Roy Davidson, 2 June 2020

With COVID-19 hitting the economy hard, the Reserve Bank of New Zealand has very quickly embarked upon quantitative easing (known commonly as ‘QE’). In this article we answer some of the key questions you may have about QE.

Before we get into it though, it is useful to remember what a central bank, like the Reserve Bank of New Zealand, does. A central bank is in charge of setting the monetary policy for a country or region. The ultimate goal of monetary policy is to keep the wheels of the economy turning without it overheating. To do this, most central banks target a rate of inflation (usually around 2%) while seeking to maintain financial stability.

The main tool used by central banks is the benchmark interest rate – in New Zealand this is the Official Cash Rate, or OCR. A lower OCR results in reduced interest rates across the economy, spurring activity and driving growth and inflation. On the flipside, a higher OCR increases interest rates, constraining economic growth and inflation. However, if such ‘conventional’ measures aren’t working as hoped, a central bank may opt for so-called ‘unconventional’ measures, of which QE is the most prominent.

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What is QE and how does it work?

QE essentially involves a central bank creating new money and using it to buy existing financial assets, usually government bonds (debt issued by the government). This extra demand for bonds drives up the price, thereby lowering the bonds’ yield (or rate of interest you receive on the bond). The yield on government bonds is a key benchmark for other interest rates in the economy. As a result, lowering the government bond yield lowers interest rates across the economy. This incentivises businesses to invest and take on more risks, as well as consumers to spend more, boosting economic growth.


So, it’s money printing?

In a roundabout way, yes. The Reserve Bank is injecting new money into the economy to spur growth. However, it’s important to note that the Reserve Bank is making its purchases on the secondary market and not directly providing the money to the Government.

Why does the Reserve Bank feel we need QE?

In 2008, just before the global financial crisis (GFC), the OCR stood at 8.25 per cent. Less than a year later the Reserve Bank had cut it to 2.50 per cent, 5.75 percentage points lower.

At the start of this year, just before COVID-19 reared its head, the OCR stood at 1 per cent. Any cuts of a remotely similar magnitude to the global financial crisis would have taken it well into negative territory – beyond what’s feasible. The Reserve Bank had simply run out of bullets.

So, with economic growth taking a hit, inflation likely to fall well below the 2 per cent target, and bond markets highly unsettled, the Reserve Bank looked to ‘unconventional’ monetary policy to provide the monetary stimulus the economy needed, and opted for QE.

With the OCR at 1 per cent, the Reserve Bank had few bullets to fire

With the OCR at 1 per cent, the Reserve Bank had few bullets to fire

How big is the Reserve Bank’s QE programme?

Big. The Reserve Bank will buy up to $60 billion worth of bonds over the next year. This is equal to 20 per cent of New Zealand’s gross domestic product (GDP) and roughly the same size as the total fiscal stimulus we’ve seen from the Government.

For comparison, after several rounds of QE over many years, the US Federal Reserve’s ‘balance sheet’, or the value of the assets it owns, is equal to around 35 per cent of US GDP, though this will increase in the future as the Federal Reserve has committed to undertake ‘unlimited’ QE.

What will the Reserve Bank buy?

Initially, the Reserve Bank announced it would buy New Zealand government bonds. However, this was subsequently expanded to include the purchase of up to $3 billion in local government bonds to help settle that market as well.

While not presently included in the programme, the Reserve Bank has also discussed potentially buying foreign government bonds. While the Reserve bank would be a small buyer of these bonds and unlikely to move the dial, the fact that it would need to convert NZ dollars into foreign currency to make the purchase would lower the NZ dollar, providing a boost to exporters.

Has QE been tried before?

In New Zealand, no. In other parts of the world, yes. The Bank of Japan adopted an early form of QE in the 2000s. Since the global financial crisis, many central banks have used the policy including the US Federal Reserve, the European Central Bank, the Bank of England and the Swiss National Bank.

Can it be unwound?

Theoretically yes, but this has proved hard to do in practice and is one of the main criticisms of the policy. If undertaking QE is like printing money, unwinding QE is like shredding it. This ‘tightening’ puts a major handbrake on the economy and unsettles markets, as we saw in late-2018.

How will we know if QE has worked?

In a way, we can say QE has already worked. Markets, including the bond market, are much more settled now than they were in March when the policy was first announced. However, ultimately, the key mark of success is if the economy can rebound from COVID-19 and the Reserve Bank can begin to unwind the policy.

Is QE the same as negative interest rates?

Both are seen as ‘unconventional’ monetary policies and basically have the same goal. However, both are quite different. Negative interest rates, as the name implies, involves cutting the OCR below zero per cent. It is effectively just the next step from conventional OCR cuts.

Negative interest rates are, in fact, the preferred tool of the Reserve Bank. It was essentially the speed at which COVID-19 rattled markets, and the banking sector’s operational unreadiness for negative interest rates which saw the Reserve Bank favour QE. We may well still see negative interest rates in the future.

It is important to note that negative interest rates wouldn’t result in negative retail interest rates (i.e. term deposits or mortgage rates). In places where negative interest rates have been tried (for example in Europe), these retail interest rates have bottomed at zero. The negative interest rate is effectively a wholesale rate designed to encourage commercial banks to lend more. However, real returns from cash (i.e. after tax and inflation), could very well become negative.

Will QE result in higher inflation?

That’s the goal to a certain extent. Part of the reason the Reserve Bank has opted to use QE is it foresees inflation falling below its target due to the weaker economic activity caused by COVID-19.

Near-term, the sharp impact on growth and spike in unemployment is deflationary – less activity means less upward pressure on prices. This is likely to exceed any inflationary impact from QE and inflation should undershoot the 2% mark for some time.

Beyond this, it’s hard to say. On the face of it, a rebounding economy with record low interest rates and high degree of central bank support should be inflationary. However, inflation has been stubbornly below target since the GFC, contrary to the expectations of many, and the key drivers of this (an ageing developed world population, technology etc.) could very well result in inflation continuing to undershoot the mark.

What does QE mean for my investments?

At the end of the day, whatever monetary tool the Reserve Bank implements, be it QE or negative interest rates, one thing is for certain – interest rates are going to be lower for longer. So, what does this mean?

With lower and lower rates on offer, the return investors can earn on cash is set to fall further. On the other side of the coin, low interest rates are very supportive for asset prices, including equities.

However, the disruption caused by COVID-19 means it’s more important than ever to be selective. Investors should focus on quality companies with clear growth opportunities, and those with defensive earnings, consistent cash generation, and pricing power. Pricing power refers to the ability of a company to maintain its prices in tougher times or increase them in-line with higher costs, thereby protecting profits.