What the hell is ‘quantitative easing’ and why are we talking about it all of a sudden?
If you have no idea what ‘quantitative easing’ is and why everyone’s talking about it all of a sudden, then this is the explainer for you.
What the hell is ‘quantitative easing’ and why is everyone talking about it?
Everybody is talking about it because on Thursday (19 March) the Reserve Bank of Australia (RBA) announced that it was going to undertake quantitative easing for the very first time.
Other countries, like the US, Japan and the EU, have done it before but Australia never has.
Sure, but what is quantitative easing?
Quantitative easing is how central banks like the Reserve Bank of Australia lower interest rates when the official rate (also known as the cash rate or the overnight rate) gets close to zero.
The RBA is trying to flood the market with money so that banks have plenty to lend out at a low-interest rate.
Why can’t they just cut interest rates the regular way?
On Thursday the RBA cut interest rates to a new record low of 0.25%.
The RBA governor said that this is as good as zero and they’re not going to lower the interest rate any further.
Why would you want to lower interest rates if they’re already at zero?
Well, the cash rate is at or close to zero, but other interest rates aren’t. There are lots of different interest rates out there.
Think of it like the difference between the interest rate on a mortgage and the interest rate on a credit card.
The banks justify the higher credit card interest rate because they don’t have any security on the loan.
If you default on your mortgage, the bank can sell the house to recoup some or all the debt. If you default on your credit card the bank has no security.
And so because credit card debt is higher risk for the bank than a mortgage, they charge a higher interest rate.
The same principle applies when big companies or governments go into debt. But instead of going to the bank for a loan, big companies and government can issue bonds directly to investors.
What’s a bond?
A bond is a small part of a bigger debt, much like a share is a small part of a bigger company. If you own a share in Telstra, you own a small part of Telstra and you have a right to claim a small part of the profit (if any) that Telstra makes. In order to get money to expand, companies float themselves by selling lots of shares. By cutting the company up into lots of little shares it’s easier to find many investors who want to invest a small amount, rather than trying to find just one investor with the money to buy the whole company.
I thought you said that a bond was a debt?
Yeah, I’m getting to that. A bond is like a share but instead of being a small part of a company, it’s a small part of a larger debt. If you want to borrow $500,000 to buy a house, a bank will happily lend it to you (so long as they judge you credit-worthy and they think you can pay it back). But if you want to borrow $100 million, a single bank is unlikely to want to lend such a large amount to just one business or government. Not because they couldn’t raise the money, but because they’d be putting too many eggs in one basket. If the business defaults on the $100 million debt, that will hit the bank hard. But if you default on a $500,000 mortgage, they’re able to absorb that easily.
So rather than ask just one bank to finance the debt, the business or government cuts the debt up into smaller pieces and lets anyone buy part of the debt. So, in our $100 million example the business might cut the debt up into one million $100 bonds. Each bond would be sold for $100 (called its face value) and they can be sold to lots of different people.
So why would someone want to buy a bond?
For those buying a bond, it’s an investment. A bond is an IOU with interest: the issuer of the bond promises to pay a certain amount each time period (e.g. a year). So, in our one million $100 bonds example, the government might make them 10-year bonds that each attract a $10 interest payment each year. This means that whoever owns the bond on a certain day each year gets $10 for each bond they own and in the tenth year they get the $10 interest payment plus the repayment of the $100 debt. At that point the bond is said to have matured (i.e. it has been paid back)
What do you mean the person who owns it? Isn’t that the same person who first bought it?
Not necessarily. Like shares, bonds can be bought and sold in the market after they’ve been issued. And like shares, bonds can go up and down in price.
Why would anyone pay a different price for a bond than its face value? After all, that’s the amount they get back when the bond matures.
Shares go up and down in price based on the expected future profitability of the company (among other things). Bonds go up and down in price based on the risk that they’re not going to be repaid (among other things). The more risky the bond is judged to be, the higher the interest rate that will have to be paid. Bond prices also reflect the interest borrowers must pay to compensate investors for locking their money away for a period of time.
So the interest rate on a bond isn’t fixed?
No. The business or government who issued the bond doesn’t promise to pay a particular rate of interest. Instead, they promise to pay a fixed amount per bond. So, in our example, if a $100 bond attracts a $10 payment each year then its effective interest rate is 10/100 or 10%.
But if the bond changes in price then the effective interest rate also changes. Let’s say the $100 bond is sold in the bond market by the person who originally bought it. Let’s say that there has been a crash in the value of the bonds and the person can only get $50 for the bond with a face value of $100. The company or government that issued the bond still promises to pay $10 for each bond. But now the effective interest rate has changed. The bond is now only worth $50 but it continues to get $10 each year (and still pays out $100 when the bond matures). The yearly interest rate is now 10/50, or 20%. When the bond halved in value the effective interest rate doubled.
It works in the other direction as well. If the bond with a face value of $100 doubles in value and is now worth $200 on the bond market, the effective interest rate changes. Now the bond, that is still getting paid $10 per year, has an effective yearly interest rate of 10/200, or 5%. So, when the value of the bond doubles the effective interest rate halves.
This is the most important part. Bond prices and interest rates go in opposite directions. When a bond goes down in price, the interest rate goes up and when a bond goes up in price the interest rate goes down.
OK. I understand bonds but what does that have to do with quantitative easing?
Well quantitative easing combines the fact that interest rates on bonds change with their price and that higher risk means the market will demand a higher interest rate.
Remember that quantitative easing was all about lowing interest rates?
Yeah but you never said what interest rate needed lowering.
Well if you were going to lend money to someone, one of the risk factors would be how far in the future they were promising to pay it back. If they were promising to pay it back tomorrow, then you would probably be able to assess fairly well how likely they would be to pay it back. Their current financial circumstances are unlikely to change much in a single day. But if they promised to pay it back in 10 years’ or even 30 years’ time then it would be a lot harder to assess that risk. Over such a long time period they could lose their job, go bankrupt, or skip town and you might never get your money back. Higher risk means the market will demand a higher interest rate.
The market also demands a higher interest rate if you want to borrow for a longer time. If you want to take my money for longer, I want a higher interest rate. The same is true with bonds. Bonds with very short maturity dates, like say 3 months or a year, attract lower interest rates than long term bonds, like say 10 years or 30 years.
You’re still not telling me what quantitative easing is.
Yeah, yeah, I’m almost there I promise.
This all means that bonds have what’s called a yield curve. When you hear ‘yield’ in financial markets it basically means the same thing as interest rate.
Well if yield means interest rate why don’t they just say interest rate?
Because if they use a different word then normal people can’t understand what they’re talking about and what they’re talking about sounds baffling and they sound smarter.
But back to yield curves.
A yield curve shows all the bonds with different maturity dates and the interest rate they attract. Here is an example of a US yield curve from 2018.
You can see as the maturity date gets longer the interest rate goes up. The lowest interest rate is for the shortest time period.
Now the shortest time period that the RBA has is the official interest rate. Remember that it is also known as the overnight rate. Basically, it’s the interest rate that the RBA will give banks if they lodge their money for very short periods (like overnight). It’s also the starting point for the yield curve.
Now the RBA can’t lower the official or overnight rate anymore (because it’s basically zero) but the longer-term bond rates are higher than the official rate. These rates are used to determine other interest rates in the economy and the RBA wants to lower them.
So how does the RBA lower the longer-term interest rates?
With quantitative easing. This involves the RBA buying heaps and heaps of longer-term government bonds. If the RBA buys up lots of government bonds this increases the demand for the bonds and so increases the price (market value) of those bonds. Just like everyone wanting to buy Telstra shares would push up the price of Telstra shares.
But we know that when the price of bonds goes up, the effective interest rate goes down. This is what the RBA is trying to do: lower the interest rate. When it buys large amounts of government bonds, it pushes down their interest rate relative to their price and therefore flattens the yield curve. The RBA has announced that they’re targeting the three-year Australian government bonds and they want to push the interest rate down to 0.25%, the same as the official rate. Effectively they want to flatten the yield curve.
Wait. I’ve heard that quantitative easing somehow involves printing money. What is that about?
Well, that’s kind of right. When the RBA buys government bonds it creates money to buy those bonds. But all this money created is in bank accounts and no actual ‘printing’ takes place.
Another impact of quantitative easing is that when the RBA takes its newly printed money (not actually printed) and buys government bonds, it’s buying them off banks and ‘bank-like’ institutions. After it does this the banks have more money and the RBA has more bonds. This floods the banks with money, and this is supposed to encourage them to lend more money out (at the new lower interest rate).
So quantitative easing is just the RBA creating money to reduce long-term interest rates because they can’t lower the short-term interest rate anymore because it’s practically zero.
Yeah, that’s basically it.
Matt Grudnoff is Senior Economist at The Australia Institute