Explain it: Cash Rates

Guest Author: ESYP

Introduction

The cash rate refers to the rate of which banks loan each other money in order to balance their ESAs (Exchange Settlement Accounts). To understand the cash rate, one must firstly understand the concept of the open market operations in Australia.

Open Market Operations

On the first Tuesday of every month, the RBA (Reserve Bank of Australia) board holds a meeting to set the target cash rate for the next month after which at 2:30pm, the target rate will be announced. This is also referred to the government’s monetary policy. Contrary to common belief, the rate does not immediately come in to operation but rather operates with a lag.

After this rate is set, the RBA will start open market operations, that is, they will start to utilise the selling or purchasing of government securities to and from financial institutions in order to reach that target rate. If the RBA board decides to increase the cash rate, in line with contractionary monetary policy, which is to decrease spending, the government aims to reduce the supply of money and thus increase the “cost” of money. To achieve this, the RBA will sell government securities such as bonds, at a discount in order to entice the purchasing of this bonds. As part of the law, the ESAs of every bank must be balanced. However the nature of the ESA is that it facilitates inter-bank monetary transfer. For example, if a customer of ANZ writes a cheque and gives it to someone who deposits the cheque at Westpac, this is an interbank transaction. In turn, along with the millions of other different interbank transactions, they must balance the differences between the banks. As the RBA pays an interest rate of -0.25 of the cash rate for excess funds and +0.25% of the interest rate for any shortages, there is an incentive for banks to loan each other this money. As such, after enough of the government securities are sold or bought, money must move between the institutions and the RBA.

When increasing the cash rate, the banks transfer their money from the ESAs to the RBA in exchange for the bonds and the RBA transfers money to the Banks’ ESAs in return for the bonds when a decrease is wanted.

Because of these transactions, there is an effect on the liquidity of financial institutions. When there is an increase in the cash rate, banks’ ESAs will now have less money and thus have to replace that money to avoid penalty and as such institutions will now have to compete for the limited cash available thus driving up the cash rate. In the event that there is a decrease in the cash rate, bank’s ESAs will now have more money and now want to get rid of this excess cash. Therefore institutions will compete to get rid of their surplus cash thus driving down the cash rate.

Because the cash rate is the wholesale rate that affects whole sale borrowing, retail interest rates will follow suit, be it with a difference to ensure the banks make profit.

 

Impact on you

You might be thinking, what’s this talk about banks and the RBA got to do with me? I’m not looking to borrow from the RBA? The key impact of the cash rate on the general population is the incentive to spend on credit. If banks decide to reduce their retail interest rates because of the lowered interest rates, interest repayments for mortgages or personal loans will drop and as such the final cost of buying that good will decrease. Additionally, reduced retail interest rates will decrease the incentive to save as your monthly interest payments from your savings accounts will decrease. This means that there is encouragement to spend!

As such, understanding the business cycle will be key in avoiding larger interest repayments than you have to. We’ll be covering that next time on Explain it!

 

 

 

 

 

 

 

 

Disclaimer: None of the information in this article is professional financial advice. The author(s) of this article will not be liable for any financial decisions made based on the information of this article.

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