About Monetary Policy
What is Monetary Policy?
The Reserve Bank of Australia is responsible for formulating and implementing monetary policy. The Monetary Policy Board of the Reserve Bank sets the target ‘cash rate’, which is the market interest rate on overnight funds. At times, the Reserve Bank Board (the predecessor of the Monetary Policy Board) has also used other tools to alter monetary policy, and it is within the powers of the Monetary Policy Board to do so again in future if necessary.
What are the Objectives of Monetary Policy?
The overarching objective of the Reserve Bank, as established by the 2024 amendments to the Reserve Bank Act 1959, is ‘to promote the economic prosperity and welfare of the people of Australia both now and into the future’. In relation to monetary policy specifically, the Act specifies that this is best achieved by the Board setting policy in a way that, in the Board’s opinion, best contributes to:
- price stability in Australia; and
- the maintenance of full employment in Australia.
Since the early 1990s, these objectives have found practical expression in a target for consumer price inflation, of 2–3 per cent per annum, while also balancing the RBA’s employment objective. The earliest references to this inflation targeting approach were contained in speeches by the then Governor in August 1992 and March and August 1993. Controlling inflation is important because if preserves the value of money and, in the long run, is the principal way in which monetary policy can help to form a sound basis for long-term growth in the economy.
The Monetary Policy Framework
The Statement on the Conduct of Monetary Policy is an agreement between the Board and the Treasurer that records their common understanding on how these legislative objectives can be best fulfilled.
The Statement records that the (Reserve Bank) Board and the Treasurer agree that the price stability objective is best met through a flexible inflation targeting framework. The goal of this framework is to maintain consumer price inflation between 2 and 3 per cent. The flexibility contained within this framework allows the Board to look through short-term deviations of inflation from this range, thereby avoiding fine tuning of monetary policy that would be unhelpful for the economic prosperity and welfare of Australians.
The Statement also records that the full employment objective is met by focusing on achieving the current maximum level of employment that is consistent with low and stable inflation. This level is not observable and must be determined by the expert judgement of the Board, supported by the analysis of staff.
The price stability and full employment objectives are very often complementary, in that the same policy setting will often be appropriate to achieve both objectives. However, if the Board judges that these two objectives cannot be simultaneously met, it must determine how best to balance each objective. In such situations, it has agreed to communicate how it is balancing its inflation and full employment objectives and, more generally, how long it expects it will be before it achieves each objective and why.
The Monetary Policy Decision Process
The formulation of monetary policy is the primary responsibility of the Monetary Policy Board. The dates of meetings are well known in advance.
The Board meets eight times a year, following the release of key economic data on inflation and economic activity. The meetings start on a Monday afternoon and conclude the following day.
For each meeting, the Bank’s staff prepare a detailed account of developments in the Australian and international economies, and in domestic and international financial markets. The papers contain a recommendation for the policy decision. Senior staff attend the meeting and give presentations.
Monetary policy decisions by the Monetary Policy Board are communicated publicly shortly after the conclusion of the meeting. The decision is published on our website at 2.30pm after each meeting. The Governor holds a media conference after each Board meeting to explain the decision.
The Implementation of Monetary Policy
From day to day, the RBA’s Domestic Markets Department has the task of implementing the monetary policy decisions of the Board. The Monetary Policy Board’s explanations of its monetary policy decisions are announced in a media release, which is distributed through electronic news services and published on the Reserve Bank’s website at 2.30 pm on the day of each Board meeting.
Over recent decades, the Reserve Bank has targeted the cash rate, which is the rate charged on overnight loans between commercial banks. It has a powerful influence on other interest rates and forms the base on which the structure of interest rates in the economy is built. Any change to the cash rate target takes effect from the day following the announcement.
In addition to the cash rate, the Reserve Bank announced various other measures in 2020 to help stimulate the economy to recover from the COVID-19 pandemic. This included:
- a target for the yield on the 3-year Australian Government bond to help lower funding costs across the economy. This target was announced in March 2020 and discontinued in November 2021.
- purchases of a nominated amount of bonds issued by the Australian Government as well as by the states and territories further out along the yield curve. This program of government bond purchases was announced in November 2020 and discontinued in February 2022. Together with the target on the 3-year Australian Government bond, these bond purchases helped to lower the whole structure of interest rates in Australia.
- a Term Funding Facility (TFF) for the banking system. The objectives of the TFF were to lower funding costs for the entire banking system so that the cost of credit to households and businesses is low, and to provide an incentive for lenders to support credit to businesses, especially small and medium-sized businesses. Under the drawdown period for the TFF, banks had access to new 3-year funding at an interest rate substantially below their funding costs. Access to funding included an additional allowance associated with a bank’s growth of business credit. The TFF was announced in March 2020 and closed to new drawdowns as scheduled on 30 June 2021. It ended in June 2024.
For more information about the implementation of monetary policy, see: Market Operations. For more information on the monetary policy measures that the Bank implemented during 2020, see: Supporting the Economy and Financial System in Response to COVID-19.
The Transmission of Monetary Policy to the Economy
Movements in the interest rates targeted by the Reserve Bank are quickly passed through to other capital market interest rates such as money market rates and bond yields. These interest rates are also influenced by the risk tolerance of investors and preferences for holding funds in a form that are readily redeemable. The cash rate and other capital market interest rates then feed through to the whole structure of deposit and lending rates. In Australia, most deposits and loans are at variable or short-term fixed rates, so there is a high pass through of changes in the interest rates targeted by the Bank to deposit and lending rates. But because of the other factors influencing capital market rates, and fluctuations in the level of competition in the banking sector, deposit and lending rates do not always move in lockstep with the interest rates targeted by the Bank.
The changes in interest rates affect economic activity and inflation with much longer lags, because it takes time for individuals and businesses to adjust their behaviour. Interest rates affect economic activity via a number of mechanisms. They can affect saving and spending behaviour of firms and households, as well as cash flow, the supply of credit, asset prices and the exchange rate, all of which affect the level of aggregate demand. In turn, developments in aggregate demand, in conjunction with developments in aggregate supply, influence the level of inflation in the economy. Inflation is also influenced by the effect that changes in interest rates have on imported goods prices, via the exchange rate, and through their effect on inflation expectations more generally in the economy.
The Relationship Between Monetary Policy and Debt Management
Sound financial policy requires that the Government fully fund any budget deficit by issues of securities to the private sector at market interest rates, and not borrow from the central bank. Many countries have legislation to deliver this outcome, though in Australia it is effectively achieved by agreement between the Treasury and the Reserve Bank. This arrangement means that there is separation between monetary policy and the Government’s debt management, with the Treasury directly responsible for the latter and the Reserve Bank responsible for the former.
It is not possible to ensure that the Australian Government’s need for funds are exactly matched day-by-day by issues of securities to the market. To overcome this mismatch between daily spending and financing, the Treasury keeps cash balances with the Reserve Bank that act as a buffer. The Reserve Bank also provides an overdraft facility for the Government that is used to cover periods when an unexpectedly large mismatch exhausts cash balances. The agreement between the Treasury and the Reserve Bank places strict controls on access to the overdraft facility. The overdraft is used infrequently, generally to cover unforeseen shortfalls in cash balances.
The Relationship Between the Bank and the Government
The Monetary Policy Board makes decisions about monetary policy independently of the political process – that is, it does not accept instruction from the Government of the day on monetary policy. This principle of central bank independence in the operation of monetary policy, in pursuit of accepted goals, is the international norm. It prevents manipulation of monetary policy for political ends, and keeps monetary policy focused on its long-term goals.
With this independence naturally comes a need for consultation and accountability. The relationship of the RBA with the Government is one of independence with consultation, as outlined in Consultation with Government and Accountability to Parliament.
Accountability for Monetary Policy
The Reserve Bank’s conduct of monetary policy is explained publicly through several channels. The RBA makes a public announcement of any policy decision, giving detailed reasoning for it. Minutes of the monetary policy meetings are published two weeks after each meeting. It publishes four Statements on Monetary Policy each year, which contain a detailed analysis of the economy and financial markets, and an account of the considerations for the policy stance adopted by the RBA. The Governor appears twice each year before the House of Representatives Standing Committee on Economics, to answer questions on the RBA’s conduct of policy. Senior officers of the Reserve Bank also give speeches and participate in panel discussions on a broad range of topics related to its role and functions, including on monetary policy.