Influencers might be a recent phenomenon, but there’s one that’s been in the business for decades with a reach tallying millions of people and the country’s biggest companies.
The Reserve Bank is not the kind of influencer you see on social media, although it does have an Instagram account with 12,000 followers. It also doesn’t control the interest rates set by the banks you and I visit.
Reserve Bank governor Michele Bullock. The RBA will deliver its next cash rate target decsion in February.Credit: Aresna Villanueva
So, why are changes our central bank announces almost always reflected in home loan rates, and why don’t they seem to flow through as much to interest rates on people’s savings?
To understand the process, we’ll need to dive into the secret life of banks, which the Reserve Bank explains on its website.
When we discuss the Reserve Bank’s monthly (now to be eight times a year) rate decisions, we’re usually referring to the cash rate target: a guide it sets for the interest rate commercial banks pay to borrow funds from other banks.
Lending and borrowing between banks mostly take place in the Australian cash market, also known as the “overnight market”. But it’s a bit of a misnomer: banks are not nocturnal beasts. Most of the interbank activity actually occurs during the day.
Every time the Reserve Bank changes its cash rate target, it tweaks the upper and lower bounds of this corridor, thereby effectively determining borrowing and lending costs between the banks.
If a bank determines it has more money than it needs on a given day, it will lend the excess to other banks on the overnight market. If, on the other hand, a bank faces a shortfall in funds to service customer needs, it will borrow from other banks. Basically, the “overnight market” is called that because any cash borrowed by banks is repaid the following day.
The overnight cash rate (a weighted average of the interest rates at which banks borrow and lend to each other overnight) isn’t fixed. It fluctuates during the day depending on how much money is being transacted between the banks. But the Reserve Bank’s cash rate target is a huge constraint on how much banks can expect to pay or receive in interest on their dealings in the overnight market.
Banks keep “exchange settlement [ES] balances”, which are stores of cash used to make interbank payments. These balances are basically the equivalent of cash, and are recorded in special deposit accounts kept with the Reserve Bank.
Since the amount of cash – or ES balances – affects the cash rate, the Reserve used to conduct daily “open market operations” before the pandemic, to manage the total supply.
The greater the supply of cash there is, the lower the cash rate, and vice versa, so the Reserve Bank would often purchase and sell bonds in exchange for cash, to influence the cash rate. This was often to keep the cash rate in line with its target day-to-day rather than to act on changes in the target.
The Reserve ramped up some of these actions during the COVID-19 recession, wielding a series of “unconventional monetary policy tools” to put downward pressure on the cash rate. That included purchasing bonds from federal and state governments in exchange for cash and offering a “term funding facility”, which gave banks access to three-year loans with interest rates fixed at the cash rate target. These strategies increased the supply of cash and brought down the cash rate.
In recent times, though, the Reserve Bank has returned to a less direct approach, especially when it changes the cash rate target, carving out a “policy interest rate corridor” to guide the banks as they determine the price – or interest rate – at which they lend to each other. The Reserve Bank creates this corridor through paying an interest rate on ES balances which is 0.1 percentage points below the cash rate target, and charging interest rates 0.25 percentage points above the target.
That generally makes borrowing and lending to other banks more appealing for banks than borrowing from and lending to the Reserve Bank, while discouraging banks from borrowing or lending to each other outside the corridor. (If they did so, no other bank would likely take them up on their offer because they could get a better deal from the RBA.)
Ultimately, the cost of borrowing for banks is passed on to consumers.Credit: AP
Every time the Reserve Bank changes its cash rate target, it tweaks the upper and lower bounds of this corridor, thereby effectively determining borrowing and lending costs between the banks.
Why does all this matter? Because ultimately, the cost of borrowing for banks is passed on to consumers.
Banks also borrow and lend funds to each other over slightly longer periods, such as a month. But even the interest rates on these slightly longer-term loans tend to track the cash rate (or what banks expect the cash rate to be over that time) closely. In fact, many interest rates across the economy are based at least loosely on the cash rate.
Since banks often fund themselves – and raise funds for lending to customers – with borrowed money, a change in the cash rate affects their funding costs, making it a major expense.
When the cash rate increases, and the banks’ funding costs increase, they tend to pass this on to borrowers through variable rates on home loans. They do the same for the money they borrow from people with bank deposits. Between May 2022 and October 2023, Australian banks passed on about 75 per cent of the cash rate increases to depositors.
While that’s in line with past periods of rising interest rates, and higher than other countries, including New Zealand and the US – where the equivalent pass-through rate is about 50 per cent and 35 per cent respectively – our banks may be more generous because they’ve been under greater scrutiny over the past year.
The competition watchdog – the Australian Competition and Consumer Commission (ACCC) – last year launched an inquiry into deposit rates amid concern that increases in savings rates were not keeping up with increases in mortgage rates set by banks as the Reserve Bank lifted its cash rate target.
It makes sense from a profit perspective that banks are eager to earn more on their mortgages by lifting repayment rates as soon as they can, while taking their time to increase rates they have to pay on people’s deposits.
The ACCC findings, released in December, showed while banks were lifting rates on deposits, there were fees and charges which made it difficult for consumers to find and switch to better deals on deposit rates, and that the highest deposit interest rates were often conditional.
The cash rate also affects longer-term interest rates and yields, but by less than the effect on short-term rates. That’s because long-term rates are affected by other factors, including cash rate and inflationary expectations, in coming months.
Because Australian home loans usually have interest rates that the banks can vary when they want to, changes in our cash rate target have a more immediate and large impact on domestic interest rates compared to countries such as the US, where most home loans have an interest rate that stays fixed for the life of the loan – often 30 years.
While the Reserve Bank will be lying low this month in its annual hibernation period, banks and consumers will be watching closely when the RBA wakes to deliver its next cash rate target decision in February. The Reserve may not have total control over the interest rates households pay and receive, but it’s an influencer neither banks nor customers can ignore.
Ross Gittins is on leave.
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