‘I’ve never been able to understand the mechanics of the RBA’s influence over bank interest rates. My understanding is that the banks simply use the RBA to close off any open positions at the end of a business day – borrowing money from them at the overnight cash rate. How then, can this have such a profound effect on mortgage rates? What percentage of total funds on loan are actually provided to the banks by the RBA? I thought most of the banks funding came from wholesale markets, off-shore lenders and deposits? What difference would the overnight cash rate make to any of these?’ – Bristlemouth comment, November 2010
The invention of money was a nifty little innovation. As an exchange mechanism, it is obviously superior to the barter system. In the days before money, if you owned a cow and wanted a sheep, you needed to find someone who owned a sheep and wanted a cow. Money allows you to sell your cow for cash and use the cash to buy a sheep, or two if that’s what your cow was worth.
Money also provided humans with a store of value, which made ‘intertemporal consumption’ possible. This is just a fancy phrase economists have for saying you can consume now, or you can save your money and consume later. And this is where interest rates come in. The real interest rate (excluding the impact of inflation) represents the reward, or incentive, to delay consumption.
In the old days, the amount of money in circulation was fixed or, more often, linked to something else, like gold, the supply of which was fixed. Under this type of system, the interest rate would fluctuate daily and represented the market rate for deferred consumption. When people were feeling frivolous, the interest rate would be high (meaning more reward for saving). When prudence was the prevailing theme, interest rates were low (meaning you didn’t need much extra future consumption to encourage you to save today).
Today, interest rates are a tool for economic management, used to stimulate the economy in times of stress and cool it in times of hubris. Instead of fixing the supply of money, central banks target a specific interest rate and supply whatever quantity of money is required to achieve that target rate.
The Reserve Bank of Australia (RBA) performs this role in Australia and it does it by manipulating the overnight money market. Each day there are millions of deposits, withdrawals and loans made across the system. Some banks end up with a net surplus of cash, others end up with a deficit and, at the end of each day, they settle the differences in the overnight money market.
If the supply of money were fixed, interest rates would adjust so that deficits and surpluses across the system netted out. Because the RBA wants to target a specific rate, however, it supplies additional money if it wants to drive this clearing rate down, and takes money out of the system if it wants to drive the rate up.
In practice, because the RBA pre-announces what it wants the target to be, the banks all lend to each other at the RBA’s target rate (plus a small margin for credit risk) and the net surplus, or deficit, is absorbed by the RBA.
When the RBA’s target rate is lower than the natural clearing rate, people will borrow more money than they otherwise would and the RBA will be consistently be putting additional cash into the system, thereby stimulating the economy. This is known as ‘accommodative’ monetary policy. When the RBA rate is above the target rate, the opposite happens and the impact is a dampening of economic activity.
That’s how the RBA sets overnight interest rates. But how do overnight rates form the basis for all interest rates, including offshore funding and the rate you pay on your mortgage?
Well, the mechanism is not always perfect. Which is why the Federal Reserve in the US has had to resort to ‘quantitative easing’. They have driven overnight rates down to zero but, because that hasn’t translated into increased demand for money, they are using alternative tools to drive down the rates in longer-dated markets.
Usually, though, the overnight rate is the base off which all other rates are constructed. Imagine the market rate for 1-year money (borrowing or lending that must be repaid in one year’s time) is 5% and that the official RBA overnight rate is 2%. If you know the overnight rate is not going to change for the next 12 months and you work for a big bank, you can borrow money in the overnight market at 2% and lend it out at 5% for the next 12 months, making yourself a guaranteed profit.
Obviously everyone else would be doing the same thing and that would, in fairly short order, drive the one year rate down to the same level as the overnight rate. Things get a bit more complicated when you start to factor in changes in the RBA rate, but all long-term rates reflect expectations about what the future RBA overnight rate is going to be.
By changing expectations about what the future official rate is going to be, then, the RBA can influence long-term rates as well as short. And that, in a nutshell, is how the RBA sets rates.