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Understanding QE and its impact on inflation

At the February 2021 Reserve Bank (RBA) Board meeting, the RBA announced it would continue its 0.1% target for the three-year Government bond yield, while committing a further $100 billion to purchase those bonds in the secondary market. This comes in addition to the $100 billion programme announced in November targeting bonds with a 5- to 10-year term.

This form of monetary policy is known as Quantitative Easing (QE). Typically, central banks resort to this when short-term interest rate targets are at or near zero, rendering conventional monetary policy no longer effective. QE may then be introduced with the aim of lowering interest rates further out on the yield curve, to encourage borrowing and spending to boost the economy.

Why do central banks target inflation of 2-3%?

When QE was put on the table by the RBA, a lot of discussion was generated and misconceptions emerged. In particular, many think that it is just a money printing exercise that will lead to high inflation.

So it’s worth exploring how such unconventional monetary policy is implemented, and what might be the effect on inflation.

We have been in a low inflation environment for some time now, well below the RBA’s preferred target range of 2 - 3%, a range considered the sweet spot by many central banks around the world. But why 2 - 3%?

If inflation was any less, then the urgency for spending would dissipate. Why spend today when it could be cheaper tomorrow? Any discretionary spending can be put on hold, which acts as a deadweight on economic growth. But any higher than the target range and consumers’ purchasing power erodes and they cut back on spending, causing businesses to reduce spending and investing, resulting in higher unemployment, even less spending, and on it goes.

QE is not money printing, but what is it?

QE involves the RBA purchasing government securities in the secondary market, which may consist of both private investors and commercial banks. Any securities purchased by the RBA are recorded as assets in its balance sheet, offset by increasing exchange settlement account (ESA) balances held at the RBA by the commercial banks, by an amount in total equal to the cost of the securities.

An ESA balance is an RBA liability and a commercial bank asset. This is called 'expanding the balance sheet'. Since the start of 2020, the RBA’s balance sheet had increased by about $160 billion by the end of January 2021.



The ESAs are accounts that facilitate payment transactions between the commercial banks, the RBA, and the Australian Government, all within a closed system. It is not possible to transact with, or lend money directly to, non-banks via these accounts. As the RBA cannot trade directly with non-banks, the commercial banks act as intermediaries when the RBA purchases securities from private investors, because they can transact with investors outside the closed system.

In effect, bank ESAs (that is, the liability side of the RBA's bond purchase) are credited with the stroke of the RBA’s keyboard. At that point, base money in the system has increased, being the RBA’s money-like liabilities, including holdings of banknotes. Importantly, this does not mean free money for banks, and far less a case of money printing.

Rather, QE is more an exercise in creating reserves, seeking to increase the quantity of broad money in the system or private sector deposits.

How does this happen, and who 'creates money'?

Suppose the RBA purchases government bonds from a bank. The bank’s ESA balance increases, while its liabilities in the form of private sector bank deposits remains the same, therefore private sector money has not increased. The bank's capital adequacy has strengthened though, giving it confidence to create more private sector loans and hence customer deposits than it otherwise would have.

Or the incentive might be to rebalance its portfolio by expanding its loan portfolio, as ESA balances currently earn 0%. Either way, increased lending increases the quantity of broad money, noting banks are not compelled by the RBA to lend. The bank could also purchase new government bonds.

Suppose also that the RBA purchases government securities from a non-bank investor. The investor’s bank facilitates the sale. That bank's ESA balance is also credited by the RBA, but this time its liabilities increase by the same amount, representing an increase in its deposits held by its investor as a result of exchanging its government bonds for bank deposits. Broad money has increased, and the investor now has available funds to spend or invest.

In both instances, the process aims to lower the yield on the bonds targeted for purchase by the RBA, thereby lowering the cost of finance to stimulate borrowing and hence, the economy. Again, such activity will depend on the risk appetite of both banks and investors.

So while the RBA may increase the quantity of broad money when undertaking QE, it is not necessarily a precursor to further money creation by commercial banks, and any inflationary effects will also be indirect.

Money creation in the private sector is the preserve of commercial banks and not the RBA. Loans to the private sector are created by the banking system when they simultaneously create bank deposits for their clients. This happens independently of the RBA and will only occur when banks are motivated to lend to willing clients. 

Back to the impact on inflation

QE is indeed an inflationary tool, but increasing the monetary base does not guarantee inflation. For example, money creation in the form of lending may not occur if banks want to shore up increased ESA balances in times of uncertainty such as recession or in a pandemic.

Or the private sector wants to stockpile cash or indeed even pay down loans, which has the opposite effect to lending in that it actually destroys money. It may be then overall, that the increase in base money by the RBA is saved and not spent.

Money is not necessarily circulating and therefore has little, if any, effect on inflation.

The other variable in the inflation equation is production. Ordinarily, increasing the money supply in an economy at or close to full capacity, would likely cause inflation. That is because there is no room to absorb excess money. Goods and services cannot outpace the growth in money, therefore prices must rise. If however, there is spare capacity in the economy, there is scope to increase production and soak up new money to stymie inflation.

In fact, increasing the money supply is not even necessary for inflation, because if there is a contraction in economic activity, less goods and services could drive price increases. Again, a case of too much money. And we are seeing output contract now with the pandemic, which may push prices up, money supply aside. When the pandemic subsides, utilising the spare capacity in the economy would have a deflationary effect.

Ultimately, the effect of QE in Australia coupled with a restricted economy due to the pandemic, may see temporary inflation, because increasing the money supply and curtailing output are both inflationary actions. Then as vaccines are rolled out and the threat of the pandemic subsides, output should trend back to more normal levels and use up any excess money. Also, we are coming off a sustained low base of inflation.

If however, policy did happen to overshoot, QE can be unwound by the RBA selling bonds back to the secondary market. The ability to unwind sets QE apart from true money printing, whereby central banks credit Treasury accounts electronically for the government to spend as it sees fit without needing to repay. An example is so-called 'helicopter money', where governments drop money into peoples’ accounts to stimulate economies. Central banks end up with no assets, and the effect is both irreversible and inflationary.

Importantly, QE also has a currency effect. With QE lowering interest rates, it can weaken a currency. And QE has been going on in Europe, the US, and Japan for quite some time now, causing lower exchange rates than otherwise would be the case. With the RBA now getting in on the act too, it should help our currency's competitiveness.

Finally, there has been a focus recently on the rise in bond yields globally, particularly in the US. Investors could be dumping bonds in the expectation of inflation finally taking off, perhaps due to the early unveiling of vaccines, and the thinking that central banks may have overstepped the mark with pandemic stimulus measures. Note, that it is expected inflation and not actual that influences bond yields.

The RBA says it expects to keep interest rates at low levels at least until 2024, and would buy even more government debt “if necessary”. It also says there are few signs of an inflation rise in Australia that would require higher interest rates. Perhaps for now.

 

Tony Dillon is a freelance writer and former actuary. This article is general information and does not consider the circumstances of any investor.

 

11 Comments
Ruth
March 23, 2021

I'm sick of this. The last globalisation of the world which left a few very wealthy, ended in WW1 followed by more war. This globalisation has left us with CCP billionaires enriched when all we did was honestly trade. We are on the brink of WWIII. You don't always get a choice.

John Pracy
March 22, 2021

Still confused!

Warren Bird
March 22, 2021

John, just focus on the fact that monetary policy is all about setting interest rates. It hasn't been about controlling money supply growth since the early 1980s. That's what a lot of commentators haven't worked out yet and they still think that central bankers are all about creating money. They don't and can't. That's why QE is not about printing money at all - it's about setting policy to keep short term rates lower for longer and also to help keep long term rates down.

Money growth will result from low cash rates and QE if and only if there's enough confidence in the economy that banks start to lend again, which is what creates the money. (A bank writes a loan, and the money gets deposited into the borrowers accounts, and then when the borrower spends it the funds go into deposits held by the people they've paid, etc.) When money growth becomes rapid enough that it's faster than the economy is growing and any slack in the economy is taken up (eg unemployment gets to a low level), then that creates inflation.

This is how it's always been. Usually it happens when the cash rate has been cut from, say 6%, to 3%. But since the GFC there's been a lack of long term confidence and a lot of slack, so that cash rates had to be cut further. Once they get to zero, the focus turned to long term rates. But this is the same process as ever.

Hope that reduces some of the confusion.



Tony Dillon
March 17, 2021

In response to Joseph O, Warren makes some good points. And I’ll add that "more money" only enters the system if it is being created faster than it is being destroyed.

Think of money sitting in two big pots. Pot A holds all the money that commercial banks and the government circulate among themselves (the ESAs). It is an RBA liability. Pot B is all other money that the private sector uses, consisting of deposits in banks, and banknotes in circulation, which the RBA prints and is another RBA liability.

QE aside, money makes its way from Pot A to Pot B when the government spends. It may be stimulus spending or welfare spending for example. The government’s ESA reduces, the banks’ ESAs increase, and private sector deposits increase. Private sector money has been created. If investors want to withdraw their deposits and hold cash, The RBA’s banknotes in circulation liability increases, but it is offset by a reduction in the commercial banks’ ESA balances against reduced private sector deposits.

Created money can be reversed when private investors pay tax for example. Their deposits decrease, banks’ ESAs decrease, and the government’s ESA goes back up. Private sector money has been destroyed. Money can also be destroyed by the government selling bonds to private investors. Money moves out of the private sector into the government’s ESA.

QE adds another layer in that it increases bank ESA balances as explained in the article, and investor deposits may also increase. But it doesn’t guarantee further money creation via banks creating loans. And at some stage, the bonds purchased by the RBA will mature and the government will have to pay the RBA back, destroying government ESA money. And QE can also be unwound as explained, reducing commercial bank ESA balances.

The point being, money is being created and destroyed all the time in both pots of money. If more money does enter the system, it may only be temporary.

Joseph O'Sterate
March 12, 2021

More money in whatever form will eventually cause inflation because it's dilutes the currency. This dishonest practice has been taking place throughout history and is simply theft by governments with fancy names for it.

Warren Bird
March 16, 2021

As the article points out, QE is NOT PRINTING MONEY. It's intended to result in a growing money supply by giving the banks the capacity to create additional credit through lending, which in turn grows the amount of deposits in the system. But for that to happen it needs both a willingness by the banks to lend and a willingness by individuals and businesses to borrow. That didn't happen very much after the rounds of QE that followed the GFC (banks wary of credit risk and borrowers wary of taking on debt during depressed times), but does seem to be happening now. (M3 in Australia grew by 13% over the last year, it's fastest rate of increase in many years.)

Stronger money growth doesn't always create inflation. For that to be the case, the growth rate has to exceed the nominal growth rate of the economy. Remember the old truism that MV = PT where M is the money supply, V is the velocity of the circulation of money, P is the price level and T is the real level of transactions in the economy. When you have a large output gap and stimulatory monetary policy meets a desire for borrowers and lender to do business, then rising M and rising T go together. Once you get to the point of 'too much money chasing too few goods', then rising M begins to push P higher.

I see a risk of that happening over the next couple of years, particularly in the US, where we could easily see inflation get up into the 5-10% region if the Fed doesn't act soon.

But growing the money supply is not a 'dishonest practice'. It's an absolute necessity if you want the economy to grow! Growing the money supply too rapidly is an issue if it pushes inflation too high, but central banks surely have demonstrated over the last 30 years that they're all over this issue and don't want that to happen. Governments have - even though sometimes kicking and screaming about it - handed independence to central banks to manage the situation precisely so that the dilution of the currency doesn't happen.

And to circle back to my first point, QE is not printing money, any more than cutting the cash rate is printing money. Monetary policy moved away decades ago from attempting to manipulate the money supply in that narrow minded fashion - mostly because it can't be done! Banks create credit, not central banks, and they do that in response to demand for borrowings from the economy. Central banks seek to influence that demand by changing the cash rate and by other measures like QE to encourage growth in M and T, as well as growth in P within their target ranges. But this is an exercise in leading the horse to water. Central banks can't force the horse to drink. That's why fiscal policy has been kicked in this time around, as only actual spending can end up as deposits in bank accounts, thus turning the central banks' purchase of government bonds into money supply growth.

It's just so easy for journalists and others who only have a dangerous 'little bit of knowledge' about monetary economics to throw lines around like 'they're printing money and that's dishonest' etc. But it just isn't true!

In the end, it's banks that produce growth in the money supply through creating credit.

Dane
March 11, 2021

I've read several finance text books from well regarded academics on monetary policy and QE and this is as good of an explanation as I have come across. Clear and concise.

Households that hold lots of debt (such as here) should actually be cheering for some inflation. But the wrinkle is liabilities here are largely floating instead of fixed so any perceived benefits would be offset by rising interest rates..

Phil
March 11, 2021

still don't quite understand, if bond yields have nearly doubled in the last 3 months, the market signalling inflation expectation and growth, and that is what the RBA wants, why does it continue with QE, to supress the rate? QE could have the opposite impact of making the market feel the economy needs stimulating and therefore less likely to spend? The only reason I can come up with is currency, they don't want a rising currency and if our rates are relatively too high compared to other countries and make us uncompetitive at the currency level.

Tony Dillon
March 11, 2021

Phil, I mentioned in the article that bonds price in expected inflation, not actual. And the RBA has stated that it will keep interest rates low until actual inflation hits the 2 to 3% range. By which time it expects unemployment to be close to 4%, and wage growth above 3% (currently 1.4%). And that these targets are unlikely to be met before 2024, so it expects the cash rate to stay at the low level of 0.1% until then. And possibly extend its QE program to also keep a lid on longer term rates. No doubt currency is also a consideration.

Jack
March 11, 2021

Thanks, Tony. As good an explanation as I've read. Not sure I could stand in front of the United Nations and explain it, but I think I'm 90% there.

George
March 11, 2021

Indeed, Jack, I'm more like 80% there but I know it's 100% important.

 

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