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What does the Reserve Bank do?
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How the Reserve Bank Implements Monetary Policy
Watch Senior Analyst Katherine Leong talk about how the Reserve Bank implements monetary policy in this short lecture-style video.
Katherine Leong, Senior Analyst, Domestic Markets Department
Hello everyone. My name is Katherine and I work in the Domestic Markets Department at the Reserve Bank. In this video, I'm going to be explaining how the Reserve Bank implements monetary policy or, in other words, how we keep the cash rate on target. I think this is something which isn't widely understood so I'm really excited to have the opportunity to discuss this with you.
I think the best place to start is with this standard textbook model for the Australian cash market. So this is the stylised demand and supply diagram for a corridor system. On the X-axis here, we have the amount of cash, or liquidity, which is available. And on the vertical axis we have the price. In this case, the cash rate - or the interest rate paid on overnight, unsecured loans between banks. Now you may know that the Reserve Bank Board meets once a month and in that meeting they decide what the target rate for the cash rate should be.
Now Australia runs a corridor system, and I've indicated this by two dotted lines on our diagram. The corridor forms a ceiling and a floor on the cash rate target at 25 basis points above and 25 basis points below. And actually, banks have no incentive to trade outside this range. They know they can always borrow cash from the Reserve Bank at 25 basis points above target, and they can always leave excess reserves at the Reserve Bank for 25 basis points below. So all market activity is actually contained within this range.
Now I've also included a standard downward sloping demand curve here. We don't directly observe demand, but we interact with the market every day so we get a pretty good gauge of what demand is.
And finally, we have the supply curve. And this is really the domain of the Domestic Markets Department. It's our job to ensure that the supply of cash is appropriate to meet demand and keep the cash rate close to target. Or in other words, it's our job to make sure the supply curve intersects that demand curve close to that target rate.
Now demand can and does move around in this market. And if demand moves then the Reserve Bank will respond by altering supply. So for example, if demand were to increase in this market, the Reserve Bank would respond by increasing the supply of cash as well, to keep that cash rate near our target. This is exactly what happened during the financial crisis. Banks wanted to hold a bit of extra cash as precautionary balances and the Reserve Bank made sure to supply some extra cash to the market.
Now I'd just like to clarify exactly what we mean by cash or liquidity in this case. To be very clear, what I'm talking about is actually exchange settlement balances, or ES balances, for short. So all of the banks and some other financial institutions each have accounts at the Reserve Bank. In these accounts, are the Reserve Bank's own electronic currency called exchange settlement balances.
Now these ES balances are really for the banks to make payments between each other. So for example, if Bank A wanted to pay Bank B, they'd do this through ES balances. Bank A's account would be debited and Bank B's account would be credited.
Now most ES balances are actually held for balances after the close of the cash market. These actually have no monetary policy impact so we can ignore these for the purpose of this presentation. A very small portion of these ES balances are actually what we call a surplus ES balance. They're held for banks to meet their payment obligations and any ad hoc increases in demand. They're really there to make sure the payment system runs as smoothly as possible.
Now the reason we care about these surplus ES balances is that if you add up the surplus at each individual bank, the total of these balances would be the supply of cash in the market or the supply from that supply and demand diagram I showed you earlier. Now I can actually show you what surplus ES balances or the supply of liquidity has been in the market since the year 2000. You can see at the moment we're sitting at around $2 billion but at one point in time we were up at over $16 billion and that was in the middle of the financial crisis. As I mentioned earlier, the banks wanted to hold a lot of extra precautionary balances at that time.
Now this is actually one of my favourite graphs, and the reason for this is that it's really useful in debunking what I think is one of the biggest myths around monetary policy. And that is that the Reserve Bank changes the cash rate target by changing the supply of cash. If I add on the cash rate target here, you can see that there are actually a lot of times when the cash rate target is changing but the supply of cash is remaining the same.
So if we don't change the cash rate target by changing the supply of cash, how do we do it? Well, I'll be honest with you, the corridor system actually does all of the work for us. These surplus ES balances are actually remunerated at that floor of the corridor: that's 25 basis points below that target rate. So regardless of the level of the cash rate target there's always a 25 basis point penalty for holding that cash at the Reserve Bank. Actually, demand remains unchanged when we change the cash rate target and the market automatically reprices for us. So a day when the cash rate target changes looks very much like any other for the Domestic Markets Department.
Let's have a bit more of a look at surplus ES balances. I've said before that if you add up all the surplus ES balances, you'll get the supply of liquidity in the market. I've represented this visually by a beaker filled with liquid, or liquidity, in this case. Now the Reserve Bank gauges demand in the market and works out the appropriate level of supply to keep that cash rate close to target and we call this our target level of liquidity. I've marked that in this little black line on the beaker here.
So all we need to do to keep the cash rate close to target is to ensure that the supply of cash remains near that target level of liquidity. How hard can that be? Well actually, it's not as easy as it sounds. And that's because there are all these other accounts sitting at the Reserve Bank of Australia. We have a few things here. We have some accounts belonging to the Australian government. Some belonging to the Reserve Bank itself. And finally, some belonging to our other clients, mostly foreign central banks.
Now the key thing about these other accounts is they sit quite separately to surplus ES balances. And we care primarily about how much liquidity is in that left-hand beaker. So if, for example, two banks made transactions between each other all within that left-hand beaker, the total supply of cash in the market would remain the same. So we don't care too much about those transactions. Similarly, if there's a transaction all within that right-hand beaker say between the government and the RBA, then that would leave surplus ES balances unchanged as well. So we don't care too much about those transactions either.
The transactions we do really care about are those which occur between these surplus ES balances and the government or other accounts because these transactions will actually change the total amount of surplus ES balances in the market and change our supply of cash available.
Let's break this down a little bit more. Suppose, for example, we have a transaction which is going from one of these government or other accounts to the surplus ES balances. An example of this might be when the go makes a payment, when they pay pensions or when they give a grant to a school. In this case, the funds would go from one of these government and other accounts to surplus ES balances. So the government account would decrease and surplus ES balances would increase. This would increase the total of supply in the market. Because we're adding liquidity to the market, we would call this a liquidity injection. Another example of a liquidity injection would be when a government bond matures. The funds are returned to the bond holder and surplus ES balances increase.
The reverse works exactly the same way. A transaction which goes from surplus ES balances to one of these government or other accounts will decrease the total amount of surplus ES balances in the market and hence, decrease the supply of liquidity. Because liquidity is being removed from the market, we would call this a liquidity withdrawal. An example of a liquidity withdrawal would be when individuals or companies pay tax to the government. This removes supply of liquidity from the market.
So the job of the Reserve Bank is really to forecast all the transactions we think are going to happen on a given day. What we'll do is add up all of those transactions and work out, on net, what we think the change in liquidity is going to be. So for example, if we were to add up all of today's transactions, we might find that we expect surplus ES balances to be about $1 billion below that target level. What does that mean? The Reserve Bank will actually have to come along and add back in that liquidity. We call this liquidity management. So we'll increase surplus ES balances back up to that target level to keep the cash rate close to our target rate.
The Reserve Bank conducts its liquidity management through its open market operations or OMOs for short and we have three different tools which we can use in our OMOs. The first are our outright government bond purchases. Then we have our reverse repurchase agreements or repos. And finally, our foreign exchange swaps or FX swaps. And I'm going to primarily discuss the first two of these.
So outright government bond purchases work exactly how they sound. The Reserve Bank receives a bond and provides cash to the market at an exchange. So this is actually adding surplus ES balances to the market. Thinking back to our beakers example, this would be an increase in that surplus ES balances, that left-hand beaker. Now this is a liquidity injection so it can be used to offset a transaction which has drained liquidity from the market. For example, when individuals or companies pay tax to the government.
Now these outright government purchases aren't typically used on a daily basis but we would use them in large volumes ahead of a government bond maturity. To give you a bit of an idea, we would probably sterilise about two of these each year. The tool that we would use most frequently are actually these reverse repurchase agreements or repos. So let's just make sure we're on the same page with what a repo actually is.
A repo is a contract between two counterparties where one agrees to sell a bond to the other and repurchase it at a specified price at some date in the future. So this is like a loan which is being secured by a bond and this transaction actually has two legs. The first leg looks very much like an outright bond purchase. The Reserve Bank receives the bond and supplies cash to the counterparty. So this add liquidity to the market and increases surplus ES balances.
On the second leg, this transaction will unwind. So the Reserve Bank will give back the bond and receive its cash back in return. This second leg removes liquidity from the market and is a liquidity withdrawal, so this leg can be used to offset transactions which have added liquidity to the market. For example, when the government makes a payment.
Now you can see that these repos are actually quite a flexible tool. The two legs have transactions going in opposite directions so they can be used to offset transactions which go in two different directions. And for that reason, the reverse repurchase agreements are used most frequently by the Reserve Bank, by which I mean, typically on a daily basis.
Now our third and final tool are our foreign exchange swaps. The FX swaps work very similarly to a repo. The only difference is instead of bonds being used to collateralise a loan, we actually use foreign exchange instead. For example, we might use US dollars or Japanese yen. Now these are our three open market operations tools and we would use these tools to manage liquidity in the market to make sure the supply of cash meets demand and keeps our cash rate close to that target level.
So let's have a look at how we've gone. This is the cash rate. The actual cash rate showing in black and the cash rate target shown in red here. You can see that over time the actual cash rate has got a lot closer to the target and that's because the market has learned over time that they can rely on the Reserve Bank to supply the appropriate amount of liquidity.
In recent times, you can see that the cash rate has remained really quite consistent with the target. And that's because we've made sure that the supply of cash is appropriate for demand and we can keep that cash rate close to target.
So that's everything from me. This is how we keep the cash rate close to target or how monetary policy is implemented. If you do have any more questions, feel free to get in contact with us and we'd be happy to help you out.
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