For the lay person it used to be simple.
The Reserve Bank of Australia would cut or raise the cash rate when it considered inflation too low or too high, and the major banks and other lenders would adjust their loan rates accordingly.
Now there is three-year bond yield targeting and the term funding facility among the RBA’s bag of monetary policy tools.
And this month it added QE or quantitative easing.
In a speech last month, RBA assistant governor Christopher Kent admitted that it’s “all become more complex”.
QE came to the fore during the 2008-2009 global financial crisis when the likes of the US Federal Reserve and the European Central Bank had no further scope to cut interest rates to steady their economies.
The RBA has joined the QE party with interest rates now as low as the bank is prepared to go, but still feeling the need to help stimulate the economy out of recession.
Along with cutting the cash rate at its November board meeting to a record low 0.1 per cent, the central bank announced it will be buying $100 billion of Australian and state government bonds over the next six months with maturities of five to 10 years.
To understand the benefit of this process, first an explanation of a bond.
A bond usually carries an interest rate or coupon that is paid to the holder. Like a company share, it can be bought or sold, but as the price of the bond changes, so does its interest rate or yield.
There is an inverse relation on a bond between its price and yield, so as the price goes up, the interest rate comes down and vice versa.
So when the RBA enters the market with a wad of cash, the bond price will go up and the yield will fall.
In this low yield environment, governments can raise cash more cheaply to either stimulate the economy through new programs or service their existing debt.
At the same time, commercial loans can be priced against government bonds at a lower rate, helping businesses to raise low-cost money.
Giving an explanation of the RBA’s bond buying program, deputy governor Guy Debelle said longer-term Australian bond yields had been higher than those of other advance economies, which was contributing to a higher exchange rate – making the Australian dollar and economy uncompetitive.
Between mid-September and the November board meeting there was speculation that the central bank would introduce a QE program, which led to yields falling and the Australian dollar declining by five per cent.
Dr Debelle believes it is reasonable to attribute the bulk of this depreciation to the growing expectation of the QE package being announced in November.
“Longer-term yields have risen a little since the November board meeting as has the exchange rate, largely due to the news about vaccines,” he told an Australian Business Economists webinar on Tuesday.
“But I would argue they are both lower than they would be absent the November policy package.”
He says the impact of the exchange rate coming down boosts domestic demand and puts people in jobs.
“We’ve seen the exchange rate come down by a noticeable amount and enough to have impact on the economy and have an impact on employment and people’s livelihoods,” he said.
“The biggest way of effecting economic outcomes is whether people have jobs or not, which I think is sometimes lost in this discussion.”
It may not be as straightforward as cutting the cash rate, but the aim is the same.