Analysis: RBA Research Makes Case for Policies Lowering Govt Bond Yields

• Published on
• 17 Sep 2020, 07:48 PM

By Sophia Rodrigues

At the cash rate target of 0.25%, the Reserve Bank of Australia could potentially lower the rate another 50bps to -0.25%.

But it does not have to venture down that path when it can achieve the same outcome by effecting a 50bps reduction in government bond yields and lending rates through unconventional monetary policies. In fact, the unconventional path could potentially produce better outcome for the economy because it eliminates side-effects of negative interest rates.

This means the RBA is increasingly likely to deploy policies that would lead to a lowering in government bond yields. This could happen via a cut in the three-year government bond target along with a cut in the cash rate target to 0.10%, and some form of bond-buying that would lead to reduction in yields at the long end.

60BPS CONVENTIONAL EQUALS 50BPS UNCONVENTIONAL

A research article published by the RBA Thursday shows a 50bps reduction in government bond yields, business lending and mortgage rates effected via a combination of unconventional policies would produce a similar outcome for the economy as a 60bps cut in the conventional cash rate.

A key channel through which this would occur is the exchange rate, which is expected to depreciate more under unconventional policy settings than conventional policy of similar magnitude. The weaker exchange rate would boost net exports and business investment, and produce the same GDP, but with a different mix, as a conventional policy rate cut

The authors of the research are Rochelle Guttmann, Dana Lawson, and Peter Rickards from the RBA’s economic analysis department.

A key message from the research is that alternative monetary policy tools are available to provide stimulus to the economy now that the cash rate is at its effective lower bound.

“A range of policies deployed in unison lowers the unemployment rate further and increases inflation in a way that closely replicates the channels of a conventional cash rate cut,” the research said.

SOME UNCONVENTIONAL IN USE ALREADY

Indeed, the RBA has already used unconventional policies since it lowered the cash rate to 0.25%. They include a three-year government bond yield target and provision of Term Funding Facility at 0.25%, along with an expansion and extension in the TFF.

With the three-year yield currently at 0.25%, there is likely just another 15bps more reduction the RBA could make. But at the longer-end of the curve, there is still a potential to cause yields to fall by 30bps-50bps.

Lower government bond yields, especially at the longer end, would be expected to put downward pressure on the exchange rate.

The RBA could also deploy policies to further increase liquidity in the system, if needed, to cause more downward pressure on lending rates.

EFFECT LARGER OR SMALLER, BUT MOSTLY LARGER

While the research shows the effect of unconventional is similar to conventional, it also acknowledged that in reality it could be larger or smaller.

This is because the modelling does not capture ways in which one policy measure can influence more than one interest rates. For example, it does not consider that lower bond yields could also lead to lower lending rates.

It also does not account for portfolio balance channel which is one of the important transmission mechanisms when the rate of return on risk-free assets is lowered. Similarly, it also does not factor in the effect of quantity-based measures to encourage lending such as the TFF which provides additional lending allowance based on expansion in banks’ lending.

On the other hand, the impact of unconventional policies could be muted when there are restrictions on international travel which affect service export or actions of other central banks place upward pressure on the Australian dollar. Also, the impact would be less if demand for credit is lower due to heightened uncertainty or lower bond yields place pressure on bank profitability and margins, and thus stifles lending activity.

--Contact: Sophia@centralbankintel.com