How the RBA Manipulates Interest Rates

The word, “manipulates,” sounds so conspiratorial. It gives the impression that a room full of bankers, economists and executives sit in secret each month, strategising how to influence our economy according to their pre-determined objectives.

Wait; Actually, That IS What Happens.

Of course, their stated role seems pure enough. The chief aims of the Reserve Bank of Australia (RBA) are to stabilise our currency, maintain full employment and promote the economic prosperity and welfare of the people of Australia. Although I’m not exactly sure how the RBA board members navigate their potential conflicts of interest, it’s probably best to trust that they really do have our best interests in mind.

So, on the first Tuesday of each month – except January, of course, because Aussies do little in January – the board members meet together to discuss monetary policy. The outcome of that meeting is the announcement of a target cash rate, which is the interest rate that banks end up paying to borrow in the overnight money market – more on that later.

Why The Target Cash Rate Matters

There’s always lots of talk in the media in the days leading up to the RBA announcement. People care about the monetary policy decision because it often has an immediate impact on their cash flow.

This is primarily because we’re a nation of debtors. When the RBA lowers their target cash rate, it usually translates into lower interest costs in the broader market. As long as banks pass along their savings, mortgage holders see an immediate decrease in their monthly expenses, boosting their cash flow.

Although borrowers win when interest rates go down, savers lose. That’s because the cash rate also impacts your return for opting out of riskier assets. When you choose to take no investment risk and keep your cash in the bank, you are being penalised by the RBA when they lower the cash rate. The biggest losers are pensioners who are in a season of life when they can’t afford to take on risk.

A few weeks ago when the RBA lowered the cash rate to 2 percent, they reiterated their intention to get you to be a spender and borrower, rather than a saver. They reckon that if they can keep your money out of the bank, it will make its way into someone else’s hands and create economic growth. Similar to Pavlov’s dogs, by diminishing the rewards for savings and enhancing the incentives for spending and borrowing, they can influence the behaviour of the masses.

One potential downside of lowering the risk free return, is that it forces people to take on greater risk to obtain returns that exceed inflation. Because most people lack the skill to invest in potentially risky assets in a non-risky way, these people have little choice but to speculate and hope for the best. This can lead to what Austrian economists call malinvestment.

For more on the dangers of low interest rates, check out my article, 5 Reasons Artificially Low Interest Rates Suck Long-Term.

The RBA’s Manipulation Process

Like many, I always thought the RBA was like the bank for the banks. I assumed that just like Commonwealth or Westpac sets the interest rate for their mortgage lending, the RBA also fixes an interest rate, and that’s what the banks pay them on their short-term loans.

In actuality, it isn’t that simple. The RBA can’t just set interest rates at 2 percent. The reason is because in a free market, banks will always try to find a better deal. The RBA must work with the forces of supply and demand for money, and then push or pull interest rates where they want them.

In other words, they must manipulate the market to produce their desired monetary outcome. That’s why they call it the “target cash rate.” It’s a rate that they aim for, not one that gets set arbitrarily.

How The Process Works

As I mentioned before, the cash rate is the interest rate that banks charge each other to borrow and lend on a short-term, overnight basis. Banks need to borrow and lend like this because they need to regulate the amount of funds in their exchange settlement account (ESA), a kind of deposit account for banks held by the Reserve Bank.

It’s through these exchange settlement accounts that the countless transactions in the economy are settled each day. When you transfer money to a friend by direct debit, the funds travel from your account and across your bank’s ESA, to the ESA of your friend’s bank, and then it goes into your friend’s account.

Just as your bank requires you to keep a positive balance, the RBA also requires that banks keep their ESA’s positive. If they happen to drop below a zero balance for the day, they can borrow from the RBA at a premium if they wish to, at a quarter of a percent above the cash rate.

But the RBA doesn’t want your bank to keep too much money in their ESA. They want that money out in the economy. So they incentivise banks by paying a very low interest rate, which is a quarter of a percent below the cash rate, on any money left in the ESA at the end of each day.

So, to keep their ESA balances in their sweet spots, and to avoid the RBA’s unattractive interest terms, banks borrow from and lend to other banks in the open money market.

Just like you, your bank wants to earn money on their money. So if they think their ESA balance will be too high for the day, they will loan their extra money out to another bank that needs to keep from going to a negative balance.

The needy bank will pay the cash rate to borrow from them, which is a win for the bank with extra money, because it’s higher than the lower rate that the RBA would have paid them.

The needy bank also wins, because they get a deal and save the .25 percent premium that the RBA would have charged them. Therefore, the RBA effectively incentivises banks to do business with one another.

How the RBA Gets Their Power to Influence the Cash Rate

In any market, whoever controls supply controls the market. You’ve probably heard the stories about the myriads of diamonds sitting in vaults in Europe waiting to be released to the market. By controlling the supply that arrives into jewellery stores, gem companies can give the illusion of scarcity and keep prices high.

The RBA’s ability to control the cash rate comes from the fact that they control the supply of funds, or the liquidity, in this overnight money market. They determine the total amount of funds available. The RBA pours additional money into the market if it wants to drive the cash rate down. It also takes money out of the system if it wants to drive the cash rate up.

If banks are happy to hold higher ESA balances, the RBA increases the supply to stop the cash rate from moving up, as the banks bid more aggressively to borrow from each other. If the banks are holding less cash in their ESA, the RBA would decrease the supply. This keeps the banks from trying to lend below the cash rate to get rid of their excess funds. By tinkering with supply, the RBA hits their target cash rate.

Where does the extra money come from to boost supply? It’s a little complicated, but basically through the process of trading government bonds, they create new money essentially out of nothing. In other words, in order to lower interest rates, the RBA must print digital money, increasing the money supply.

Of course, creating more money makes our currency worth less against other currencies, which is why the Aussie dollar has weakened so much over the last six months. In fact, this devaluing of the dollar has been one of the primary stated goals of the RBA.

Conversely, if the RBA were to pull money out of the system by buying bonds to increase the target cash rate, the currency markets would likely drive up the value of our dollar.

As long as the system functions as it should, this cash rate is a significant determinant of the banks’ overall costs of funding. If the cash rate drops by .25 percent, then the whole structure of funding costs for the banking system would also shift down by around the same amount.

But the prevailing lending rates in the broader market to households and businesses are not only based on the cash rate. Banks want to make money, so they add on premiums for both risk and profit for shareholders. This is why the banks don’t always pass on their savings to customers.

Is this not complicated enough for you? If you want to delve even deeper into this whole process, you can have a read through of a speech given a few years ago by Assistant RBA Governor, Guy Debelle, at the University of Adelaide Business School.

The Limits of a Central Banks Power

Sometimes those who must manipulate to get what they want find they don’t have as much power as they had hoped they would have. Although central banks, as we know them today, have been around for about a 100 years, the recent phenomenon of quantitative easing (QE) and artificially low interest rates is very much an experiment.

The entire system rests upon the faith that people have in the Aussie dollar. As long as enough people believe it has value, the RBA has significant power. But if we ever reach a tipping point where that sentiment changes, the RBA would find their hands tied.

To quote Warren Buffet, “QE is like watching a good movie, because I don’t know how it will end.” Only time will tell how this all will turn out, but keep in mind, there are forces greater than supply and demand at work here.

By Jason Staggers

Jason was a personal mentor working with Steve McKnight's Property Apprentices. He helped hundreds of investors apply Steve's teachings in the real world and achieve greater results on their journey to financial freedom. Jason now lives in Perth, WA where he leads Neuma Church.