Understanding quantitative easing

In November 2020, the Reserve Bank of Australia (RBA) announced that it would introduce a $100 billion quantitative easing program.

The focus of the program is to keep Australian interest rates low and support economic growth after the challenges we’ve seen this year.

Quantitative easing is a tool utilised by central banks around the globe when trying to encourage economic recovery. It is a measure that has been regularly employed by the US Federal Reserve since the 2008 Global Financial Crisis.

Today, we take a look at what is involved and how it will help the Australian economy.

What is quantitative easing?

What is quantitative easing?

Quantitative easing (QE) can be a difficult term to explain. It is an unconventional monetary policy where central banks essentially increase money supply within the economy in order to boost inflation and stimulate economic recovery… particularly during a recession.

Sometimes it is referred to as ‘printing money’ but that isn’t quite right as the RBA won’t just switch the printers to 24-hour production. The process actually involves the RBA utilising cash reserves to purchase government bonds, and this is how they encourage a new spending cycle.

The theory is that when the RBA uses its money to buy government bonds – either from the Government or a standard bank in the secondary market – the payment received by the seller gives them additional financial security to offer people more money. If the seller is the Government then they can provide tax cuts, or if the seller is a bank they can offer more loans for people to buy a house or other valuable assets, or perhaps start or grow a business, all of which helps economic growth.

The other theory on how QE can kick start recovery is that it helps to keep interest rates low. When banks have more lending ability – through their increased funds from the sale of bonds – people are able to shop around to find the best interest rate on offer. Increased competition has a downward effect on rates and again this encourages people to spend more money.

This results in a higher demand for goods and services, creating more jobs and pushing the economy forward.

Of course, these are the theories behind QE and, in practice, the results can vary. In countries such as Japan, England and the US, it hasn’t necessarily achieved the desired outcomes and other measures have been used in combination with QE.

How will the RBA use quantitative easing?

How will the RBA use quantitative easing?

As mentioned, the RBA intends on spending $100 billion on QE measures. It will purchase government bonds over a six month period from November 2020.

These will be made up of approximately 80% federal and 20% state and territory bonds. These bonds will predominantly have five to ten-year maturities.

Government bonds provide regular interest payments for the life of the bond, so the RBA will receive these payments along with the full investment amount when they reach maturity. RBA Governor Philip Lowe said,

“It is important to point out that the bond purchases by the RBA will have to be repaid by the Government at maturity. They will have to be repaid in exactly the same way as would occur if the bonds were held by others. The fact that the RBA is holding some bonds makes no difference to the financial obligations of the government, other than through a lower cost of finance.”

The purchasing of the bonds will occur through the secondary market, which means the RBA will buy them from institutional investors such as local or foreign banks. The increased demand for bonds will lead to a decrease in the interest rate on the bonds, subsequently enabling the governments to borrow at lower rates.

Will it help the Australian economy?

Will it help the Australian economy?

In addition to stimulating economic growth through bank lending, it is believed that these QE measures will impact the value of the Australian dollar. Governor Lowe said,

“The Australian dollar has been the great shock absorber for the Australian economy, and I am confident it will continue to act in that way.”

Keeping the dollar low when compared to international currencies is beneficial for Australian exporters as their products are more economical for overseas buyers. While the lower interest rates and a low dollar value might not be attractive for foreign investors, it can certainly help our export markets.

This year is the first time that the RBA has ever implemented QE measures, and that is an indication of just how extraordinary the current economic situation is. Here at First Financial, we are always monitoring market conditions and are dedicated to keeping you informed. If you have any questions, please contact our team of professional financial advisers today. Read another investments article.

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