QE, the collapse of the money multiplier, and the bond multiplier

In a new report published today we argue that this year has seen a sea change in the operation of monetary policy in Australia with the Reserve Bank adopting several unconventional measures that have been part and parcel of its peers’ policy toolkits since the global financial crisis. With the cash rate now at the Reserve Bank’s self-imposed effective lower bound of 0.1%, the bank’s balance sheet – its size, composition and term structure – is now the better measure of the stance of policy because it captures the impact of quantitative easing (QE) and cheap loans to banks made under the Term Funding Facility (TFF).

QE and the TFF should see the Reserve Bank’s balance sheet almost triple to about 27% of annual GDP by Q2 2021, with the bank likely to own 20% of the combined Commonwealth and semi-government bond market, which is still relatively small compared to some peers overseas. QE can promote easier financial conditions via several channels, the most important of which is the portfolio balance effect, where a central bank’s purchase of bonds is the catalyst for investors to rebalance their portfolios and search for higher-yielding assets, leading to lower bond yields and higher asset prices. 

The expansion of the Reserve Bank’s balance sheet involves sharply higher exchange settlement (ES) balances, which are the reserves banks hold at the Reserve Bank to settle transactions between themselves, the Reserve Bank, and the Reserve Bank’s clients. Some market participants believe in “the money multiplier”, which states that this increase in reserves will significantly boost the money supply via the successive lending and redeposit of excess reserves. However, this old-fashioned view does not fit the facts of a modern economy, where money is most often created when a bank creates deposits to write a loan, such that the money multiplier has collapsed both in Australia and abroad. 

Instead, it seems likely that there is a bond multiplier from large and growing ES balances, where transactions have almost dried up in the interbank cash market with large balances serving as a buffer for banks’ cash needs. Balances no longer earn interest and the loss of bank profits provides an incentive for banks to “recycle” them by either buying Commonwealth and semi-government bonds and/or paying down liabilities. Bernanke called this the “hot potato” effect when discussing QE in the US, where reserves can only be recycled between banks given system-wide interbank cash is fixed by the central bank.

While international research into this effect has been limited, a detailed study of European banks showed banks responded to the European Central Bank’s QE-driven surge in reserves by buying domestic government bonds and paying down a range of funding sources. Although we could not replicate this work given the required detailed bank data are not publicly available in Australia, it seems likely to us that the huge increase in ES balances will trigger more active management of reserves by banks, with this recycling effect reinforcing the more well-known portfolio balance channel in placing downward pressure on both Commonwealth and semi-government bond yields.  This is likely to be welcomed by the Reserve Bank given its desire to reduce upward pressure on the Australian exchange rate resulting from our globally elevated long-term government bond yields while reducing debt servicing costs for both the Commonwealth and state governments at a time when they are pursuing expansionary fiscal stimulus to reduce labour market slack created by the pandemic.

Please click here to download the full report.