RDP 9504: The Link Between the Cash Rate and Market Interest Rates 1. Introduction

As an operating objective, Australian monetary policy is directed at affecting the interest rate paid on overnight funds (the “cash rate”). The eventual impact that changes in this interest rate have on the business cycle and inflation depends upon how the changes are transmitted to other interest rates in the economy, and then how those interest rates affect economic activity. This paper explores the first link in this chain – that is, the relationship between the cash rate and money-market interest rates, bond rates and the interest rates paid and charged by financial intermediaries.^[1] Given the importance of changes in lending rates in the monetary transmission mechanism, the paper pays particular attention to the link between the cash rate and banks' indicator lending rates.

In textbook discussions of the monetary transmission mechanism, the focus is typically on the relationship between “the” interest rate and the real economy. In reality, there is a whole range of interest rates that affects economic activity. While the levels of the various interest rates tend to move together in the long run, considerable divergence between movements often occurs in the short run. This is seen most clearly in the shape of the yield curve, where sometimes, changes in interest rates at the short end of the yield curve lead to long-term interest rates moving in the opposite direction. Less dramatically, at the short end of the curve, the interest rates paid and charged by intermediaries on variable-rate deposits/loans seldom move immediately one for one with changes in the cash rate. The resulting change in intermediaries' interest rate margins has been the subject of considerable debate and comment over recent years.^[2]

Many factors influence the reaction of market interest rates to changes in the cash rate. For rates determined in auction markets, expectations of future changes in the cash rate and expectations of future inflation are particularly important. For lending and deposit rates set by intermediaries, the degree of competition is important, as are the perceived riskiness of lending, the structure of intermediaries' liabilities and the magnitude of operating costs and bank fees.

The spread between the average interest rate charged by banks and their average cost of funds has shown little change over the past decade. By international standards, this spread is relatively high, although this largely compensates for the fact that fee and non-interest income is relatively low.^[3] While the comparison of average deposit and lending rates is important for assessing bank profitability, examining changes in spreads between lending rates and the marginal cost of funds (approximated by the cash rate) can help in understanding the dynamics of bank competition.

The spreads between lending rates and the cash rate tend to fluctuate more than average spreads. In the late 1980s, the spread between the banks' typical indicator rate for business lending and the cash rate, averaged around 2 per cent. This spread widened to over 4 per cent in late 1991, only narrowing significantly in late 1994. Large movements have also occurred in the spread between the standard interest rate on variable-rate mortgages and the cash rate. These changes in marginal lending spreads have had little impact on the average spread, as the margin between the cash rate and deposit rates narrowed around the same time that the marginal lending spreads widened.

The relatively large marginal lending spreads in the early 1990s meant that lending for housing, in particular, was very profitable. Initially this was not reflected in widespread profitability of the banking sector, as many banks were suffering the consequences of the bad loans made in the late 1980s, and the adverse effects of a change in the structure of their deposits. As the bad debts problem receded, the profitability of lending became increasingly apparent. A number of new competitors entered the market and existing institutions shaved their margins, particularly for new customers.

The intensification in the degree of competition, especially from new entrants, has been particularly evident in the market for housing finance. This competition, while taking time to develop, has played some role in the recent narrowing of margins. The entry of new providers of finance for small business has been much slower, despite the existence of relatively large margins. To a considerable extent this reflects the difficulty in developing the capability to undertake the necessary information assessment needed for successful lending to small business. In contrast, lending for housing requires the collection and evaluation of relatively few pieces of information, and the resulting lower information costs have allowed finance providers to enter the housing-finance market in response to profitable opportunities at the margin.

The remainder of this paper analyses the relationship between the cash rate and market interest rates. Section 2 briefly describes the role that the cash rate plays in the operating procedures for Australian monetary policy. Section 3 examines the extent to which, on average, changes in the cash rate are “passed through” to other interest rates in the economy. Section 4 presents a model of the relationship between the cash rate and bank lending rates and then analyses the factors that have led to recent changes in the spreads between key indicator lending rates and the cash rate. Finally, Section 5 presents a summary and conclusions.

Footnotes

See Grenville (1993) for a recent summary of the details of the second link in the transmission mechanism. [1]

See for example Blundell-Wignall (1994), Harper (1994) and Moore (1994). [2]

For a more detailed discussion of average interest rate margins see Reserve Bank of Australia (1994). [3]