The Implementation of Monetary Policy: Domestic Market Operations

Monetary policy refers to actions taken by central banks to affect monetary and financial conditions with the aim of achieving the broader macro-economic policy objectives of low inflation and sustainable economic growth. This paper discusses the actions the Reserve Bank undertakes in financial markets to achieve the desired stance of monetary policy.

Financial markets are important for monetary policy for at least three reasons: firstly, the desired stance of policy is achieved by Reserve Bank operations in these markets; secondly, financial markets are the channel through which the effects of policy are most immediately transmitted; and, thirdly, they provide feedback to policy makers – financial markets contain information that is of value to central banks in considering monetary policy. This paper mainly covers the first aspect – i.e. operations to implement monetary policy – and deals briefly with the transmission process.

Implementation of Monetary Policy

The process of implementing monetary policy has two parts:

First, since 1990, the Reserve Bank has announced the desired stance of monetary policy in Australia in terms of a target for the interest rate on overnight funds borrowed and lent in the money market; this interest rate is known as the cash rate. It is the interest rate the Reserve Bank's domestic market operations directly affect. When changing monetary policy, the Bank announces a new target level for the cash rate.

• The cash rate target establishes the operating objective for the Bank's market activities.
• It also provides an anchor for the market's expectations about where the cash rate will be.

Second, the Bank then operates in the market each day to maintain the cash rate at the target. These operations are also known as the Bank's domestic, or open, market operations. They involve transactions to buy (or sell) securities, to add funds to (or withdraw funds from) the banking system to influence its liquidity.

• The aim of these operations is to bring supply and demand in the cash market into balance at the desired cash rate.

Traditional textbook discussions of the operation of monetary policy focus on the quantity of money. In this model, the transmission mechanism works through either changing banks' reserve requirements or using open market operations to change the money base, which is essentially liabilities of the central bank. Changes in the money base, operating through the money multiplier, were designed to influence growth in the money supply, which in turn influenced interest rates and, ultimately, economic activity.

It is important to recognise that operating procedures for monetary policy in Australia – or in any country for that matter – do not conform to this traditional model. There are no reserve requirements on banks in Australia; their demand for central bank funds comes from their need for settlement balances, not reserve requirements. The Reserve Bank's operations focus on establishing a price at which these are made available, rather than on the quantity of liquid funds – i.e. they operate to affect the cash rate, not the money base.

(a) Announcing the Target

Graph 1 shows the announced target for the cash rate since 1990; since then, there have been 23 policy changes:

• 15 easings from 1990 to 1993, which saw the cash rate fall from about 18 per cent to 4.75 per cent;
  
• three tightenings in late 1994, which raised the cash rate by 2.75 percentage points in total; and
  
• five easings between July 1996 and July 1997, which reduced the cash rate by 2.5 percentage points, to 5.0 per cent.

This might be summarised as there having been three cycles in monetary policy in the 1990s.

In normal circumstances, the cash rate is the base on which the structure of interest rates in the economy is built. The major reductions in the 1990s in interest rates that banks charge their customers has been due to the fall in the cash rate. In a more general sense, of course, the reduction in interest rates has been made possible by the reduction in inflation.

The cash rate is an intermediate or operating objective of monetary policy: the ultimate goal of policy is low inflation and sustainable economic growth, not a particular level of interest rates. But the Bank cannot reach out directly and set inflation and full employment as it would like. It relies on adjusting something that it can influence and, by setting this dial correctly, eventually steer the economy toward the ultimate objectives.

Monetary policy announcements are an important part of the policy framework. Transparency is important because:

• it reduces uncertainty about the stance of monetary policy;
  
• over time, it helps change behaviour in ways that support the aims of policy; and
  
• it disciplines the Bank's market operations and makes the Reserve Bank more accountable for the success of these operations.

Sending a clear signal about the stance monetary policy also helps reinforce the link between, on the one hand, the interest rate that policy operates through – the cash rate – and, on the other hand, the lending rates charged by intermediaries that affect the decisions of households and businesses to borrow and spend.

The Board of the Reserve Bank ultimately makes the decision about the cash rate target, based on recommendations from staff. (The Board meets monthly.) These recommendations are based on an appraisal of economic conditions and the outlook, and analysis of financial market developments. If the Board decides to change monetary policy, this is subsequently announced as a change in the cash rate target and the market typically adjusts immediately to this new target (for reasons to be explained shortly). On (the vast bulk of) days when policy is not changed, the Bank's market operations are vital in keeping the cash rate at the target.

(b) Liquidity Management

In deregulated financial systems around the world, and such as we have in Australia, central banks implement monetary policy by undertaking transactions to influence short-term interest rates, usually interest rates on overnight borrowing. The market for such short-term funds is known as the money market or cash market. Central banks have a pivotal role in this market. Like all markets, it has a demand side and a supply side.

The Demand for Cash

The demand for cash is determined by settlement obligations of the financial system. There are two classes of settlement obligations: those between commercial banks themselves; and those between commercial banks, as a group, and the Reserve Bank.

The interbank market

In modern economies, economic activity involves transactions largely conducted through the banking system. These transactions involve the buyer of goods or services (or assets) paying the seller an agreed amount of money; this usually involves the transfer of funds between banks, as cheques (or other claims) are written on bank accounts. This process gives rise to a body of obligations of banks against each other. Those obligations are ultimately settled in the cash market.

It is possible to think of some typical transactions that result in flows through the cash market.

Firstly, take the example of a retailer writing a cheque on his account at Bank A in favour of his supplier who banks with Bank B. The result is that Bank A has an obligation to pay Bank B. This obligation is settled when Bank A transfers funds to Bank B. Each day thousands of transactions of this sort – both large and small – flow through the banking system.

The transfer of funds between banks to settle such transactions occurs through banks' accounts at the central bank. In Australia, these accounts are known as Exchange Settlement Accounts (ESAs). Each bank has an ES account at the Reserve Bank, which it is required to keep in credit at all times. Balances in ES accounts are also known as Exchange Settlement (ES) funds.

How do banks manage their interbank obligations? If a bank with an obligation to another bank already had balances in its ES account, it would simply have some of its ES funds credited to the other bank's ES account. If the paying bank did not have sufficient funds to make an interbank payment, it would borrow these funds from another bank. In either case, however, the total volume of ES funds in the system would be unchanged. Such interbank transactions have no effect on the system-wide demand for ES funds or on the pool of available ES funds.

The cash market has another important role which involves participation by major institutional players which trade cash and borrow and lend short-term funds.

These professional participants play an active role in the cash market, adding depth to it. The activities of some of these participants mean that they tend to be almost-perennially short of cash, while others tend to be ‘cash rich’. For example, an investment bank that holds a portfolio of bonds would tend to be in need of cash to fund these assets. On the other side, funds managers and insurance companies tend to have surpluses of funds which they are prepared to lend short term. There is an obvious complementarity between these institutions: the institutions holding bonds can borrow cash from the funds managers, on the security of their bonds if needs be, while the lenders of cash acquire a short-term asset. These transactions are an important part of the activity of the professional cash market.

But it is important to remember that non-bank financial institutions do not have ES accounts. Transactions between such institutions involve an exchange of bank cheques and are ultimately settled through their respective banks. The transfer of funds is, therefore, ultimately carried out through the ES accounts of these banks. So, like transactions instigated by banks' other customers, they merely shuffle funds – through banks – between borrowers and lenders of cash.

The flows of cash between institutions can be either secured or unsecured. If borrowing occurs against security, the most likely instrument that will be used is a repurchase agreement (RP or repo).

Repos involve a holder of securities selling them (for cash), and simultaneously agreeing to repurchase them at a fixed price on a fixed date in the future. Repos are extremely flexible instruments for managing liquidity because their terms can be tailored to suit particular circumstances. Securities of all maturities can be used as collateral in the transaction. So, even long-term bonds can be used to generate short-term liquidity without the holders permanently giving up ownership of their asset.

Transactions between the Reserve Bank and the banking system

The Reserve Bank's influence over the cash rate comes from changes in the system-wide demand for ES funds: these are determined – not by transactions within the commercial banking system – but by transactions between the Reserve Bank and the banking system. Payments from the banking system to the Reserve Bank reduce aggregate ES funds; and payments from the Reserve Bank to banks add to ES funds.

Transactions between the banking system and the Reserve Bank come from a number of sources:

• First, the Reserve Bank is the banker to the Australian Government. This is the main ongoing source of fluctuations in ES funds. In this role, the Bank makes payments for the Australian Government (or receives funds on its behalf). When individuals and companies make tax payments, funds flow out of the banking system to the Government. Banks' holdings of ES balances are reduced and balances in the Australian Government's account at the Reserve Bank rise. This drains cash from the banking system. The opposite transactions occur when the government makes payments. Similar flows are involved when payments are made for new issues of Commonwealth Government securities (reducing banks' ES funds) or when CGS matures and the Government repays debt (increasing ES funds).
• Second, the Reserve Bank also undertake transactions on its own behalf. An example is when the Reserve Bank undertakes foreign exchange transactions. If the Reserve Bank were to sell US dollars in exchange for Australian dollars, the bank it is dealing with would make payment by reducing its ES balances, representing a reduction in system cash.
  
• Thirdly, the bulk of the Reserve Bank's market operations are carried out as repurchase agreements, which, as we have discussed, are bipedal transactions, i.e. they have two legs. Typically, the Reserve Bank provides cash in the first leg, with a commitment by its counterparty to reverse this transaction in the second leg. The second leg of the transaction adds to the demand for ES funds on the day on which the repo is unwound and has to be accommodated by the Reserve Bank in its dealing operations.
• A fourth, relatively minor and highly predictable, source of movements in ES funds, is purchases of banks' currency notes from the Reserve Bank. Banks purchase bank notes with ES funds.

In summary, flows to the Government's accounts at the Reserve Bank, and the Reserve Bank's own operations, create settlement obligations between the Reserve Bank and commercial banks. This determines the daily demand for ES funds.

Supply of ES Funds

While the demand for ES funds is quite predictable, it does fluctuate from day-to-day. Unless the supply of ES funds adjusts to accommodate fluctuations in demand, however, there would be correspondingly large swings in the cash rate. The Reserve Bank's operations in domestic markets are designed to offset these variations in the demand for cash, and maintain steadiness in the cash rate by supplying adequate ES funds.

When there is an outflow of ES funds from the banking system (a deficit in system cash), the Reserve Bank tends to buy securities from the market, thereby replenishing ES funds. Other things equal, this action would tend to prevent the cash rate rising in the face of cash shortages. Conversely, when there is an inflow of ES funds to the banking system (a surplus in system cash), the Bank typically sells securities, to withdraw excess funds from the market. This action tends to prevent the cash rate falling.

The crucial point is that the Reserve Bank is always guided in its operations by their likely effect on the cash rate. Except on the rare days when policy is being changed, this means undertaking operations to keep the cash rate steady. As noted, on days when policy is changed, the market tends to move to the new cash rate target in anticipation that the Bank's operations will be consistent with this new target.

Since ES funds can be created only when transactions are undertaken with the Reserve Bank, the Bank is a monopoly supplier of ES funds, and typically makes funds available at an interest rate near the cash rate target. It is this monopoly position which enables the Bank to determine the cash rate.

As I have said, only banks have ES accounts. The Reserve Bank, however, is prepared to deal with all major financial institutions, both bank and non-bank, provided they are members of RITS. RITS is the Reserve Bank Information and Transfer System, an electronic system for settlement of CGS and cash transactions. RITS has 148 members, of which 52 are banks and 96 are non-banks. In practice, the Bank deals regularly with about a dozen institutions, about half of which are banks. When the Reserve Bank deals with a non-bank, it credits the corresponding ES funds to its banks' ES account.

To summarise, the Bank implements monetary policy in the cash market. The price of funds in this market – the cash rate – is determined, as in other markets, by the forces of supply and demand.

• demand is determined by commercial banks' demand for settlement deposits at the Reserve Bank, that is ES funds. Banks use these funds to settle obligations against other banks, including importantly, the Reserve Bank.
  

• the Reserve Bank determines the supply of cash via its domestic market operations, and – because it is a monopoly supplier of cash –can keep the cash rate, over time, at the desired level.

Thus the Bank's operating objective is to supply, at interest rates determined by the Reserve Bank, the liquidity that the banking system needs to achieve balance each day.

Instruments Used in Market Operations

The Bank's domestic market operations involve two types of transactions:

• The Bank is prepared to buy (or sell) short-term government securities outright – that is take (or relinquish) ownership of – in exchange for cash – Commonwealth Government securities (CGS), i.e. Treasury Notes or Bonds of less than one year to maturity; or
  

• Enter repurchase agreements (RPs or repos). The Bank is prepared to accept both Commonwealth and State government securities in its repo transactions.

Repos account for about 90 per cent of the Bank's transactions, which average about $900 million a day.

On occasion, the Bank might also undertake a foreign exchange swap for liquidity management purposes. Such transactions are discussed more fully in the companion paper on the Reserve Bank's foreign exchange operations; they are essentially a repo underpinned by foreign exchange rather than securities.

The Reserve Bank's Dealing Schedule

The Reserve Bank's daily dealing routine is well known to the market. At around 9.00 am each day, the Bank has an estimate of the expected system cash position – the demand side of the equation. The system cash position is the change in the availability of ES funds if no domestic market operations were undertaken that day.

• At 9.30 each morning, the Bank announces on the electronic screen services this estimate of the system cash position. In other words, the Bank announces whether it expects the market to make payments to the Bank (a cash deficit) that day, or whether the Bank will make payments to the market (a surplus).
• The Bank also announces its dealing intentions at this time. If there is a cash deficit, the Bank will usually offer to buy CGS or RPs from the market, thereby injecting funds. If there is a large surplus, the Bank will usually announce an intention to sell CGS or RPs. The market understands that, as the monopoly supplier of ES funds, the Bank has, over time, control of the cash rate. So whether the system is in surplus or deficit is, of itself, not an important consideration for the market. The market accepts that the Bank will operate to keep the cash rate at the target.
• Market participants can then submit offers to sell (if the Bank is buying) or bids (if the Bank is selling) by 10 o'clock:
  • For repos, these bids and offers specify the interest rate and term at which market participants are prepared to deal.

  • For outright transactions, counterparties specify the stock and yield.

Market operations are conducted in the form of a tender, i.e. bids or offers are accepted in order of attractiveness based on term and yield; transactions are conducted up to the volume necessary to maintain the cash rate around the desired level – the supply side of the equation. Dealing is usually completed by around 10.15 am.

Under Real-Time Gross Settlement (RTGS) (discussed more fully below), the Bank will have less firm information than at present on which to base its daily estimate of system cash. Consequently, these estimates are likely to be subject to greater forecasting error. If the forecasts turn out to be significantly in error, we would expect some pressure on the cash market because our dealing operations will likely have been inadequate or too generous. In these circumstances, the Bank will be prepared to deal a second time during the day.

It is one thing to announce a target but another thing to hit it via daily market operations. How close does the Bank typically get to the target? Graph 2 shows that, in practice, the Bank manages to keep the cash rate quite close to the target day by day. The cash rate recorded in the market each day is usually within a 5–10 basis point range around the target. On days when policy is changed, the rate moves to the new target very quickly. This outcome partly reflects the effectiveness of the Bank's market operations day to day – which gives the market confidence that the Bank can hit the announced target. But the announcementof the target, itself, also anchors market expectations near the cash rate target.

(c) RTGS

As I have explained, the Bank operates in the market for settlement funds. The infrastructure of this market in Australia is about to change fundamentally, as real-time gross settlement (RTGS) is expected to be introduced in late June 1998. This will radically change how interbank settlements occur.

Current settlement arrangements are described as a deferred net settlement system. The best way to explain this is to dissect the term itself. We should deal with the deferred part first:

• At the moment, a payment made by a customer with a bank cheque will affect ES accounts the day after the cheque is lodged with the receiving bank, i.e. settlement is deferred until the next day. This is because the settlement process occurs overnight through the banks' clearing house.
  
• In the clearing house, banks “bundle up” and present all of the cheques (and electronic claims) they hold against other banks. At the end of this reckoning, banks will have payments to make to other banks, while also being owed funds by them. These aggregate obligations and claims for each bank are reduced to net figures, which banks settle with each other.

RTGS is very different from this. There is, in principle, no bundling up of transactions, no netting and no deferral of final settlement. Again, perhaps the best way to explain it is to dissect the acronym. RTGS requires banks to make full value of payments on the instruction to do so by customers.

• That is, in principle, they transfer value immediately, not next day. (Hence “real time”.)
• The amount paid is the full (gross) value of the individual transaction.

So banks will have a continuous stream of payments and receipts, for the gross value of individual payments, and will make these payments throughout the day. This steady stream of payments between banks occurs through banks' ES accounts; payments cannot be made unless the paying bank's ES account is in credit.

While RTGS is not expected to be fully operational until late June 1998, the system is currently being used by banks to settle transactions. Each day:

• the system carries about 14,000 transactions, valued at about $100 billion;
  
• 60 per cent of transactions have a value of less than $1 million;
  
• 4 per cent of transactions have a value of more than $100 million but account for 60 per cent of the total value of transactions.

Graph 3 shows the flow of transactions during the day, reaching peaks late morning and mid afternoon.

While it will revolutionise the settlement system, RTGS has few implications for the Reserve Bank's market operations. Cash will still flow between the Bank and commercial banks as now, and the Bank will still control the supply of liquidity.

Nevertheless, a risk with RTGS is that something unexpected might happen that drains liquidity from the banking system. For example, consider a situation in which a bank was unexpectedly instructed to make a large payment but did not have sufficient ES funds. This could have a knock-on effect, delaying payments of other banks which were waiting to receive funds from the original bank. In the extreme, the payments system might come to a standstill: if the first bank did not have funds to pay the second bank, the second bank might not have funds to pay a third, and so on. Such a situation is known as “gridlock”.

To minimise this sort of risk, the Bank will provide two new facilities which can be activated at the discretion of individual banks, to ensure that ample liquidity will be available to banks continuously during the day, and to help smooth settlements at the end of the banking day.

To make sure that banks have continuous access to ES funds during the day, the Bank has established an intra-day repo facility which will be available to ensure that banks will be able to raise cash from the Reserve Bank at any time. This will involve banks engaging in repo transactions with the Reserve Bank, in exchange for ES funds, with the transaction reversed before the system closes that day. This facility will be available free of charge.

An end-of-day standby facility has also been established. If banks find that they are short of ES funds late in the day, and are unable to borrow funds from other banks, they will be able to undertake an overnight repo with the Reserve Bank. This means that the Bank will provide cash overnight in exchange for securities. This facility is available at an interest rate of 25 basis points above the cash rate, i.e. overnight funds from the overnight facility would currently be at a cost of 5.25 per cent, consistent with a prevailing cash rate target of 5 per cent. The relatively high cost of this facility is to provide an incentive for banks to find cash in the market, rather than come to the Bank at the end of the day.

Both the intra-day and overnight repo facilities can be used at the discretion of banks. The purpose of both facilities is to ensure liquidity remains plentiful, and the cash rate remains near the target.

The centrepiece of the Bank's operations – the morning dealings to offset system cash shortages or surpluses and achieve the cash rate target – will remain in place under RTGS, although, as noted, it may be augmented by a second round of dealing, if necessary.

Graph 4 summarises the Bank's potential daily operations under RTGS.

The approach of real time gross settlement (RTGS) has led to other changes. For almost 30 years, until August 1996, the Reserve Bank carried out its daily operations through a small group of institutions, known as authorised money market dealers. These dealers were a conduit through which the Reserve Bank's operations affected the financial system as a whole. The role of the dealers also meant that banks held their cash (or settlement) balances with them (such balances were known as loans to dealers). Banks earned interest on loans to dealers but the Reserve Bank did not pay interest on ES balances which banks, accordingly, kept at a very low level.

Since August 1996, the Bank has been prepared to deal directly with all major financial institutions, including banks and non-banks. Authorised dealers are no longer part of the Australian financial system. With the demise of the dealers, the Reserve Bank agreed to pay interest on banks' ES balances. At first, this rate of interest was set at 10 basis points (0.1 of a percentage point) below the cash rate target. This margin proved attractive for banks, which were happier to hold ES funds at this rate than to lend cash in the market to other institutions of inferior credit standing than the Reserve Bank. Accordingly, balances in ES accounts rose sharply, as illustrated in Graph 5. This unwillingness to lend cash had the effect of making it more difficult to achieve the cash rate target.

In June 1997, the Bank announced that, from October 1997, this margin below the cash rate target would be increased to 25 basis points, i.e. 4.75 per cent at the moment. The aim of this reduction was to provide greater incentive for banks to lend cash rather than horde it at the Reserve Bank. As Graph 5 shows, the fall in ES funds since mid 1997 has had the desired effect.

The Transmission Mechanism

Monetary policy operates, in the first instance, via the Bank's influence on an interest rate that has little direct effect on households and most businesses. It is determined in that part of the financial system in which the Reserve Bank deals with the financial institutions to provide ES funds. The ultimate effect on inflation and unemployment of changes in the cash rate depends on how these changes are transmitted through the financial system and economy, and how business and households react. The cash rate is important because it influences other interest rates, particularly rates on short term securities, such as bank bills.

Changes in monetary policy usually feed quickly through to the rate at which banks fund themselves, i.e. raise deposits in short-term markets. Changes in monetary policy are, therefore, usually also translated into the rates that banks charge for lending. This is a key channel for transmitting monetary policy to the real economy because these lending rates influence decisions of businesses and households to borrow and spend.

Movements in intermediaries' rates are the first step in influencing behaviour elsewhere in the economy. The effect on a family's cash flow of a rise in mortgage rates may, for example eventually tip the balance against the building of a new house or mean that the family cannot spend quite as much as it had been on consumer goods. Or, a rise in business lending rates may lead to a small business deciding to defer the purchase of some new equipment.

This graph shows that changes in the cash rate are reflected reasonably closely in the interest rates that banks charge for mortgages and business lending. The cash rate does not determine the level of intermediaries' rates. These are somewhat higher than the cash rate because banks charge a margin for the risks they take in making loans, to cover costs and earn a profit margin.

While changes in monetary policy have an immediate effect on short-term interest rates and intermediaries' rates, the relationship between the cash rate and long-term interest rates is less clearly defined. This is because long-term interest rates, such as the 10-year bond yield, takes into account all the factors which might affect borrowing costs over a 10-year period. The most important of these are expectations of inflation, and interest rates on world capital markets.