RDP 9703: The Implementation of Monetary Policy in Australia 2. The Australian Framework for Implementing Monetary Policy

2.1 Current Operating Procedures

Domestic market operations became the main mechanism for implementing monetary policy in Australia in the mid 1980s, as part of the general trend towards deregulation. The immediate objective of these operations is the overnight interest rate (also known as the ‘cash’ rate), which is the instrument of monetary policy. Since 1990, the Bank has announced an operational target for the cash rate each time monetary policy is changed.

Market operations influence the cash rate by changing the availability of banks' ‘settlement’ balances – that is, the funds used by banks to settle payments across their accounts at the Reserve Bank. These settlement balances are held in banks' Exchange Settlement Accounts at the Reserve Bank, and do not count towards reserves held for the purpose of meeting reserve ratios.^[2] Interest is paid on settlement balances at a rate 10 basis points below the Bank's target for the cash rate.^[3]

Exchange Settlement Accounts must be in credit at all times, so banks seek to maintain sufficient funds in these accounts to meet their daily settlement needs – i.e. the demand for these reserves is essentially a transactions demand, and is quite well defined. Any tendency for reserves to move away from the level that banks regard as desirable quickly results in pressure on the cash rate as banks attempt to restore their holdings to the desired level. The fact that banks earn a rate of return on their settlement balances which is only a small margin below the overnight rate means that downward pressure on rates is limited.

The Bank's market operations are conducted in Commonwealth Government securities (the securities issued by the Federal Government). They involve both outright trading and repurchase agreements, though the latter account for about 90 per cent of transactions. At times, the Bank supplements these operations with foreign currency swaps. Any participant in the wholesale market for government securities is eligible to deal with the Bank.^[4]

Inter-bank settlement is on a net, deferred (next-day) basis.^[5] This means that the ‘exogenous’ factors which affect the banks' cash position are largely known at the start of each day. The Bank publishes this estimate of the cash position at 9.30 am each day, together with its dealing intentions for the day (whether it will buy or sell, though not the amounts). Announcements of monetary policy changes are also made at this time. Dealing operations are conducted later in the morning, around 10.30 am. Because the market cash position is known at the start of the day, the Bank usually needs to engage in only one round of dealing each day to maintain the required degree of reserve pressure.

Should, for some reason, banks wish to obtain additional reserves to those supplied by the Bank in its morning dealing round, they (and any other market participant) may rediscount Treasury notes at the Reserve Bank at their discretion. A substantial penalty applies to rediscounts (75 basis points over market yields) and, given that the cash rate rarely diverges from the target by this margin, the rediscount facility is used only infrequently.^[6]

2.2 History of Policy Announcements

Prior to January 1990, the Bank did not announce its monetary policy stance when changes were implemented; instead, market participants assessed the stance of policy from the Bank's actions in money markets and from changes in the overnight interest rate. Under this arrangement, changes to policy were not always immediately obvious to the market due to noise in the overnight rate.

This method of operation was common to a number of countries at that time. After the difficulties experienced with administered interest rates in the 1970s, central banks saw advantages in implementing monetary policy through market operations and having some volatility in short-term interest rates; in particular, this was seen as providing some flexibility in policy implementation – e.g. there was scope to start ‘snugging’ rates higher and then reverse if subsequent data did not support the move. This arrangement was seen as allowing central banks to take timely action, particularly in raising rates, as it avoided the risk of having to announce reversals of policy which could be damaging to credibility. To the extent that volatility in interest rates encouraged a public perception that markets set financial prices, it was consistent with the then prevailing view that central banks should focus on quantities rather than setting financial prices.

In January 1990, the Bank decided to ease policy after a prolonged period of very tight monetary conditions in the late 1980s. There were concerns about how this would be received in financial markets. For one thing, the change marked a reversal of a process of policy tightening that had been going on for about two years. The decision was also somewhat pre-emptive, and therefore ahead of a clear consensus in the market about the need for an easing. The situation was further complicated by the fact that a federal election was imminent, and there was a risk that in the circumstances the easing could have been interpreted as being politically motivated. For these reasons, it was felt that the Bank should make a public explanation of the policy change.

This initial announcement was made mid-morning, at the end of the Bank's dealing session for that day and as market interest rates began to fall. The announcement was seen as being very successful and a similar approach was followed in the subsequent easing. The practice of announcing each policy change has continued since, with the timing being brought forward to the start of the day – i.e. ahead of the Bank operating in the market.

The decision to make announcements brought with it the need to make explicit the size of the change in interest rates. Initially, the Bank gave a range for the cash target, on the grounds that it was not sufficiently confident that it could immediately achieve a precise target. In the event, however, the Bank soon found that its control over the cash rate had increased under the new arrangements, and it therefore began to announce a single target rate. As time went on, market dynamics changed further, with the cash rate moving quickly to the new target on the announcement – i.e. ahead of the Bank operating in the market for the day.

The effect of the change in operating procedures on the speed of adjustment of the actual cash rate to changes in the target rate has been estimated using the following error-correction model,

where r_t is the actual cash rate and is the target cash rate.^[7] The equation was estimated using daily data and over two time periods: the first running from 1 July 1985 to 22 January 1990 (the day before the first announcement) and the second from 23 January 1990 to 2 September 1996. In estimating the equations we initially included seven lags of the changes in both the actual and target cash rate and then used the general-to-specific methodology to obtain a more parsimonious specification. The estimation results are reported in Appendix A.

As expected, the estimates for both periods indicate that eventually changes in the target cash rate are fully reflected in the actual cash rate. There are, however, important differences in the two sets of results. First, in the earlier period the absolute daily changes in the cash rate were much larger and much less well explained by movements in the ‘target rate’. Second, in the period in which announcements have been made, the actual cash rate has adjusted more quickly to the target rate. By the day after the change in the target rate, the adjustment is complete with the vast bulk of the adjustment occurring on the day of the policy change.^[8] In contrast, in the earlier period the point estimates suggest that if the ‘target rate’ was changed by 100 basis points, the actual rate would move by only 34 basis points on the day of the change; after one week the actual rate would have moved by around 60 basis points, and after one month, by around 85 basis points.

Footnotes

The reserve ratio on banks is set at 1 per cent of liabilities. The reserve requirement is determined each month in relation to the previous month's average liabilities. This reserve ratio currently has no monetary policy significance, but effectively acts as a tax on banks (they are paid a rate of interest 5 percentage points below the market rate). [2]

In June 1997, the Bank announced its intention to increase this margin to 25 basis points. [3]

Prior to June 1996, the Bank's dealing counterparties were restricted to a group of authorised money market dealers (discount houses). [4]

Australia is scheduled to move to a real-time gross settlement payments system over the next year. [5]

For more detail on the history of the Bank's domestic market operations see Rankin (1992, 1995) and Battellino (1990). [6]

In the earlier period, where there was no official target cash rate, we have used the mid-point of the informal band that guided the operations of the Bank's domestic trading desk. [7]

Prior to the Reserve Bank paying interest on settlement balances, there were opportunities for banks to earn a small profit around the time of the change in policy by attempting to adjust their level of float, i.e. net obligations arising from unsettled cheques. Because the interest rate paid on the float was based on the average cash rate for the week, a change in policy late in that week meant that banks had some scope to arbitrage between the overnight rate and the float rate, which could slow down the adjustment of the overnight rate to the new target. [8]