Cash rate is king and Reserve still holds all the aces
Fortunately for all of us, this impression was wrong. That so many people came to this conclusion showed their grasp on the mechanics of monetary policy (the central bank's manipulation of interest rates to influence the strength of demand in the economy) was shaky.
But this week one of the Reserve's assistant governors, Dr Guy Debelle, gave us all a little tutorial in a speech to a business school breakfast.
On Tuesday (and on the first Tuesday of every month bar January), the board of the Reserve meets to determine the appropriate "stance" (setting) of monetary policy. The decision takes the form of a target for the official rate (known in the trade as the "cash" rate). Sometimes the target is moved down a little, sometimes up a little, but mainly it's left where it is.
How does the Reserve unfailingly achieve the target? Settle back. The cash rate is the interest rate the banks charge each other to borrow and lend funds overnight.
Every bank has an account with the Reserve called its "exchange settlement account". Just about every monetary transaction in the economy goes through these accounts. As Debelle explains, when you pay your electricity bill by direct debit, the funds are effectively transferred from your bank account, across the exchange settlement account of your bank to that of your electricity company's bank and into the electricity company's account.
All these transactions mean the balance in each bank's exchange settlement account goes up and down throughout the day. But the Reserve requires each bank to ensure its account always has a positive balance. Banks that leave funds in their account overnight are paid interest at a rate 0.25 percentage points below the cash rate, whereas banks that look like having a negative balance may borrow the difference from the Reserve overnight at a rate 0.25 percentage points above the cash rate.
Get it? These penalties are designed to encourage the banks to borrow and lend to each other overnight at the (more attractive) cash rate.
The Reserve's ability to control the cash rate arises because it has complete control over the supply of funds in this market. It ensures there is just sufficient supply to meet the demand for funds at the interest rate it is targeting.
Where an increase in demand threatens to push the interest rate up, it will use its "open market operations" to increase the supply of funds just sufficiently to keep the rate where it wants it. Where a fall in demand for funds threatens to push the rate down, the Reserve will reduce the supply to ensure the rate doesn't change.
Historically, the Reserve would increase the supply of cash by buying second-hand government bonds from the banks and paying for them with cash. (Note that in this context, "cash" doesn't mean notes and coins, it's a nickname for the funds in exchange settlement accounts.)
Conversely, it would reduce the supply of funds by selling bonds to the banks, which they had to pay for from their exchange settlement accounts. These days, however, the Reserve achieves the same effect using repurchase agreements ("repos").
The main reason for fluctuations in the overall daily demand for exchange settlement funds is transactions involving the Reserve's one big banking customer, the federal government. Demand will rise on days when the government's receipts from taxation exceed its payments of pensions and all the rest. Demand for cash will fall on days when the government's payments exceed its receipts.
All this ensures the Reserve has a vicelike grip on the cash rate. And this gives it the ability to influence all the other interest rates in the economy. Why? Because the cash rate is, in effect, the anchor point for all other rates.
Banks fund only a very small part of their operations in the cash market, Debelle explains, but all their funding could be done from that market if they wanted to. The rate at which they're prepared to borrow for periods longer than overnight is the averaged expected path of the cash rate over the life of the loan plus various margins for risk.
If this were not the case, a bank would be better off borrowing all the funds it needed in the overnight cash market and rolling them over every day.
The reason banks borrow and lend at rates higher or lower than the average expected cash rate over the life of the loan is the need to allow for the various risks involved (the risk of not being repaid, the risk in agreeing to lend your money for a longer time, and so forth) and, of course, profit margins along the way.
For several years leading up to the global financial crisis, these various margins (known as "spreads" or "premia") didn't change much, meaning a change in the cash rate brought about an identical change in mortgage and other bank lending rates.
Since the crisis, however, margins have been changing a lot, as a result of people realising they weren't charging enough to cover the risks they were running, and our banks realising they needed more domestic, retail and longer-term funding to protect them against future crises, leading to intense competition between them to attract term deposits.
The net effect has been that the banks' borrowing costs have risen more (or fallen less) than the cash rate has, causing changes in, say, the mortgage rate, to be less generous than changes in the cash rate and thus widening the margin between the cash rate and the mortgage rate.
The Reserve has allowed for this shift in margins, cutting the cash rate by more than it would have so as to ensure market interest rates - the rates people actually pay - are where it wants them to be.
Its influence over market rates thus remains undiminished. And that's because the cash rate remains by far the most powerful influence over other interest rates - though, as we've seen, not the only influence.
Twitter: @1RossGittins
Frequently Asked Questions about this Article…
The cash rate is the overnight interest rate banks charge each other to borrow and lend funds. The Reserve Bank board meets regularly (usually the first Tuesday of each month, except January) to set a target for this rate because the cash rate acts as the anchor for other interest rates in the economy and helps the central bank steer demand through monetary policy.
The Reserve controls the cash rate by managing the supply of funds in the overnight market. Every bank has an exchange settlement account at the Reserve, and the Reserve uses open market operations (now mainly repos) to ensure there is just enough supply to meet demand at the target rate. It also pays or charges interest on overnight balances at 0.25 percentage points below or above the cash rate to encourage interbank lending at the target.
Exchange settlement accounts are the Reserve Bank accounts every bank uses to settle transactions. Everyday payments—like a direct debit for an electricity bill—move funds between these accounts, so the daily ups and downs in those balances are what the Reserve manages to keep the cash rate stable.
Repos (repurchase agreements) are short-term operations the Reserve uses to add or remove funds from the overnight market. They replace older practices of buying or selling government bonds from banks to increase or reduce cash in exchange settlement accounts, achieving the same effect on the supply of funds and therefore on the cash rate.
Banks price loans based on the expected path of the cash rate plus various margins (spreads) to cover risks and profits. Since the global financial crisis these margins have changed a lot—banks increased their funding costs and competition for longer-term retail deposits—so mortgage rates have at times risen more or fallen less than changes in the cash rate.
Yes. The Reserve retains strong influence because the cash rate remains the anchor for other interest rates. Even though banks set margins for risks and funding costs, the expected path of the cash rate is a central determinant of the rates banks charge over longer terms.
When banks' funding costs or the spreads they add to the expected cash rate increase, the rates consumers pay on mortgages and loans can fall less or rise more than the cash rate itself. That means a cash rate cut may not translate into equally large reductions in mortgage rates, and vice versa.
The federal government's receipts and payments are a major source of daily fluctuations in demand for exchange settlement funds. On days when tax receipts exceed government payments demand for funds rises; when payments exceed receipts demand falls. The Reserve accounts for these swings when managing supply to keep the cash rate at its target.
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