RDP 9214: The Cash Market in Australia 3. Determination of Cash Rates

In practice, the official and unofficial cash rates are determined simultaneously by a complex interplay of demand and supply for the different categories of cash. Further, as both ES and non-ES loans are used by market participants to fund holdings of securities, typically of fairly short maturities, changes in demand for or supply of cash will affect the demand/supply balance in markets for these securities. Yields on these securities will be determined simultaneously with cash rates and will, in general, reflect expectations about the levels of cash rates over the term of the securities.

In this section, however, the determination of cash rates is presented using a partial equilibrium approach which brings out the key linkages between the different parts of the market. It first outlines the workings of the unofficial cash market and the determination of the unofficial cash rate. It then shows how the official cash rate is determined, taking the unofficial rate as given.

The Unofficial Cash Rate

As indicated by the model in Section 2, it is movements in non-ES loans to authorised dealers and the broader market for securities which play the pivotal role in the adjustment of the market in ES funds to changes in ES cash flows. When the level of non-ES loans to authorised dealers changes, it adds to or subtracts from the availability of non-ES funds in the wider unofficial market.

Under its present operating procedures, the Reserve Bank announces a target level for cash rates. In practice, it is the unofficial cash rate which is targeted by the Bank (though, as explained later, the unofficial and official cash rates are about equal). The unofficial cash rate fluctuates from day to day but the Bank acts to keep it fairly close to the announced target. Market participants will expect the unofficial cash rate to equal the target rate on average in the future until a new target is announced.

Demand for non-ES funds is likely to he highly elastic at the Reserve Bank's announced target interest rate. Above that rate, demand will fall steeply as the loan rate approaches the late repurchase rate (at which dealers can obtain cash from the Reserve Bank) or the rediscount rate — the late repurchase rate is normally the lower of the two and in practice is often equal to the announced target rate for unofficial cash. Below the announced target rate, demand will rise steeply as participants try to take advantage of what they expect to be a temporary low cost of funds.

Supply will be positively related to the unofficial cash rate, but it too is likely to be fairly elastic in the vicinity of the announced target rate. Because participants expect rates to remain close to the target rate, they will be willing to lend considerably more for a small rise in returns and, conversely, will curtail lending quickly if rates were to fall by a small amount.

Graphically, this can be represented by:

In Figure 1, DD' represents the demand for non-ES loans and SS' the supply of these loans. Both curves are relatively flat at around r^e, the announced target interest rate; r^* is the late repurchase rate, at which dealers would cease to bid in the market for non-ES funds and instead would sell CGS to the Reserve Bank under repurchase arrangements to raise cash.

It should be emphasised that the shapes of the supply and demand curves depend on perceptions in the cash market that the Reserve Bank will take action to keep cash rates close to the announced target rate r^e and about where the Bank will choose to set the late repurchase rate.

This model can be used to analyse the effect on the unofficial cash rate of a one-off sale of CGS by the Reserve Bank, as shown in Figure 2.

The sale of securities by the Reserve Bank causes a rightward shift in the demand curve for non-ES loans, from D₁D_1' to D₂D_2', as authorised dealers enter the market to fund the CGS they have bought from the Bank. The equilibrium level of loans rises from L₁^e to L₂^e and the equilibrium unofficial cash rate rises from r₁^e to r₂^e.

The next day, the spillover effect discussed in Section 2 would cause the demand curve to move right again by L₂^e − L₁^e. This process would continue from day to day while the authorised dealers were substituting non-ES funds for ES funds in their stock of loans.

It is clear from this analysis that the Reserve Bank would have to sell a large amount of CGS to cause a significant rise in the unofficial cash rate. Alternatively, it would have to sell a smaller amount and allow the effects to keep spilling over for several days, with the cash rate rising from day to day. However, this results from a set of demand and supply relationships which are based on the expectation that the Reserve Bank does not want to move the cash rate by a significant amount, but in fact wants to keep it within a narrow range. When the Bank does want the rate to move, it announces a new target which causes the curves to reshape, with their elastic segments at the new target rate, because the market knows that the Bank will seek to manage the flows of ES funds to clear the non-ES market at that rate. Indeed, having announced a new target, there may be very little need in practice for the Bank to buy or sell CGS to add pressure for the cash rate to move close to the new target.

The Official Cash Rate

As noted in Section 2 above, there are few uses for ES cash in the hands of banks which are surplus to their needs for exchange settlement. Banks can use them to make deposits with the Reserve Bank (generally at low or zero interest), to purchase notes and coin, to purchase CGS previously won at tender but not yet taken up, or to make loans to authorised dealers. Only the last two offer a market return on the funds, and of those the former is not always available.

Banks are willing to lend their ES funds to authorised dealers at less than the unofficial cash rate, for two reasons:

• the presence of a captive market element, reflecting the relative lack of opportunities for banks to invest ES funds;
• banks' loans to authorised dealers are secured, either by CGS (attracting a concessional risk weighting for capital adequacy purposes and included in PAR) or other securities.

The official cash rate is the average rate paid by authorised dealers on all their loans. From an authorised dealer's point of view, ES loans from banks and loans of non-ES funds from banks or others are very close substitutes — both can be used to square the dealer's clearing account. As a result, dealers' demand for ES loans is highly interest-elastic.

The market for official cash can be represented graphically as follows:

In Figure 3, the SS curve is drawn as vertical at loan rates below r^d. This would be the case if there are no CGS previously won at tender by banks but not yet taken up. If banks have such CGS available to be taken up, they might use some ES for this purpose if the loan rate falls sufficiently and the SS curve may kink to the left at some point.

To determine the official cash rate, it is necessary to know r^e, r^u and the proportions of loans to authorised dealers in ES and non-ES funds. Generally, the proportion in ES loans is large — 80 per cent is not unusual — so the official rate is dominated by the rate in the ES part of the market.

Loans of ES funds between banks on the interbank market are generally at a rate slightly higher than the rate on ES loans to dealers, because the interbank loans are unsecured.

In Figure 3, the rate on ES loans will be r^e, which is less than r^u as the demand curve for ES funds is always below that point. If ES funds are in plentiful supply, r^e may be considerably below the unofficial cash rate but typically the margin is around 10 basis points (0.1 percentage point). In such a state, however, banks which held high levels of ES loans to authorised dealers would be much more willing to lend non-ES funds in an attempt to run down their ES holdings — this would tend, in terms of Figure 1, to shift the demand curve for non-ES loans to the left and the supply curve to the right. In the absence of some offsetting withdrawal of ES funds from the market the plentiful supply of ES funds would flow through to lower unofficial cash rates and the normal margin between official and unofficial rates would tend to be restored. Of course, if the unofficial rate were to fall too far below the Reserve Bank's announced target rate, the Bank would step in to remove ES funds and reverse the process.