The start of 2015 may well be remembered for a large increase in central bank activity. After years of low or zero interest rates and quantitative easing across most of the developed world, many of us are now getting very familiar with seeing the likes of the Reserve Bank of Australia (RBA) governor, Federal Reserve (Fed) chair or European Central Bank (ECB) president across the front pages of our news.
However, even after years of industry exposure and study, the mechanisms and workings of monetary policy (interest rate and money supply manipulation) can still seem to be quite confusing and even, at times, counter-intuitive.
In short, the Reserve Bank of Australia (RBA) is our central bank and is charged with, among other things, the setting and managing of monetary policy. Monetary policy refers primarily to changes to the overnight cash rate. The overnight cash rate is the rate of interest charged by the RBA to lend out funds to banks. Banks are the companies who make billions of dollars whilst claiming poor. But why do they need to make changes to this rate, and how does it affect us.
The overnight cash rate set isn't actually a mandated market rate, but is in fact a target rate. Every morning the banks look to determine whether they will have surplus funds or insufficient funds for that day. If they have surplus, they will look to invest it in the overnight (1 day) money market and if they don't think they will have enough, they will look to borrow for the day in the same market. The main players in the overnight money market (i.e. investing or saving for just the one day) are the banks, and it is why it is usually referred to as an interbank market. The rate will be set just like it is set in any other market, by supply and demand for the overnight funds, but the central bank intervenes in this market, changing the supply or demand to ensure that the overnight rate is as close to their target rate as possible.
From an overall point of view, the seemingly collective aim of the central banks of the developed world is to manage inflation and stabilise economic growth – mainly keeping things steady. Inflation occurs when prices rise and high inflation is feared amongst most economists, as it tends to indicate an economy that is growing too fast, with lack of stability or sustainability. The RBA would love for inflation to hover around the 2-3% pa level, and economic growth to hold around the 3-4% pa mark. For much of the past decade we have been above these inflationary levels, which was the main reason for the interest rate increases seen from 2003-2008. During the GFC, though inflation was still high, the RBA did see fit to slash interest rates in an effort to make the impending slowdown feel not so bad. And it did help to a large extent.
So the main workings of the RBA seem to be either to stimulate or dampen economic fervour. If things are moving too fast (as measured by inflation, wage growth, GDP growth and maybe some employment indicators) the RBA can tighten monetary policy by raising the overnight cash rate. This leads to economic contraction as it becomes more attractive to put your money in the bank rather than spend or invest. Increases in debt repayments also lead to the same outcome. Less spending and investment means less profits, inflation and growth. The opposite outcome can be achieved when things are moving too slow through the loosening of monetary policy.
Into the future, central banks will continue to walk that fine line between economic sense and public angst. Low rates are good for some (mortgage holders), but not all (retirees living off fixed income assets). This is the reason why they will continue to take up so much of our news space, as their actions affect so many. And in communicating with the public, their aim is likely be to create assurance and calm, just as their policy settings are meant to help support economic stability.
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