrawing cash from deposits to stuff under their mattresses, threatening a key source of funding for lending to borrowers.

The Treasurer’s office requested the background briefing on unconventional monetary policy following two official rate cuts over June and July — the first back-to-back RBA cash rate ­reductions in almost a decade, which at the time sliced interest rates to 1 per cent.

The government blocked access by The Weekend Australian to one ream of documents discussing unconventional monetary policy due to its status as a “Cabinet Paper”.

In late July, Treasury head of Macroeconomic Modelling and Policy Ian Beckett provided Mr Frydenberg with the lengthy ministerial submission outlining the potential paths for unconventional monetary policy under consideration by the RBA, warning that conventional reductions to the cash rate took between 12 and 18 months to be felt by the broader economy and that unconventional policy may be necessary.

RBA governor Philip Lowe this month said negative interest rates would be “extraordinarily unlikely”, but has confirmed the central bank has considered a range of unconventional policy options, which it is prepared to launch to help drive unemployment lower to its target of 4.5 per cent.

A jobless rate of 4.5 per cent is believed to be low enough to trigger a rise in wages, inflation and consumer spending.

Treasury told Mr Frydenberg that international experience suggested unconventional policies were a “useful and in some cases necessary policy response” when traditional policy tools were no longer effective.

“Although the banking system passed through the two most recent reductions relatively comfortably, it is likely that the transmission of policy decisions will become impaired as the cash rate approaches zero and banks’ margins come under more intense pressure from lower rates.”

Since May, the RBA has cut the cash rate by a cumulative 75 basis points. However, the major banks have copped political wrath by passing on an average of just 57 basis points to mortgage borrowers in a market worth $2 trillion, of which the big four banks command an 80 per cent share.

The difference between the RBA rate cuts and those passed on by the banks is more than $500 a year for average owner-occupier home loans.

“Given that Australia’s financial system is dominated by bank lending to households it is likely that the Bank would first consider options aimed at lowering bank funding costs or supporting mortgage funding directly,” Treasury said.

“This would involve either buying commercial bank bills or residential mortgage backed securities. The latter may be particularly attractive as the RBA already holds these assets as collateral as part of its existing operations.

“While it is not close to being an immediate consideration, were the RBA to look at undertaking QE, the type(s) of securities purchased would need careful assessment, given the Australian economy is heavily reliant on bank financing rather than financing via securities markets. This may point to other unconventional policies being more appropriate to our circumstances, such as funding-for-lending.”

During the global financial crisis, the government allocated about $20bn towards purchasing residential mortgage-backed bonds after funding markets completely froze.

Treasury said although purchasing government bonds would be “low risk purchases”, it was a “less certain” form of effectively stimulating the economy as the government was “unlikely to respond directly to lower interest rates and, unlike in other countries, relatively few borrowers have interest rates linked directly to government bond yields”.

The documents came as Westpac chief economist Bill Evans on Friday said the RBA should consider buying corporate bonds, bank debt and foreign bonds as part of any quantitative easing program, given the limited supply of Australian government bonds. Valued at $567bn, 60 per cent of government bonds are held by foreigners and a further 15pc held by banks. With the government attempting to run budget surpluses, only about $150bn in bonds on issue might be available for purchase by the central bank.