RBA Quantitative Easing: What exactly is it & how does it work in Australia?

Discussion in 'Property Market Economics' started by Redom, 31st Mar, 2020.

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  1. Redom

    Redom Mortgage Broker Business Member

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    Australia has joined much of the developed world and begun engaging in what is commonly known as 'Quantitative Easing' (QE).

    The purpose of this post is to unpack what QE is, how it works, unpack some common myths (and answer any questions).

    1. So, what exactly is the RBA doing?

    The RBA is making money ('printing') to purchase government bonds from the secondary market. The RBA have indicated they will buy however many bonds it takes to bring down the yield of 3 year government bonds down to 0.25% (the same as the cash rate on overnight funds).

    The bonds being purchased go onto the RBA's balance sheet. That is, RBA have transferred the money they created out of thin air to something real, government bonds.

    2. Why are the RBA doing this?

    The RBA are looking to add monetary stimulus to the economy, but can't reduce the cash rate any lower (it's already at its lower bound).

    They want to reduce interest rates across the economy and provide liquidity to financial markets too (to promote risk taking and economic activity).

    Given they can't lower the cash rate (that targets overnight funds rate), they've chosen to influence interest rates settings in other markets. Overall, this is far less powerful than actually changing the cash rate itself.

    3. So, where does the money that the RBA has 'printed' go?

    Contrary to popular opinion, they aren't dropping the money they're making into the street for the average Joe to spend. They also are not 'giving' the money to the government to give to Joe.

    Given the RBA are purchasing government bonds in the secondary market, it goes to the existing owners of these bonds.

    Financial market participants are the owners of these secondary government bonds. Government bonds are a very low risk asset, regarded as one of the safest assets in the world, particularly in Australia as one of 10 AAA government rated bonds in the world. They are a common asset owned by super funds, banks, etc.

    Therefore, the made up money is actually going into the hands of the owners of these secondary bonds. These bond owners have swapped their assets that they held for the RBA's printed money (cash).

    This cash injection to bond holders adds a lot of liquidity into the financial market.

    4. What happens to the price of government bonds?

    Given the RBA have chosen government bonds to purchase, they have added a LOT of demand for this product. This drives the price of the bond up (more demand, price rises!).

    Given the price of the bond has increased, the yield of the bond has fallen.

    Prices & yields have an inverse relationship. To think of this as a property investor, when the price of any real estate asset rises & the rental income remains the same, the rental yield falls. This is the same with a government bond asset.

    5. What impact does this have on broader interest rates?

    The governments interest rate on their debts is set by the government bond yield. This has come drastically down. This makes the ongoing cost of the governments debt lower.

    This has further consequences to wider interest rate settings too. The government yield curve impacts other interest rates in the marketplace, including the mortgage, consumer and business lending markets.

    Therefore, interest rates across the economy are coming down (particularly interest rates that are tied to longer time periods of the yield curve).

    6. Why are the RBA targeting government securities?

    In general, the RBA only want the safest assets possible on their balance sheet in first instance. They are not looking to take much risk with the assets they are purchasing. Other central banks around the world have also purchased mortgage backed securities, which reduces funding costs & provides direct liquidity to owners of these assets (and helps reduce origination costs for those who rely on mortgage securities to fund).

    7. What will happen with the government securities owned by the RBA?

    Eventually, the RBA will seek to take these bonds of their balance sheet, and 'sell them' back into the market. This will take 'money' out of the financial markets, and increase the cost of borrowing. This is similar to increasing interest rates.

    8. Does this mean that they are giving the money to the government?

    The RBA's printed money isn't going to the government. It is going to financial market participants, which in turns has the impacts noted above.

    9. So how are the government funding all of these policies (JobKeeper, etc)?

    The government can rely on its tax collections to fund its expenditures.

    When tax receipts are not enough, they can raise debt to fund their expenditure too. Government debt is viewed as a safe asset, particularly in Australia as it is one of 10 countries with AAA rated bonds.

    To raise debt, the Australian government issue primary government bonds (via AOFM). That is, the AOFM, on behalf of the government, sell bonds to the marketplace and raise cash. This cash is used to fund expenditures. That is, the government raises debt from financial markets to go and spend money.

    The RBA will not purchase this debt directly, but may purchase this from those who purchase the debt.

    10. So, will 'printing' money lead to hyperinflation?

    The impacts of QE on economic activity indicators is reasonably similar to cutting interest rates (albeit, usually not as powerful). Rate cuts technically should push up inflation around the edges.

    But inflation is a function of real demand. Real demand has fallen of a cliff, so inflation isn't really a worry at the moment. It will be very hard to get any meaningful inflation growth where economic demand falls of a cliff.

    Typically, where you get hyper-inflation from 'printing' money is when the government prints money to fund its expenditures (among other structural economic reasons). This is NOT happening in Australia.

    The government isn't printing money to fund its expenditure, it is BORROWING money. There's a very big difference in terms of its flow through to the real economy & inflation. When a government cannot borrow money any longer, it may need to resort to actions like printing money to fund its expenditure. This has happened in the past and history books have shown that this leads to inflation (hyperinflation).

    The Australian government can borrow money fairly easily - they can source funds from the the financial market by selling bonds (AAA rated).
     
    Last edited: 1st Apr, 2020
  2. obiuquido144

    obiuquido144 Well-Known Member

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    Another way to look at QE (and reserve banks' bond buying in general) - and some economists would say the correct way - is that it's an orchestrated mechanism through which one arm of a currency issuing government (the RBA) completes the government's spend (through the issue of currency - effectively bank notes in AUD) initiated by another arm of the government (the Treasury, which issued money or money-equivalent in the form of IOUs denominated in the government's money of account - bond notes in AUD), in a way that allows the government officials at the Treasury to maintain the doctrine that they are - independently of the RBA - "funding" government spending through "borrowing" and "taxes" (and working with a "budget"), i.e. using concepts and analogies of a private firm and household finance, rather than conceptualising the reality of a financially unconstrained sovereign currency issuing government.
    It's a way to achieve the necessary government spending (e.g. the JobKeeper) by issuing currency, but without needing a paradigm shift in the thinking of the treasury and other officials and public involved (like Redom above), which would then likely open other issues and moral debates about "printing money" and fear of hyperinflation which would be full of misunderstanding and could create an unnecessary conflict in society (people might e.g. demand politicians to overspend which could then actually cause inflation if it happened in an economy that's at real production capacity - far from the current situation where aggregate spending has plummeted and there are lots of idle - stood down etc. - real resources etc).

    In general some economists see the issuance of bonds by the Treasury as a monetary policy operation that drains excess reserves from the banking system to achieve that the overnight interbank interest rate doesn't drop to 0% because of a surplus of bank reserves (called "high powered money"). When the commercial banks can exchange their reserves that no other bank wants to borrow (i.e. priced at 0% interest) for a government bond that provides an above-zero yield they will exchange the reservers $-for-$ for the Treasury's (higher) interest-earning IOUs, the bonds. This is especially important in countries where the central bank doesn't provide a "support rate" - interest paid on extra overnight reserves that are left over after all interbank clearing has finished.
    When the market participants know that they can buy Treasury bonds from AOFM and immediately "flip" them for capital profit to the central bank that's openly engaging in a QE program (while for political reasons the reserve bank needs to keep the "we only buy in the secondary market" narrative to stay as far as possible from the morally dangerous notion of OMF - overt monetary finance) the firms serve as a happy intermediary, facilitate the government's operations and enjoy the capital gain.

    The world's monetary systems have operated like this only since 1971 so understandably there is a lot of misunderstanding between people, economists and policy makers who think and were taught in the old paradigm and who intuitively reach for the household finance analogy. One big exception monetary system is the Eurozone where the individual member countries are not sovereign issuers of currency, so their fiscal capacity is exactly as the non-modern theory would claim with one difference which is the ECB using its discretionary power to sweep up their bonds as necessary and indefinitely park them on its balance sheet with its QE programs like PSPP and the new PEPP. But a Euro member country could still default on its own "non-sovereign" Euro debt (however ECB would likely intervene "as much as it takes and as long as it takes" to prevent the breakup of the EMU). California or Victoria are in a similar situation because they issue bonds but they are just states that don't have the sovereign's power to issue the currency that the bonds are denominated in, so could theoretically default (rather than just mark up a number at the central bank's computer to create the money to pay the interest or to pay off the bond at the time it matures).

    L. Randal Wray: Modern Money Theory 2nd Edition (A Primer on Macroeconomics for Sovereign Monetary Systems)

    And our own Prof. William Mitchell provides the specific numbers further down in this article:
    The Australian government is increasingly buying up its own debt – not a taxpayer in sight

    Quantitative easing 101

    Money multiplier and other myths (best part of the article starts from the paragraph that first mentions "HPM")

    These economists and other people like Warren Mosler and Stephanie Kelton think of the RBA and Treasury as one "consolidated government" and see the relatively recent split of the bank away from the treasury as an unnecessary and misleading concept that only serves a political function. (Which could be actually very useful and important to ensure a stable "blind" society, incl. politicians who then don't have to be put in a position of moral hazard etc. But obviously they don't like that the science of economics suffers because of all the implications of this setup. They'd prefer to risk it, remove these veils, and try to evolve to a policy that leverages the opportunity that arose in 1971 for social causes like a universal Job Guarantee where the government would step in and offer to employ anyone who the private sector doesn't take - not unlike the current JobKeeper scheme, or for programs like the Green New Deal, universal healthcare, pensions etc. The political discourse would then be about where to focus spending the out-of-thin-air-created money and also where to withdraw the issued money from and at what magnitude - through taxes which reduce the inflationary forces by destroying the issued money and drive policy such as "make coal burning expensive").
     
    Last edited: 30th May, 2020
  3. DueDiligence

    DueDiligence Well-Known Member

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    So what is the outcome of pumping billions of dollars into an economy with no demand?
     
  4. ToBeFree25

    ToBeFree25 Active Member

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    zombie company..
     
  5. DueDiligence

    DueDiligence Well-Known Member

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    It’s not 2008, this is a solvency crisis, it’s not about liquidity.

    You can’t print demand, you can’t print jobs.
     
  6. ToBeFree25

    ToBeFree25 Active Member

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    hi,

    is it better to be debt free now ? or getting deeper into good debt ? seeing whats coming.. (money printing, lowest interest rate in the history)

    somehow we still need to pay back our debt to the bank, and if the money velocity start to catch up, our rent still lagging on the old yield.
     
  7. obiuquido144

    obiuquido144 Well-Known Member

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    People are not fired from their jobs and this prevents aggregate demand from dropping (which would then cause further job losses, further demand drop and so on in a cascading fashion).

    Scenario 1:
    1. A Big Fear causes an aggregate demand drop and companies are just about to fire some workers that they don't need since no one is buying these workers' work.
    2. Government chooses to intervene and pay the full wage of every worker who would otherwise be fired, for a period of 6 months, so these workers cost nothing to the companies and the aggregate demand doesn't drop further.
    3. Government with its monopoly currency issuing power (administered by a department called the RBA) identifies the affected workers, their net monthly wages and their bank account numbers. On the 15th day of every month, in the case of Joe, a clerk at the RBA marks up, out of thin air, $3125 to Joe's bank's (ANZ) reserve account with the RBA (i.e. on the asset side of ANZ's balance sheet) and also instructs ANZ to mark up a $3125 deposit on Joe's account (liability side of ANZ's balance sheet). The RBA also on their computer mark up a corresponding $3125 on the RBA's liability side of its balance sheet to balance the credit in ANZ's reserve account.
    4. After 6 months the RBA informs other government departments (e.g. the Treasury) that they've issued $18750 of money in the form of new bank reserves to Joe's bank and the Treasury reports this at the end of the accounting year as the government deficit spend. Joe got to keep his job and paid his mortgage, coffees, child's private school fees as he did before the Big Fear period and 6 months later fear the fear disappeared and everything is back to normal. The RBA has an accounting entry of $18750 that just sits there, for eternity, doing nothing but documenting the government spend into Joe's account during the Big Fear period.

    Scenario 2:
    1. A Big Fear causes an aggregate demand drop and companies are just about to fire some workers that they don't need since no one is buying these workers' work.
    2. Government chooses to intervene and pay the full wage of every worker who would otherwise be fired, for a period of 6 months, so these workers cost nothing to the companies and the aggregate demand doesn't drop further.
    3. Government with its monopoly currency issuing power (administered by a department called the RBA) identifies the affected workers, their net monthly wages and their bank account numbers.
    4. Government imposed political constraints on itself in how it handles things related to its currency and financial and spending matters. On the 1st day of every month, the Treasury issues a piece of paper that says "IOU 3125 RBA DOLLARS and will pay this sum to the holder of this paper on 1.X.2025 and will also pay 0.5% of $3125 to the holder on 1.X. every year between 2021 and 2025".
    5. Bankers and pension funds get an email about an auction of a treasury note for nominal 3125 RBA dollars and show up in front of the Treasury building (with an AOFM sign on it) the next morning. One of the bankers is a guy from UBS (who on the way to the auction stopped at the RBA's building, told the clerk "I want to withdraw $3200 cash from the UBS account" and got notes worth $3200). After a bit of bidding the banker from UBS l wins the auction, pays $3140 cash for the note to the Treasury clerk, puts it in his pocket and walks away.
    6. The treasury clerk goes to the RBA building with the cash, gives it to an RBA clerk and says "please deposit this to the Treasury account with the RBA".
    7. Ten days later, reserves in the banking system are running low because commercial banks are writing a lot of new loans for struggling businesses and need to back these loans up with capital (so that transfers between banks clear and the businesses can also convert the banks' dollar-denominated IOUs into RBA DOLLARS and withdraw these as notes from ATMs) and the reserve capital is becoming a bit hard to raise for the banks on the open market. The RBA's job is to help exactly with this situation and the clerk remembers that a UBS guy recently withdrew money to buy something, so he ring him up and asks "what did you end up buying with the money and would you sell that thing to me?". UBS guy says he got a treasury bond the other day and the RBA agrees to buy it for 3333 RBA DOLLARS and both parties agree that this time the RBA won't run its printing press to produce RBA dollar notes and that an electronic deposit entry on the central bank's computer will be sufficient for UBS.
    On the 11th the trade is completed and RBA's balance sheet now has an asset of $3140 Treasury's paper, and liabilities of $3333 to UBS and $3140 to Treasury.
    8. On the 15th day of the month, in the case of Joe, a clerk at the RBA deducts $3125 from Treasury's account and deposits $3125 to Joe's bank's (ANZ) reserve account with the RBA (i.e. on the asset side of ANZ's balance sheet) and also instructs ANZ to mark up a $3125 deposit on Joe's account (liability side of ANZ's balance sheet). So the RBA now have an asset of $3140 of Treasury's paper, and liabilities $15 to Treasury, $3333 to UBS and $3125 to ANZ's reserve accounts.
    9. By the 26th of the month, people and businesses have been saving and deleveraging by paying off loans, especially UBS customers, and UBS now has $3333 of reservers that it can't put to good use as capital for backing new loans and the RBA wants to target an 0.25% p.a. overnight rate but it's fallen to zero because no banks have a need to borrow overnight: the system is bursting at the seams with reserves (represented by UBS's $3333).
    10. On the morning of the 27th the Treasury and the RBA have their daily phone call where they coordinate what each is going to do today. RBA says "we need to drive the interest rate higher, either you guys issue some new bonds at good yields, or we'll sell a bond of yours we bought earlier in the month". They agree that Treasury will do nothing and the RBA will sell the nominal $3125 bond (for which it issued $3333) to drain some reserves out of the system so there is less oversupply of reserve dollars overnight and the price of reserve money/interest rate is not being pushed down because of that oversupply. RBA sells the bond to UBS who pay 3200 RBA DOLLARS for it from their reserve account. The RBA's balance sheet looks now like this: Assets nil, Liabilities $15 to Treasury, $133 to UBS and $3125 to ANZ (representing Joe's JobKeeper deposit equivalent in ANZ's reserve account).
    11. After 6 months the RBA informs other government departments (e.g. the Treasury) that they have $18750 of liabilities to Joe's bank, $15 to Treasury and $133 to UBS. Treasury informs the public that they deficit spent $18750 by "borrowing" from UBS and other institutions and the public. The treasurer says in an emotional interview that "one day, we or our children will have to pay this debt back and there will be austerity we'll have to have, but what's important is today and how great I managed these 6 months of winning the battle with fear". Joe got to keep his job and paid his mortgage, coffees, child's private school fees as he did before the fear period and 6 months later fear the fear disappeared and everything is back to normal. The RBA has an accounting entry of $18750 that just sits there, for eternity, doing nothing but documenting the government spend into Joe's account during the Big Fear period.
    12. For the next 4 years, UBS is holding a Treasury note and collecting risk-free interest. In the 5th year a recession hits, the banking system needs liquidity/reserves and the RBA buys the nominal $3125 from UBS for the second and final time, marks up $3269 on their computer out of thin air as a deposit in UBS's reserve account, marks up a $3200 (or is it 3269?) on the asset side of its balance sheet and then puts the Treasury paper in a drawer in a clerk's desk.
    13. On 1.X.2025, an RBA clerk pulls out the paper out of the drawer with the left hand and reads... "I owe you"... and then he suddenly stops as he needs to go to the toilet. Once finished and having washed his hands, standing in front of the big bathroom mirror, he pulls out the paper again, and reads - still standing and looking at himself in the mirror, and in his capacity as a sovereign currency issuer authorised by the government - he reads "I owe you 3125 RBA DOLLARS and will pay this sum to the holder of this paper on 1.X.2025". He looks at himself in the mirror again, says "I owe you" again, laughs (as he's done many times before), looks at the piece of paper and thinks that after five years of battering and changing hands it's looking a bit sad. But no, he doesn't crumple it and he doesn't throw it in the paper towel bin, like some kind of bully! Instead he tells the paper "you've done a good job mate", and because he's a well trained government employee, instead of chucking the paper in the bin, he takes it down to the office in the basement of the RBA building and puts it on a pile of worn out bank notes to be shredded by the day's end, professionally.
    The next morning, when looking at the 10,000,000 RBA DOLLARS worth of bank note IOUs that just came out of the printing press, he tries to imagine a possibility if perhaps the 3125 RBA DOLLARS' worth from the yesterday's IOU which he presented to himself to clear could perhaps "live on" in some of those 10 million. But the only thing his smart and well paid brain can think of is that with the capacity he is looking at this clearly doesn't matter. And smiles again.

    Some economists would argue that 4 steps is better than 13 for achieving an identical outcome.
     
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  8. DueDiligence

    DueDiligence Well-Known Member

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    So , doe this then fix the underlying economic problems going forward? The entire process just kept everyone solvent. But for what?
     
  9. DueDiligence

    DueDiligence Well-Known Member

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    It would appear right now, the more debt the better.

    To say the same thing in a different way.

    Be as vulnerable as the masses.The lowest common denominator sets the standard
     
  10. obiuquido144

    obiuquido144 Well-Known Member

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    Debt and borrowing as a concept only applies to entities that don't control the issue of the respective unit of account/currency of the IOU: a household, a firm, or a Euro or another country that borrows in foreign currency.

    It doesn't apply to a sovereign government finance on financial instruments denominated in such government's own curency. A government can't be in debt with itself in its own IOUs, a government can't borrow from itself (Treasury department can't borrow from the RBA department, they are part of the same accounting identity - the same consolidated government that has the monopoly control of the creation and destruction of its currency. The idea of A borrowing from A or G being in debt to G, or I being in financial debt to myself is non-sensical, say some economists).
    What applies to a government is a technical term called deficit, which is simply the rolling tally of the difference between the amount of all currency issued and all currency returned/destroyed through taxes.

    So right now the deficit serves a good purpose of keeping people in jobs, in the future it could serve a public project of building a Sydney to Melbourne high speed rail, or putting people on rockets to Mars.

    As long as the government issuing money and buying real assets with it from the private sector (worker's labour, planes etc.) doesn't cause inflationary forces due to overbidding for real resources in a situation of having reached the economy's full real production output capacity there is no issue with any particular size of deficit money issue.
    Moreover, in aggregate it's a self moderating system, say these economists: larger deficits stimulate the economy, leading to a larger financial wealth in the private sector and thus more taxes collected, resource allocation then shifting more into the wealthier private sector, or vice versa like we're sort of experiencing now during Covid with JobKeeper recipients effectively becoming government employees for a period of time with the private sector in hybernation, but with the aggregate demand in the system not being higher than say 6 months ago, so inflation staying more or less the same and quite likely lower.

    There's a distilled 6 minute video on the bond existence issue and also touching on the things above
     
    Last edited: 31st May, 2020
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  11. John_BridgeToBricks

    John_BridgeToBricks Buyer's Agent Business Member

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    Great post.

    Just a small point which doesn't get made enough but feels relevant here: what is "money" vs "currency".

    "Money" is a store of value as well as a medium of exchange. Money is gold and silver only.

    "Currency" is a medium of exchange but not a store of value.

    Governments and central banks can print currency (or debt), but they can't print money.

    The quote “Gold Is Money, Everything Else Is Credit” is from JP Morgan himself while testifying in front of Congress back in 1912 shortly before his death.

    I think we are going to re-discover the difference between money and currency the hard way when this is all over. Real estate folks are in a good place to weather what is coming.
     
  12. obiuquido144

    obiuquido144 Well-Known Member

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    These economists would disagree with everything you said John! :)
    But yes, the distinction between financial wealth and real wealth is important. But typically these are convertible between one another. Some people think, and there have been cases in the past, that the convertibility is at a much higher risk of disappearing than other people believe.
    I personally believe in about 50:50 ideal allocation split between property and equities in my portfolio but every sane investor holds what they understand and what matches their psychological profile which is as it should be. The important thing is we invest :)
     
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  13. John_BridgeToBricks

    John_BridgeToBricks Buyer's Agent Business Member

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    True, although I didn't say property was the only way to weather a currency debasement, just a reliable one. You certainly benefit from the liquidity of equities, and you also have the option to reinvest dividends, which magnify gains over long periods of time.
     
  14. John_BridgeToBricks

    John_BridgeToBricks Buyer's Agent Business Member

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    Plus, most modern economist are Keynesians and don't know what they are talking about....
     
  15. albanga

    albanga Well-Known Member

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    @Redom very detailed post as always but I just have three questions which the post doesn’t clarify.

    1 - Your post suggests this is the RBA’s new shots fired over lowering the cash rate. So I read that as this is the lowest rates are possibly going to go. We will definitely not see the RBA reduce this further??

    2 - If 1 is correct then the 2.09% on offer for some lenders to fix is actually the lowest you may ever see rates....Ever

    3 - Most importantly if you were explaining this to 95% of people in the world the answer would be. “Yeah that’s all well and good, but what does it mean for me?”.
    Let’s break that down further. What is it that almost all people care about for wealth.
    I would say they are:
    1 - A job.
    2 - The value of their house (which is most peoples only asset)
    3 - Their super

    So what do you believe will happen to each of these 3 categories as a result of QE?
     
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  16. DueDiligence

    DueDiligence Well-Known Member

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    Agree , I’m interested too, all we have to do is look at the last decade to see QE inflates assets, reduces yields and destroys price discovery. Its resulted in a larger gap in wealth inequality , driven wage growth down and put equities in a bubble.
     
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  17. Melbourne_guy

    Melbourne_guy Well-Known Member

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    I doubt the Govt care about wealth inequality too much. It's dressed up to the masses as an 'aspirational goal' and provided the revolution is avoided, the can keeps being kicked further down the road.
     
  18. Beano

    Beano Well-Known Member

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    So the $64k question I have " is do I increase debt (buying more investments ) or repay debt (from profit and sales) ? "
     
  19. Redom

    Redom Mortgage Broker Business Member

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    1. RBA has indicated negative interest rates unlikely. Doesnt mean they can't lower rates further.
    2. No I don't think it will be (ever is a long long time!)
    3. The same impacts are similar to any other rate cuts, even though the transmission mechanism & target rate is different: helps support economic activity, helps asset values. Reduces the value of cash itself though, so those super funds that just hold cash will earn lower returns. It promotes risk taking, i.e. using cash to take on riskier assets.
     
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  20. ttn

    ttn Well-Known Member

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    I have no economics or market or industry knowledge so dont know about no 1 and 2 but for the contestant no 3, i reckon

    1. More jobs created are coming up
    2. House price will appreciate in value because more people are employed so they tend to have more demand in housing
    3. Super values will go up because more investments are pouring in so should be more returns in terms of profits, dividends and etc

    Just look at the US after they had been doing QE in the last few years - more jobs, house price increases and the dow jones goes off to record high ;) my 2c

    and thanks to Redom and obiuquido144 for easy to understand govt bonds, QE, Treasury & RBA roles