RDP 9504: The Link Between the Cash Rate and Market Interest Rates 2. The Operation Of Monetary Policy
May 1995
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Monetary policy operates via the Bank influencing the interest rate paid on overnight funds (the “cash rate”).[4] Changes in this rate affect the entire structure of interest rates in the economy. The Bank's influence over the cash rate comes from its ability to control the availability of funds used to settle transactions between financial institutions. By undertaking open market operations, principally in government securities with less than one year to maturity, the Bank controls the availability of settlement funds and hence the interest rate paid on overnight deposits.[5]
Prior to January 1990, the Bank did not announce its desired level for the cash rate. Instead it signalled the desired level by operating in the market for settlement funds, which meant that there was considerable daily volatility in the cash rate. This operating system had the advantage of allowing policy to be changed in a relatively low-key manner, but it had the disadvantage of sometimes making it difficult for the market and others to distinguish between noise and a change in policy.
In January 1990, the Bank began announcing its desired level for the cash rate. When announcing a change in the desired level, the Bank explains to the market and the community at large the reasons for the change. The impact on the behaviour of the cash rate of announcing the Bank's desired level can be seen in Figure 1, which shows the cash rate on a daily basis since the beginning of 1988. Since January 1990, the rate has been considerably less volatile, with the actual rate prevailing in the market being very close to the Bank's desired rate.
