RBA prepares for ‘fire drills’ to deal with the next COVID-like crisis

The Reserve Bank has revealed it may cut interest rates deeper and more quickly to soften the hit caused by shocks such as the pandemic recession rather than print money, as it plans to run “fire drills” to test how it would deal with another economic earthquake.

The bank’s assistant governor for financial markets, Christopher Kent, this morning said the pandemic – during which the Reserve took official interest rates to 0.1 per cent and pumped almost $500 billion into the economy – had confirmed the importance of looking at other ways to support the country.

Elements of the bank’s handling of the crisis have been criticised, including the amount of stimulus it produced, its so-called “forward guidance” under former governor Phil Lowe that interest rates were likely to stay around 0.1 per cent into 2024 and the winding up of programs that had been put in place during the pandemic.

Kent, releasing a set of new guidelines for how the bank would deal with a period of low interest rates, said cuts in rates remained the RBA’s first port of call when facing disinflation or economic downturn.

But he said in the future, the Reserve may be more aggressive with rate cuts as this may reduce the need for more creative and non-traditional measures.

“More broadly, when interest rates are already low, the [bank] may have less tolerance for inflation falling below the 2 to 3 per cent target,” he said.

“In those circumstances, it may consider responding earlier and more decisively to disinflationary shocks by pre-emptively lowering the cash rate target.

“Such a response may reduce the need to rely on alternative tools. But they can still provide valuable support in extraordinary times.”

Kent cautioned that while cutting rates was the best way to support the economy, it became more difficult as the Reserve Bank had interest rates at an already low level.

Before and during the pandemic, some central banks took interest rates negative. Kent said while this remained an option for the RBA, they were “deeply unpopular” in countries where they had been used and could add to systemic financial risks.

A key element of the bank’s response to the pandemic was to buy federal and state government debt with money it created.

Before COVID, the bank held just $12 billion in government bonds. By February 2022, it owned $355.9 billion of government debt, including $288.1 billion in federal debt.

This has gradually fallen but even now, the bank holds $230 billion in government debt. Of that, $177 billion is federal debt, while it holds large quantities of state debt including NSW ($13.3 billion), Victoria ($12.7 billion), Queensland ($14.9 billion) and Western Australia ($5.2 billion).

The vast holdings of the debt, however, have hit the bank’s bottom line. In 2021-22, the bank reported a record loss of $37 billion due to the drop in the value of the government bonds.

Kent said in the future, the purchase of government debt was likely most useful during a financial shock such as the global financial crisis rather than during a period of falling demand across the economy.

“Experience suggests that in Australia, government bond purchases are most effective as a targeted tool to restore market functioning in periods of stress,” he said.

“In some circumstances, they can also be effective at easing financial conditions and supporting economic activity, but their use should be guided by the limits and associated risks of such purchases.”

During the pandemic, the bank was heavily focused on the possible economic costs to the country. Most central banks, including the RBA, were surprised by the fast recovery, which contributed to a global surge in inflation.

Kent said this showed there was value in testing a wide range of economic scenarios, including a faster-than-expected recovery. If that had been done during the pandemic, the bank may not have extended its $188 billion support program for commercial banks.

“Exit strategies need to be considered from the outset. There can be a trade-off between effectiveness and flexibility,” he said.

“A strong commitment may make a tool more stimulatory, but also much harder to unwind if the economy evolves differently from expected. We would set out how the exit would be determined as part of the design of any tool or package.”

Kent said the bank, including the committee which sets interest rates, would go through a series of “fire-drills” to test how it would make decisions “under time pressure and with incomplete information”.

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