Due to COVID-19 and the fire in Australia, a large area of houses and farmland were destroyed, plenty of people moved their residences for refuge, the unemployment rate rose significantly, and Australia’s economy suffered heavy losses. In the initial stage of the economic shock, with the market in a state of tight liquidity, the central bank could lower short-term interest rates by lowering the target overnight rate. This would increase the money supply and regulate the cash flow in the market. When the interest rate decreases, people become less likely to save money in the bank or in cash, but instead will use it for investment or consumption, and the funds will flow from savings accounts into the market. At the same time, interest rate cuts also reduce the cost of borrowing, leading to an increase in borrowing from corporations to grow business. Increased liquidity of money, incremental investment and higher consumption can alleviate the impact of this economic crisis. However, due to the rapid spread of COVID-19 and multiple outbreaks in congested urban areas, the economy is deteriorating, and interest rates have dropped to close to 0%. At this time, conventional monetary policy may not be enough to stimulate the economy, and unconventional policies will need to be implemented.
Unconventional monetary policy
Forward Guidance
In the Great Financial Crisis of 2008, the United States central bank once lowered interest rates to close to zero (Federal Reserve, 2020). When conventional monetary policy was exhausted and no longer useful, the central bank committed to keep and maintain the low short-term interest rates in the future to try and stimulate growth in the economy, a policy known as Forward Guidance (European Central Bank, 2017). To try and combat Australia’s economic crisis, the Bank of Australia might follow this policy and publicly announce a commitment to loose monetary policy and ensure that short-term interest rates shall remain low until the economy recovers. An increased level of transparency in monetary policy will help the Australian market restore confidence, reduce information asymmetry, guide people to form reasonable expectations, and reduce market volatility (Reserve Bank of Australia, 2020b). According to the expectations theory of the term structure, long-term interest rates are approximately equal to the average of short-term interest rates over the long-term period. If the central bank promises to stay at low interest rates in the future, people’s expectations for short-term interest rates will fall, triggering a fall in long-term interest rates, fostering increased aggregate demand through lower financing costs.
Quantitative Easing
With Australia’s short-term interest rates at near zero levels, quantitative easing is a sensible option for potential monetary policy. To implement Quantitative Easing, the central bank increases the money supply in the market by purchasing government securities from commercial banks (Chappelow, 2020). The central bank’s large purchases will increase prices or long-term government bonds, while reducing the yield and interest rates. At the same time, the increase of money flowing into the market will expand the monetary base and strengthen market liquidity, thereby increasing consumption and investment. As the government bond prices rise and yields decline, investors and commercial banks will invest elsewhere in stocks, futures, corporate bonds etc., increasing prices of those commodities and encouraging growth in the financial markets.
Creadit Easing
Credit Easing refers to the monetary policy in which the central bank increases liquidity in the market by purchasing private sector assets and relaxing loan conditions (Shleifer, 2010). With the current Australian crisis, commercial banks’ lending capacity and willingness to lend has decreased due to increased risks. The central bank may directly acquire private issued securities such as commercial paper, corporate bonds, and Asset-Backed securities. Credit Easing would provide funds to business, increase market liquidity, reduce illiquid trading conditions and liquidity premium, and positively stimulate the economy. However, since most private sector assets purchased by the central bank are relatively risky, the central bank would assume a large amount of credit risk. Therefore with the implementation of Credit Easing, appropriate credit supervision should be employed to ensure the rationality of money flows.
Negative Interest on Excess Reserve
When the inflation is too low and the pace of economic recovery is extremely slow, the central bank may use a negative interest rate policy. This implements this policy, the central bank charges fees for the excess reserve of financial institutions, meaning financial institutions have to pay for the privilege of investing in safe government bonds (The Japan Times, 2019). Japan adopted a negative interest rate policy in January 2016, and the Japanese central bank adjusted the interest rate to negative 0.1%, which means that the central bank will charge financial institutions for the excess reserve of financial institutions 0.1% interest (Ibid). Australia could emulate the policy adopted by Japan and offer negative interest rates to the excess reserves of financial institutions. This will discourage commercial banks from investing in safer bonds, but to invest in the financial markets causing increases in market liquidity, allow the market to recover, and the stimulation of the economy and aggregate demand.
Lowering the Exchange Rate
The central bank may also use the method of lowering exchange rate to stimulate the economy. The central bank may regulate the exchange rate by engaging in international financial transactions. The central bank would sell its own currency or buy foreign exchange assets to increase the supply of its own currency in the foreign exchange market, thereby reducing the value of the Australian dollar. The depreciation of the Australian dollar would make Australian products more competitive internationally, increase Australian exports, and increase the balance of payments (Mishkin & Serlitis, 2019). Additionally, engaging in downward exchange rate manipulation would expand investment in Australia’s export industry and boost Australia’s economy due to the lower prices foreign countries would have to pay.
3. Monetary Policy Implementation
Conventional monetary policy
Lowering the short-term interest rate.
In Australia, the policy interest rate used for conventional monetary policy is the ‘cash rate’, with the Reserve Bank Australia changing the cash rate to influence aggregate demand that is consistent with its inflation target and efforts to maintain full employment. (Reserve Bank of Australia, 2020). To prevent coronavirus-driven recession, the Reserve Bank of Australia has announced to cut their short-term interest rate about 0.25% (Khadeem, 2020; RBA, 2020). This is because the Australian economy continues to experience a slowdown as panicked investors have withdrawn billions of dollars from their stock market. The RBA will keep the short-term interest rate (cash rate) at 0.25% until this policy can encourage full-employment and inflation to be more stable at 2-3% (Figure 3.1; RBA, 2020).
Moreover, the current condition of the Australian economy is predicted to cause the loss of many jobs (Khadeem, 2020). This policy follows classical Keynes (2007) theory that lowering interest rate will create an increase in real GDP (higher rate of economic growth) by increasing (C), (I) and (X-M) as presented in Figure 3.1 in the Appendix. In detail, lower interest rates have reduced loan-loss provisions, because they reduce servicing costs of debt and probability of default risk. This policy also increases non-interest income by improving the securities’ valuations. Furthermore, the short-term nominal rates drop has gone along with decreased real (inflation-adjusted) rates to negative levels (Borio & Hoffman, 2017).
Unconventional monetary policy
Forward Guidance
According to Keen, Richter & Throckmorton (2015), forward guidance is a policy related to the communication of monetary policy. Forward guidance could be calendar based. That is, it could be scheduled to end on a specific date. In the current crisis, “state-based” forward guidance is applied, meaning that the government announces that interest rates will not be increased until specific economic conditions are met (Reserve Bank of Australia, 2020b). A related motivation is to provide transparency about the central bank’s reaction and strategy for the market participants during this recession. This strategy is proved to be beneficial, particularly in reducing uncertainty (Ibid).
Quantitative Easing
Asset buying, commonly known as quantitative easing (QE), is the purchase of assets by the central bank from the private sector, where the central bank pays for it by creating a “central bank reserve”, or better known as the “printing money” policy (Reserve Bank of Australia, 2020b). This is a policy that accompanies the policy changes, especially the reduction in interest rates. This policy aims to lower interest rates on risk-free assets such as government bonds. Using quantitative easing, the central bank can indicate to the market that the interest rate will be kept low in the future, and will impact long-term bond yields.
In March 2020, the Reserve Bank of Australia had purchased 3-year government bonds with bond yields near the cash rate, aiming to inject liquidity into the market. (Cranston, 2020). The step of increasing aggregate demand is graphed on Figure 3.3b where quantitative easing increases the money supply, decreases the interest rate, and increases the aggregate demand.
The Reserve Bank of Australia stated that it will target the 3-year Treasury bond yield at around 0.25%, the lowest level in its history, and will start to purchase treasury bonds and semi-government securities in the secondary market on March 20 to achieve the aforementioned goals and attempt to correct mismatches in the market. In addition, the Reserve Bank of Australia will also provide the Ontology Banking System with a fixed interest rate of 0.25% and a three-year financing facility with a total scale of at least A$90 billion with the prerequisite that banks increase loans, especially to SMEs (Cranston & Shapiro, 2020).
Credit Easing
Credit easing is a policy applied by central banks to make credit and liquidity become available in times of financial stress. Credit easing increases supply of many by purchasing private-sector assets, such as corporate bonds and residential mortgage-backed securities (Bernanke, 2009). During the pandemic crisis, the Australian government through the RBA also bought A$15 billion mortgage-backed securities and other asset-backed securities within the next year which is expected to ease liquidity constraints (Pandey, 2020) The application of this policy follows the theory that by buying these securities will increase the money supply and encourage lending and investment so that it will shift the aggregate demand curve to the right (increasing aggregate demand) (RBA, 2020b).
Negative Interest Rate
Negative interest rate policy (NIRP) is a monetary policy where the central bank sets its target nominal interest rate at less than zero percent (Borio & Hoffman, 2017). The objective of this policy is negative interest rate drive borrowing costs lower and punish lenders that play it safe by hoarding cash and encourage them to use their money for consumption, saving and investment to increase aggregate demand (Ibid). This policy will incentivize banks to lend money more freely, and encourage businesses and individuals to invest, lend, and spend money rather than pay a fee to keep it safe. However, this policy has never been implemented in Australia because the long-term impact of the interest rate is very detrimental for depositors because they do not earn interest income, instead of being discharged by the bank for the money they deposit. This will cause people to choose to keep their money outside the banking system, for example, “keeping cash under the mattress” (Ibid).
Lowering the Exchange Rate
Exchange rate depreciation is the decrease in the exchange rate of one currency against the currencies of another country. This exchange rate depreciation will lead to cheaper export value and more expensive imports (Mishkin & Serlitis, 2019). The Australian government has also implemented a policy of reducing the exchange rate by 60 basis points to 72.40 per USD, even though the current AUD rate is the lowest in the last 11 years to increase aggregate