RBA’s Esoteric Levers: Australian Interest Rates & Costs

Introduction: The RBA’s Broader Toolkit

In our previous article, we explored how the Reserve Bank of Australia (RBA) uses its cash rate target to influence Australian Interest Rates. However, the RBA’s influence extends beyond this primary tool. During times of severe economic stress, or when the cash rate nears zero, the RBA has deployed other powerful measures. This article delves into these unconventional tools and examines the significant financial costs they can impose on the RBA’s own balance sheet.

1. Beyond OMOs: Other Tools Influencing Australian Interest Rates

While the cash rate target is the main tool, the RBA has used other measures. This is especially true during tough economic times. It also happens when the cash rate is very low. These tools include:

Forward Guidance: The RBA tells the market its future plans for the cash rate. For example, in March 2020, the Board promised not to raise the cash rate. This was until inflation was steadily within the 2-3% target. It also waited for progress towards full employment. Forward guidance aims to affect longer-term interest rates. It does this by shaping market expectations.[19]
Quantitative Easing (QE): This policy involves buying large amounts of assets. Mainly, these are government bonds in the secondary market. The goal is to lower long-term bond yields. It also aims to reduce overall borrowing costs. This helps to boost the economy. The RBA bought $281 billion of federal and state bonds. This was through its QE program between November 2020 and February 2022. QE adds to the money supply. It creates commercial bank reserves, or ES balances.
Yield Target: From March 2020 to November 2021, the RBA set a target for the yield on the three-year Australian Government bond. This was a direct way to achieve low funding costs. It also supported the forward guidance about the cash rate staying low. The RBA bought bonds to maintain this target.
Term Funding Facility (TFF): This facility gave low-cost, long-term funding to banks. It further supported credit flow. It also boosted confidence in the financial system.

The RBA uses both traditional and unconventional tools. This shows a smart and flexible approach to monetary policy. When the cash rate is near zero, it cannot stimulate the economy much more. Unconventional tools let the RBA directly influence longer-term Australian Interest Rates. This affects borrowing costs for businesses and homes over longer periods. This broad approach shows the RBA’s commitment to its goals. It acts even in very difficult economic times. The choice to use such tools means the RBA judged the economic shock, like the pandemic, was severe. It needed special actions to keep the financial system stable. It also needed to support economic activity. The RBA later reviewed the yield target. It noted its “disorderly exit” and “reputational damage”. This shows the RBA is always learning and improving its policy tools. It constantly checks its strategies. This is to make them work best and avoid bad side effects.

2. The Financial Cost of RBA’s Australian Interest Rates Management

Keeping the cash rate at its target can be costly for the RBA. This is especially true with many ES balances. These balances were created by policies like Quantitative Easing. In 2022/23, the RBA reported an accounting loss of $6 billion ($4 billion accounting loss in 2023/24).

A main reason for these losses is negative net interest earnings. The RBA pays interest on the large amount of ES balances held by commercial banks. These are a liability on its balance sheet. As the cash rate rose, so did the interest paid on ES balances. This interest paid to banks was more than the interest the RBA earned on its assets. These assets include government bonds bought during QE.

The RBA also has gains or losses on its government bonds and foreign exchange. When market yields on bonds rise, it leads to losses in value. This is because bond prices move opposite to yields. In 2022/23, unrealised losses of $1.8 billion added to the total loss. Because of these losses, the RBA had negative equity of $17.7 billion by June 30, 2023. The RBA says negative equity does not stop it from working. But it plans to restore its equity by keeping future profits.

The risks of the RBA’s operations vary. Floating rate OMOs are directly linked to the RBA’s liabilities. They do not carry interest rate risk for the RBA. But other operations, like buying bonds outright under QE, can have financial risk. The yield target, for example, is estimated to cost $1-2 billion. This is due to later rises in bond yields.

The financial cost borne by the central bank itself represents a crucial, yet often overlooked, consequence of modern monetary policy. The RBA’s substantial accounting losses and negative equity position are not merely abstract figures; they are a direct outcome of its actions to stabilise the economy during and after the pandemic. The mechanism behind these costs is clear: Quantitative Easing massively increased banks’ Exchange Settlement (ES) balances, which are liabilities for the RBA. When the RBA subsequently raised the cash rate to combat inflation, it was compelled to pay higher interest on these ample ES balances. Concurrently, the rising interest rates led to a decline in the market value of the bonds the RBA held from its QE purchases, resulting in significant valuation losses.

This situation effectively represents a transfer of wealth: from the RBA, and indirectly potentially the taxpayer, to commercial banks, via interest on ES balances, and to bondholders, whose bonds were purchased at higher prices. This underscores that policies designed to inject liquidity and stimulate the economy during a crisis, while effective, often come with a deferred financial reckoning for the central bank’s balance sheet. This can also generate political scrutiny and raise questions about central bank independence, even if the RBA maintains its operational capacity.

The question of whether these significant costs could be better used by the government rather than “funnelled into pockets of money market participants” is a matter of ongoing public and economic debate. The RBA’s view is that these costs are a necessary consequence of implementing monetary policy effectively to achieve its mandate of price stability and full employment, which ultimately benefits the broader economy. Not an unexpected admission.

Conclusion: The Broader Toolkit and Its Trade-offs

The RBA’s monetary policy extends far beyond simple cash rate adjustments. Its use of unconventional tools like QE and yield targets, while crucial for economic stability during crises, comes with significant financial implications for its own balance sheet. These costs, though often accounting-based, highlight the complex trade-offs inherent in modern central banking and the broader impact on Australian Interest Rates.

What’s Next?

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Disclaimer

🔒 This article is for general information only and is not legal or financial advice. Business owners should contact C3 to obtain independent professional advice specific to their situation.