The Reserve Bank of Australia implements monetary policy using a variety of tools.The primary tool of monetary policy is the cash rate target, while other tools have,at times, included forward guidance, price and quantity targets for government bondpurchases, and the provision of low-cost long-term funding to financialinstitutions. This Explainer describes how each tool is implemented.
1. Cash Rate Target
How the cash rate target is implemented can be explainedby stepping through five aspects of the cash market: theprice, quantity, demand, supply and the policy interest rate corridor.
1.1 Price
The cash market is where banks lend and borrow funds from eachother overnight. The price in this market is theinterest rate on these loans. In Australia, thisinterest rate is called the cash rate. As the Reserve Banksets a target for the cash rate, it is often referred to as a‘tool’ of monetary policy.Prior to the COVID-19 recession, the cash rate target was the Reserve Bank's onlyactive monetary policy tool.
1.2 Quantity
The quantity traded in this market is called ExchangeSettlement (ES) balances, which are used to settle interbanktransactions. Banks have deposit accounts at the ReserveBank to record the value of their ES balances. Because theReserve Bank is Australia's central bank and controls banknotesavailable to the public, ES balances are considered to be the equivalent of cash.
1.3 Demand
Banks use ES balances as a store of value and tomake payments between each other. Some ofthese payments are on behalf of their customersand some are related to their own business.Demand may vary for a number of reasons,including changing financial market conditions.
1.4 Supply
Prior to the COVID-19 recession, the Reserve Bankmanaged the supply of ES balances so that it metestimated demand and the cash rate was as closeas possible to its target. This was mainly achievedwith open market operations to manage factorsthat can change the supply of ES balances.
In particular, the Reserve Bank typically managedthe supply of ES balances through repurchaseagreements (repos). A repo is a transaction withtwo parts.In the first part, the Reserve Bank could lend ES balances to a bank and receive abond in exchange (seeExplainer: Bonds and the Yield Curve).This increases the supply of ES balancesavailable to banks. In the pre-arranged secondpart, the transaction is reversed. The ReserveBank returns the bond and receives back the ESbalances. As a result, the supply of ES balancesdecreases. This could help to manage changesin the supply of ES balances arising from otherfactors. For example, any payments made bythe Australian Government or received into itsaccounts at the Reserve Bank will affect the supplyof ES balances.
The package of policy measures introduced by theBoard in response to the COVID-19 recession ledto a substantial increase in ES balances. As a result,the Reserve Bank no longer conducts daily openmarket operations to manage ES balances. Thecash rate is maintained consistent with the targetthrough the interest rate corridor.
1.5 Policy interest rate corridor
The Reserve Bank currently pays an interest rateon ES balances that is 0.1 percentage points belowthe cash rate target. Banks have an incentive todeposit as little as possible at this rate, and insteadprefer to earn the higher cash rate by lending outtheir balances.
The Reserve Bank is also willing to lend ES balancesto banks if this is required. The interest rate onthese loans is 0.25 percentage points above thecash rate target. Banks have an incentive to borrowas little as possible at this rate, and instead prefer toborrow at the lower cash rate in the market.
The deposit and lending rates form the lower andupper bounds of the policy interest rate corridor.Banks have no incentive to borrow or lend ESbalances outside this corridor. If interest rates inthe market were lower than the deposit rate paidby the Reserve Bank, banks would choose tohold more ES balances. Similarly, if market interestrates for cash balances were above the top of thecorridor, banks would choose to borrow morecheaply from the Reserve Bank. The corridorrepresents a range within which banks have anincentive to trade ES balances among themselves.
The corridor also provides a mechanism forimplementing changes to the cash rate target.The bounds of the corridor are set with referenceto the target, so the corridor shifts in line withchanges in the cash rate target, as do theincentives for trading within that range.
In response to the COVID-19 recession, the ReserveBank began actively using other ‘unconventional’monetary policy tools, such as its ‘Term FundingFacility’ and bond purchase program, whichincreased the supply of ES balances (that is, theyshifted the supply curve in the cash market tothe right). This caused the cash rate to drift belowtarget. While the Reserve Bank still operates acorridor system, the increase in supply meansthat the cash rate can trade near the floor of thecorridor, rather than at the cash rate target.
2. Unconventional Monetary Policy Tools
Since the COVID-19 recession, the Reserve Bank has actively used a number of othermonetary policy tools.
Forward guidance
Forward guidance refers to public commitments made by the RBA as to how it willconduct monetary policy in the future. The RBA's forward guidance takes the form ofdescribing the economic conditions the Board would look to see before it wouldconsider raising the cash rate target. The guidance is based on the state of the economy –that is, it is ‘state-based’. For example, in mid March 2020, the Board communicatedthat it would not increase the cash rate target until progress was made towards fullemployment and it was confident that inflation would be sustainably within the 2-3per cent target band. Reflecting community interest in the Bank's views about howlong it will be before the economy will reach these conditions, the Board alsoprovided a possible timeframe for when these conditions might be met. Given itsforecasts at the time, the Bank initially expected this would take at least threeyears.
Price and quantity targets for asset purchases
In 2020, the Reserve Bank introduced explicit price and quantity targets for itspurchases of government bonds. These programs were designed to reduce longer-terminterest rates, lower funding costs and boost liquidity in the economy during theCOVID-19 recession. The Reserve Bank purchased government bonds to: support a targetfor the interest rate on three-year bonds (the yield target); lower the yield onbonds with a term of longer than three years below where they would otherwise be;and support the smooth functioning of the bond market.
The Reserve Bank purchased government bonds issued by the federal and stategovernments in exchange for ES balances. Importantly, the Reserve Bank purchasedbonds from the private sector in the secondary market, and not from governmentsdirectly.
Term Funding Facility
Also in 2020, the Reserve Bank established a ‘Term Funding Facility’ (TFF) in orderto lower funding costs across the economy. The TFF provided low-cost, fixed termfunding to banks and other financial institutions such as credit unions and buildingsocieties. The TFF worked by offering banks access to three-year loans with theinterest rate fixed at the cash rate target. Because this interest rate was lowerthan banks were usually able to access, banks' funding costs declined and banks wereable to offer lower interest rates on loans to households and businesses. The TFFlaunched in April 2020 and remained open for new borrowing until June 2021. Allloans made under the TFF will mature by June 2024.
To learn more about unconventional monetary policy, see theExplainer: Unconventional Monetary Policy.
3. Future System of Monetary Policy Implementation
In March 2024, the Reserve Bank Board endorsed a plan to move to a new system ofimplementing monetary policy. It will use a system called ‘ample reserves’. Furtherdetails will be provided in due course.[1]
Endnotes
For more information, see Assistant Governor Christopher Kents speech The Future System for Monetary Policy Implementation. [1]
