Understanding Reserve Bank of Australia Interventions (Wonkish)

In what follows is, I hope, an explanation of the recent Reserve Bank of Australia (RBA)’s $8.8 billion intervention into the Australian financial markets. The RBA, like other Central Banks across the world, sets a specific short-term interest rate, also known as the Cash Rate, which is at 0.5%. This is the rate at which commercial banks lend to one another in the money markets. It is not the rate at which banks lend to you or I when we borrow for a credit card, personal loan, or mortgage.

Consequently, the RBA as a setter of its Cash Rate allows the quantity of monetary aggregates to float.

The cash rate is the price for borrowing; the reward for lending between surplus and deficit commercial banks. Consider that the banking system as a whole cannot resolve a system-wide surplus or shortage of bank reserves, much like a game of hot potatoes. If there is an excess supply of bank reserves, that puts downward pressure on the Cash rate; an excess demand puts upward pressure. To maintain its desired Cash Rate, the RBA must use open-market operations to increase/reduce the supply of reserves depending on money market decisions.

Given recent fears of a possible recession in Australia, there has been disruption to financial markets. Keynes’ liquidity preference theory offers a useful explanation for some of the behaviour that we have seen. Cash is the most liquid of all assets, and an asset’s liquidity can be seen as its convertibility to cash. On one hand, treasury bonds are not much different from a term deposit with a bank, so both will have similar liquidity. On the other hand, housing is a highly illiquid asset: There are substantial transactions cost to selling a house to get cash as well as other barriers. Regardless, for Keynes, if liquidity preference rises – that is, people’s demand for cash or ‘money’ in general rises – there is upward pressure on interest rates, downward pressure if liquidity preference falls. How this plays out is that people holding assets such as treasury bonds or corporate bonds will sell these assets as their liquidity preference rises, which puts downward pressure on their prices. There is an inverse relationship between a bond and its interest rate. Hence a lower price increases its interest rate.

Yet, our Central Bank – the Reserve Bank of Australia – has a Cash Rate of 0.5%. Given the arbitrage opportunities that come with different interest rates, the RBA must intervene in the financial markets endogenously to maintain control over interest rates. In other words, through what is called the repo market (repo is short for repurchase agreement), the RBA becomes the buyer of the treasury bonds to put upward pressure on their prices and stabilise yields (which is their interest rate). At the same time, given that there are more reserves in the banking system as a consequence of such open-market operations, the RBA maintains control of its Cash Rate.

It is important to understand that this is not a ‘bailout’ of the financial system per se. Open-market operations do not change the net financial assets of the private sector. If the RBA purchases treasury bonds from the private sector, the private sector holds fewer bonds and more reserves. One asset is exchanged for another. The private sector altogether is not any wealthier as a result of open-market operations. What about income flows? Well, if interest rates fall, it is a rise in disposable income for borrowers but a fall for savers, and vice versa if interest rates rise. There is, of course, an indirect impact on net income flows of the private sector which is through federal government interest payments. If interest rates fall, the private sector as a whole has lower interest income because interest payments on ‘public debt’ fall, which translates into reduced interest income for private-sector recipients.

More accurately, a bailout is fiscal policy. Fiscal policy can change the net financial assets (NFA) of the private sector, increasing NFAs through deficits and decreasing NFAs through surpluses. We also have to include the external sector (the rest of the world from Australia’s point of view). Moreover, the budget balance is largely endogenous.

Tax receipts are driven largely by changes in economic activity while many forms of public spending are also endogenous. So if the private sector tries to go on a saving spree (Keynes’ paradox of thrift) and increase its net financial assets through a higher propensity to save, it will force the budget into a deficit (or larger deficit) through declining tax receipts and higher welfare spending as unemployment rises. So although causality can often run from a desired increase in NFAs, this increase can only be financed through public net-spending (budget deficits) or through foreign net-spending (current account surpluses, which means that the sum of the trade balance and net income balance is positive). But for the global economy as a whole, current account surpluses and deficits cancel one another out. As a result, for the world economy as a whole, private sector accumulation of NFAs depends on budget deficits.