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 Reserve Bank's official interest-rate target — essentially the overnight rate banks charge one another. The Reserve Bank board meets (generally on the first Tuesday of every month except January) to set the cash rate as the stance of monetary policy.
The Reserve controls the cash rate by managing the supply of funds in the overnight interbank market. It uses open market operations (now mainly repurchase agreements or 'repos') to add or remove just enough funds so markets clear at the target cash rate, and it sets incentive rates around the cash rate to steer banks' behaviour.
Every bank has an exchange settlement account at the Reserve Bank and most transactions flow through these accounts. The Reserve requires banks to keep positive balances in them. Banks that leave funds overnight earn interest at 0.25 percentage points below the cash rate, while banks that need to borrow from the Reserve pay 0.25 points above. Those incentives encourage banks to lend to each other at the cash rate, helping the Reserve hit its target.
Historically the Reserve changed cash supply by buying or selling government bonds with banks. These days it achieves the same outcome mostly through repurchase agreements (repos), which temporarily inject or withdraw funds from banks' exchange settlement accounts to keep the overnight rate at the target.
The federal government is the Reserve's biggest banking customer. On days when tax receipts exceed government payments, demand for exchange settlement funds rises; when payments exceed receipts, demand falls. Those flows cause day-to-day swings in demand that the Reserve offsets to keep the cash rate stable.
Mortgage and other bank lending rates are based on the expected path of the cash rate over the loan plus margins for various risks and profit. Since the global financial crisis those margins have been more volatile — banks need more long-term, domestic funding and charge higher spreads — so changes in the cash rate often translate into smaller or uneven changes in mortgage rates.
Longer-term lending rates are effectively the average expected cash rate over the life of the loan plus risk premia (for repayment risk, term risk, etc.) and profit margins. Banks could fund via the overnight market, but they carry extra margins to cover those risks and funding costs.
It means the cash rate remains the anchor for other interest rates — the Reserve still has strong control over the interest-rate environment. However, market lending rates that affect investors and borrowers may not move one-for-one with the cash rate because banks' funding costs and risk spreads also influence the rates consumers actually pay.
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