Think Big: Here’s how the RBA creates e-money ‘out of thin air’
Link copied to
The practice of quantitative easing by central banks is sometimes referred to as ‘printing money’.
The phrase brings to mind rows of printing presses at RBA headquarters, churning out fresh $100 notes for the bank to buy bonds with.
That doesn’t happen. But in an explainer on the topic, CBA credit strategist Belinda Cheung said Australia’s central bank does “have the power to create e-money out of thin air and use this e-money to pay for stuff (and assets)”.
The RBA launched QE in November, announcing plans to buy $100bn of government bonds as part of efforts to foster more liquidity in the financial system.
Earlier this month, RBA governor Phil Lowe said the bank will buy an additional $100bn of bonds once the current program expires in April.
When Cheung says the RBA creates e-money “out of thin air”, technically she’s referring to Exchange Settlement (ES) balances (which only exist electronically).
That’s important because ES balances are amounts held by financial institutions at the RBA. They exist within their own ecosystem, which is completely controlled by the central bank.
“It’s really important to understand that the ES balances created by the RBA cannot be directly deposited into your bank account,” Cheung says.
“ES balances only exist in the ecosystem created by the RBA.”
And the more ES balances there are, the more liquidity there is in the financial system — but they can’t ever leave the central bank.
So with ES balances in mind, what does the RBA mean when it says it’s buying $100bn worth of bonds?
For starters, the RBA really does create a new ES balance “out of thin air”. And theoretically, it could make as many as it wants.
It then uses the ES balance to buy government bonds. The next crucial step is that it only buys bonds in the ‘secondary’ market (as opposed to the primary market).
Primary markets relate to new issues. So when the government issues a freshly minted bond, it sells them to the initial buyer in the primary market.
The key point to note is that for the purposes of its QE program, the RBA is never the initial buyer.
That would be walking directly down the path of MMT policy — an idea Lowe has poured cold water on in the past.
Instead, the RBA buys bonds in the secondary market from groups that already own them. That could be, say, a large offshore financial institution.
Another critical point to understand is how the RBA accounts for that process — creating new ES balances and buying bonds.
The ES balances are recorded as a liability, and the bonds are recorded as an asset.
So the overall size of the RBA’s balance sheet has increased, with a commensurate rise in assets and liabilities.
Recall that the RBA’s ES ecosystem is tightly controlled. Which means that the initial buyers of government bonds in the primary market are “unlikely” to have an ES account with the central bank, Yeung said.
Instead, they need an intermediary — typically in the form of a large Australian commercial bank which has an ES account.
The ES balance that the RBA created (as a liability) is transferred to the commercial bank, which records it as an asset.
The commercial bank matches those new ES balances with deposits. Those deposits are the funds paid to the initial bond buyer in the primary market, for selling its bonds to the RBA.
The net result is that the overall pool of assets and liabilities in Australia’s financial system expands.
Why is the RBA doing it? When the bank launched QE back in November, it said the focus of purchase program “will be bonds with residual maturity of around 5 to 10 years”.
Governor Lowe indicated that QE is designed to work in concert with the RBA’s yield curve control (YCC) program, which keeps 3-year government bond yields capped at 0.25 per cent.
Therefore, focusing QE on longer-dated bonds will serve to “lower the whole structure of interest rates in Australia”, the RBA said.
“This lower structure of interest rates will work to support the economy through the normal transmission mechanisms, including lower borrowing costs, a lower exchange rate than otherwise and higher asset prices.”