Central banks have ditched their traditional caution in attempting to stimulate economies during the COVID-19 pandemic, and an ongoing evolution in thinking about monetary policy helps explain why.
Central banks have ditched their traditional caution in attempting to stimulate economies during the COVID-19 pandemic, and an ongoing evolution in thinking about monetary policy helps explain why.
The Reserve Bank of Australia has been particularly innovative in its approach, adopting a yield curve target that effectively guarantees it will print money to buy bonds in any quantity to maintain an interest rate of 0.25 per cent on three-year bonds.
That operation will last until 2023. Other moves have included a $90 billion fund to support small business lending, and a reduction in the official cash rate.
Conventional wisdom says increased printing of money will lead to inflationary pressure, but there are other variables that could alleviate that impost as major economies are shut down and reopened.
The RBA’s flexibility when confronting challenges was outlined in a 2018 speech by assistant governor Chris Kent, who said money was created by the financial system making loans, rather than purely through decisions of the central bank.
This reflects a big change in thinking about monetary policy in the past decade.
“When a bank extends a loan, it makes money available to the borrower, for example, to buy a car, a house or equipment for a business,” Mr Kent said.
That is credited into an account, and adds to the money supply in most cases.
The money supply is deemed to be both physical currency and accessible deposits at banks.
“The process of money creation is constrained in numerous ways and depends on the behaviour of borrowers, banks and regulators, as well as the stance of monetary policy,” he said.
“The process of money creation requires a willing borrower.
“That demand will depend, among other things, on prevailing interest rates as well as broader economic conditions.
“Other things equal, lower interest rates or stronger overall economic conditions will tend to support the demand for credit, and vice versa.”
A similar tack was taken by the Bank of England in a 2014 report, which created an intellectual underpinning for quantitative easing policies.
“In exceptional circumstances, when interest rates are at their effective lower bound, money creation and spending in the economy may still be too low to be consistent with the central bank’s monetary policy objectives,” the report said.
Quantitative easing will mean the central bank buying assets from banks, which increases the level of cash in the economy and can then be used to buy other assets. But the report also cautioned that easing did not represent “free money” for banks.
The RBA’s yield curve targeting policy is slightly different from QE as it focuses on the price of bonds, rather than quantity.
The Bank of Japan embraced a yield curve target in 2016, although otherwise the mechanism is rare.
One complication here is that there’s traditionally pressure on bond prices when governments borrow large sums of money, with the Australian government planning upwards of $200 billion of spending during the crisis.
That will mean a big increase in the bond supply and potentially significant pressure on the RBA to transact to maintain the target.
However, under the theory the RBA is using, the potential impact on inflation will be low despite the big flow of new deposits into banks the policy creates.
The flow-on effect depends on demand for money, rather than just supply, the central bank contends.
