Bridging the Textbook Gaps on How the RBA Implements a Change to the Cash Rate | Teacher Updates | Education | RBA (2024)

One of the most commonly asked questions by educators has been about how the Reserve Bank ofAustralia (RBA) implements monetary policy. In particular, they are interested in understanding howclosely the actual process of monetary policy implementation matches the typical textbookexplanation. Practice differs from theory and there are some gaps in the explanations provided bythe typical textbook. This article aims to bridge these gaps by providing a stylised but morecomprehensive explanation of the process. It will also describe how the introduction ofunconventional monetary policy tools following the onset of the COVID-19 recession has affectedthe process.

Background

The RBA, the nation's central bank, is responsible for setting and implementing monetary policy inAustralia. The primary and conventional tool for monetary policy is the nation's policy interest rate(known as the cash rate). The Reserve Bank Board sets the target for the cash rate in the Australian cashmarket – the market in which banks lend to and borrow money from each other overnight. Changes inthe cash rate then flow through to other interest rates in the economy, influencing economic activityand ultimately inflation.^[1]

It is commonly described in textbooks that a policy interest rate is managed by a nation's central bankthrough the use of open market operations (OMOs).^[2]These operations involve the central bank buyingand selling bonds (typically government bonds) to inject cash into and withdraw cash from the financialsystem to influence the cash rate.

In Australia's case, this is true – but in practice there is more to the story. Essentially, prior to the COVID-19 recession, OMOs were typically used to manage the supply of cash (or liquidity) so that the RBA couldmeet demand and ensure that the cash rate remained consistent with the target the Board set as partof their monetary policy decision. This was done on a daily basis - regardless of whether there was achange to the cash rate target - and was often referred to as ‘liquidity management’. However, when the RBA didchange the target for the cash rate, this was achieved by shifting something knownas the ‘policy interest rate corridor’.

This article reconciles how the RBA has typically managed the cash rate in the past with standardtextbook descriptions. It will explain the workings of the policy interest rate corridor and the use ofOMOs to manage the supply of cash (liquidity) to keep the cash rate within this corridor and at target.It then describes how the RBA's policy actions following the onset of the COVID-19 recession hasaffected this process.

Some Things You Need To Know

The functioning of the Australian cash market

The Australian cash market is the market for overnight loans between banks. Theinterest rate in this market is called the cash rate.

After each meeting of the Reserve Bank Board, a target is set for the cash rate as part of the Board'smonetary policy decision. Before the onset of the COVID-19 recession, the RBA's Domestic MarketsDepartment was tasked with maintaining conditions in the Australian cash market to ensure that thecash rate target was achieved. This was done on a daily basis by managing the supply of cash. In thecontext of the Australian cash market, ‘cash’ refers to the Exchange Settlement (ES) balances that bankshold in ES accounts with the RBA in order to make payments to each other and the RBA.^[3]

There are four key aspects of the Australian cash market that are commonly referred to by standardtextbooks when describing the management of the cash rate:

• Price – the interest rate in the Australian cash market for overnightloans, known as the cash rate.
• Quantity – the quantity of ES balances (cash) which are used by banks tomake payments to each other and the RBA.
• Demand – the demand for ES balances (cash) from banks. The source of thisdemand stems from banks needing to make payments. This is done throughdebiting/crediting their ES accounts. The RBA estimates the demand for ES balances eachday.
• Supply – the supply of ES balances (cash) managed by the RBA. Prior to the COVID-19 recession,the RBA managed the supply of ES balances to meet its estimated demand in order to ensurethat the cash rate was consistent with the Board's target. Following the introduction of theRBA's comprehensive package of monetary policy measures in response to the economiceffects of COVID-19, the supply of ES balances increased considerably.

Understanding How the Cash Rate is Managed

What does the typical textbook say?

Typical textbook analysis uses simple demand and supply curves to define how the central bankimplements monetary policy. Figure 1 shows demand and supply in the overnight cash market (for thecash used by banks to settle payments with each other which is known as liquidity). The demand curveis downward sloping and intersects with the supply curve to give the price of cash – the cash rate (r).The supply curve is often depicted as vertical, because the central bank has control over the supply ofcash.^[4]Shifts in the supply of cash are determined by the central bank through its use of OMOs to eitherinject cash into or withdraw cash from the financial system.

The typical textbook explains that if the central bank wanted to raise the cash rate, it would do so bywithdrawing cash from the system, decreasing the supply and quantity of cash available from S to S1(Figure 2). This in turn would place upward pressure on the cash rate (from r to r1) to reach a newequilibrium. Conversely, if the central bank wanted to decrease the cash rate, it would increase thesupply of cash from S to S2. This would place downward pressure on the cash rate (from r to r2).(See Table 1 for a summary of the relationships.)

Typical textbook analysis shows that the shift of the supply curve for cash is achieved through OMOs.When the central bank sells bonds to banks and receives cash (in return for bonds), it reduces the supplyof cash in the market. Conversely, when the central bank buys bonds from banks and provides cash(in return for the bonds), it increases the supply of cash in the market.

However, there are gaps in this analysis which are important for understanding how the RBA managesthe cash rate in practice.

What actually happens?

Typical textbook analysis captures most aspects of the Australian cash market (price,quantity, demand and supply), but critically omits the role of the policy interest ratecorridor.

What is the policy interest rate corridor and why is it important?

The policy interest rate corridor is defined by a floor and a ceiling around the cash rate target in theAustralian cash market. The floor is the RBA's deposit rate, which is currently the cash rate less0.1 percentage points on any excess ES balances banks deposit at the RBA. The ceiling is the RBA'slending rate, which is the cash rate plus 0.25 percentage points on any ES balances banks borrow if theyneed to cover shortfalls.^[5]

Figure3 provides a stylised model of the Australian cash market by including the policyinterest rate corridor. Banks have no incentive to borrow at interest rates higher than theRBA's lending rate (the ceiling), so there are no transactions above the corridor. Andthey have no incentive to accept a deposit rate lower than the one the RBA offers (thefloor) – so there are no transactions below the corridor. All market activity iscontained within the corridor.

Furthermore, those banks that have excess ES balances are always willing to deposit their cash withother banks at a higher rate than the RBA's deposit rate (the floor of the corridor) to earn a higherreturn. At the same time, those that need to borrow in the Australian cash market seek a rate that islower than the RBA's lending rate (the ceiling of the corridor). Consequently, the price of transactionshas historically gravitated towards the cash rate target inside the corridor.

Demand in the cash market can and does move around. Before the COVID-19 recession, the RBAtypically responded to any shift in demand for cash (ES balances) by managing the supply of cash. Thisensured the cash rate remained consistent with the cash rate target. In other words, the RBA wouldattempt to manage liquidity to shift the supply curve so that it intersected the demand curve at the cashrate target. Figure 4 shows how the cash rate can be maintained at its target by responding to anincrease in demand by increasing supply (with both curves shifting to the right). On the other hand,Figure 5 shows that to keep the cash rate at target, a decline in demand is responded to by reducingsupply (with both curves shifting to the left).

The important point is that in practice, before the COVID-19 recession, changing the supply of cashthrough OMOs had typically been done to keep the cash rate at target on a daily basis – notto change the target after a monetary policy decision.

So how is the cash rate target changed?

After the announcement by the Reserve Bank Board to change the target cash rate, the RBAresets the policy interest rate corridor around the new target cash rate. In essence, theexistence of the policy interest rate corridor does all the work.

But how did this happen before the COVID-19 recession?

If the cash rate target was lowered as part of the monetary policy decision, the RBA's deposit rate andlending rate would be adjusted so that the entire policy interest rate corridor shifted lower (Figure 6).The incentives for banks to trade within the new corridor would remain, and transactions wouldgravitate to the middle of the corridor (the new cash rate target). This is because banks would want toborrow at rates lower than the RBA's lending rate (the ceiling) and make deposits at rates higher thanthe RBA's deposit rate (the floor). Because of this, the new cash rate target would be achieved withoutthe need for the RBA to conduct any OMOs.

In practice, the market moved automatically, and immediately, to the new cash rate target. The processwas reinforced by the RBA's credibility in managing the supply of cash in the market and has fostered aconvention for almost all transactions to occur at the cash rate target. As shown in Graph 1, for most ofthe past two decades, there has been little deviation of the cash rate from its target.

What happened after the onset of COVID-19?

Following the onset of COVID-19, the RBA began using unconventional monetary policy tools.This caused the supply of cash in the cash market to increase substantially, which caused the price inthe Australian cash market (the cash rate) to fall below the target cash rate.

The impact of unconventional monetary policy tools on the cash market is depicted in thestylised diagram below (Figure 7). The cash market is originally at point A, where the demand andsupply curves intersect at a cash rate equivalent to the cash rate target. When the RBAintroduced unconventional monetary policy tools, such as the Term Funding Facility, the supplyof ES balances in the cash market increased (shown as a rightward shift of the supply curve).The demand and supply curves now intersect at point B, with the cash rate below the cash ratetarget. The increase in the supply of ES balances has effectively meant that the cash rate is nownear the floor of the corridor as opposed to being at the cash rate target.

A Closer Look at Open Market Operations

Prior to the COVID-19 recession, OMOs were used to keep the cash rate at targeton a daily basis.

Typical textbook analysis generally describes the central bank's OMOs as the direct buying and sellingof government bonds. When the central bank buys bonds, it injects cash into the financial system(as banks' ES accounts are credited with cash in return for bonds)^[6]When the central bank sells bonds,it withdraws cash from the financial system (as banks' ES accounts are debited to pay for bonds).

This process is correct. However, there is more to OMOs.

Prior to the COVID-19 recession, the RBA typically conducted OMOs on a daily basis. The RBA announcedthe value of cash it intended to inject into or withdraw from the financial system, the type of transactionand its duration as part of an auction process.

There are three types of transactions which the RBA typically conducts as part of its OMOs:

1. Bond purchases or sales. The RBA buys or sells bonds in exchange for ESbalances – cash. As a result, these transactions change the supply of cash in themarket.

2. Repurchase agreements (Repos). The RBA uses repurchase agreements. A repo is atransaction that occurs in two parts. In the first part, the RBA lends a bond to a bank andreceives ES balances (cash) in exchange, resulting in a decrease (drain) in the supply ofES balances on that day. In the pre-arranged second part, at an agreed price and date in thefuture, the RBA receives the bond back and returns the ES balances (cash) to the bank, resultingin an increase in the supply (injection) of ES balances on that day.

   In the opposite case – commonly referred to as a ‘reverse repo’ – the RBA commences thetransaction by borrowing a bond and providing ES balances (cash) to the bank, resulting in anincrease in the supply (injection) of ES balances. The second leg of this transaction involves theRBA returning the bond to the bank and receiving ES balances (cash) back, resulting in adecrease (drain) in the supply of ES balances on that day. (See the comparison in Figure 8.)

3. Foreign exchange swaps. The RBA also engages in foreign exchange swaps.A foreign exchange swap is similar to a repo. The main difference is that, instead ofbonds, foreign currency (e.g. US dollars or Japanese yen) is used in the transaction.

Of the three types of transactions, reverse repos are the most commonly used by the RBA in their OMOsrather than outright purchases/sales of government bonds, as is commonly described by textbooks. Thisis because the RBA mostly injects cash into the market to cover ES balance shortfalls and their flexibilityallows the RBA to manage liquidity on two separate days, using the one tool.^[7]Repos give the RBA theflexibility to manage the supply of cash in the market (liquidity) and smooth the effects of largetransactions between banks and the RBA or the government - such as tax and social welfare payments– that can have a material effect on the total amount of cash in the market (or ‘system liquidity’).To help manage liquidity, the RBA forecasts cash movements to inform its decisions about when to‘unwind’ repos.

Since the COVID-19 recession

The RBA's unconventional monetary policy measures have led to an increase in the supply of ES balancesand the cash rate drifting below its target. Accordingly, the RBA currently does not conduct OMOs tokeep the cash rate at its target level. Instead, OMOs are used to complement the other monetary policymeasures introduced since the onset of the COVID-19 recession.^[8] As a result, currently the RBA takesinto account market conditions when considering when to conduct OMOs (rather than conductingOMOs on a daily basis).

Wrapping Up

The RBA's implementation of monetary policy is an area of confusion for professionaleconomists, commentators and educators alike, particularly in reference to how closely theactual process aligns with the standard textbook explanations. The two main gaps in typicaltextbook explanations relate to:

1. The omission of the policy interest rate corridor. The corridor is key to how the RBAimplements monetary policy, particularly a change in monetary policy, as it encouragesbanks to trade ES balances at an interest rate within the corridor; prior to the COVID-19recession, ES balances were traded at an interest rate consistent with the target cash rate.
2. The use of open market operations. Textbooks often link OMOs with achieving a change inthe cash rate. However, the RBA has typically used OMOs in the past to manage the supplyof cash and keep the cash rate at its target on a daily basis.

In summary, prior to the pandemic, the market automatically traded at the new cash rate targetfollowing a change to monetary policy. This was achieved by the policy interest rate corridor, whichreset around the new cash rate target, and banks having no incentive to trade outside of thiscorridor. OMOs were used by the RBA to manage the supply of cash (liquidity) in the market on adaily basis as part of its liquidity management practices. Since the onset of the COVID-19 recession,OMOs have largely been used to complement the RBA's other monetary policy tools.

This information can be viewed at a glance in the accompanying table ‘The Reality ofMonetary Policy Implementation’.