EXPLORING YOUR OPTIONS Dr Frédérique Bracoud WHAT’S THE FUSS ABOUT THE CASH RATE?
Transcript
EXPLORING YOUR OPTIONS
Dr Frédérique Bracoud
WHAT’S THE FUSS ABOUT THE CASH RATE?
Frederique Bracoud
Hi everyone. I hope you are all having a wonderful time at UQ today. My name is Frederique Bracoud and I have been teaching financial markets and institutions to UQ Economics students for the past eight years. Today I would like to give you a flavour of a fascinating topic that I teach to my students: how the Reserve bank of Australia uses the cash rate to conduct its monetary policy. Every month on the first Tuesday the media would report on the cash rate decisions of the RBA and every month, let's face it, analysts would go on and on about that decision. Surely you may have wondered what is so special about that cash rate to deserve that level of attention.
The fuss….
2.00%
Cash rate target
Frederique Bracoud
Speaking of cash rate, Just curious, can someone remember the decision that was taken by the RBA two weeks ago on the 1st july? have a guess! Indeed the RBA decided to keep the cash rate target on hold at 2.50% the same level since August last year.But what is this number standing for?
What is the cash rate?
The cash rate is the interest rate on
A. RBA loans to commercial banks.B. mortgage loans to households.C. loans among banks.D. deposits that banks have at the RBA.
Not obvious for some people ….. even for chief economists in banks
….. or Wikipedia!
Frederique Bracoud
"The cash rate is the rate that's paid on the balances which the banks maintain in their exchange settlement accounts with the Reserve Bank”, [Answer E] Bank of America Merrill Lynch Australia's chief economist Saul Eslake said. is the rate of interest which the central bank charges on overnight loans to commercial banks. Wikipedia
Frederique Bracoud
What is the cash rate? let's do a quiz!. i read. Please have a guess. The answer is loans between banks and the first remark is that at first sight that has nothing to do with the RBA. Anyone had the good answer? Well done! for those who chose D do not feel bad. A very important analyst at merrul lynch thinks this is the defintion of csh rate. he is wrong. If you have answered A do not feel too bad either. This is the definition given by Wikipedia and it is wrong. So please listen to your teachers here when they say to USE WIKIPEDIA with caution?
End of the day
The day after
2% per year 0.0055% per day
Overnight interbank interest rate
interest rate
Bank A Bank B$1,000,000
Bank A Bank B$1,000,055
Frederique Bracoud
let's say it again: The cash rate is the interest rate on the loan between two banks. to be more precise this applies to an overnignt loan.one day say bank A lends 1 million to bank B and the day after bank B repays the 1 million plus some interests equal to 68 dollars. Why 68 dollars? simply because an annual rate of 2.5% gives an overnight rate 365 times smaller whcih is 0.0068%.The question is what is the nature of this money that is lent between commercial banks?
Central bank moneyThe funds that banks lend to each other are very special.
█NOT notes and coins
█NOT balances in commercial bank deposit accounts
█They are balances in deposit accounts at the RBA
can only be transferred among banks, to the government or to the RBA
$
RBA
Frederique Bracoud
Never seen or used by mortals like us. So where the media blame the banks for have a lot of central money and not lending it, it makes my hair ?? as technically speaking they simply cannot. A loan to a business is not lending central money!
Frederique Bracoud
The money that banks lend to each other is a very particular type of money called central bank money. it is different from notes and coins that you may have in your wallet to buy a coffee. It is different from the money we all have in a bank account, which by the way is electronic money, not a pile of notes sitting in a pigeon hole with your name on it. Central bank money is the balance in the deposit accounts that banks hold at the central bank. To say it in a straighforawrd way, The central bank is the bank of the commericial banks. It is a very special type of money that only banks have and can use with another bank, with the RBA and with the government.You and me will never be able to own and use that type of money. Commercial businesses and most financial institutions like insurance companies, superannuation cannot have this money either. Only banks can have it.why that?
Behind the scene all the time!Mobile phone monthly bill
paid by Will (bank account at Bank B)to the Mobile phone provider (bank account at Bank C)
Will’s bank account
Mobile Phone provider’s
bank account
$45
$
Bank B Bank C$45
$RBA
Frederique Bracoud
45 is if you respect the quota. If not be aware Mine was nearly the double this month!Imagine this transaction being reproduced for all Australians households and for all businesses. GIVE A FIGURE!!!!!! All payments will be netted and at 9am the net amount will be taken from banks account at the RBA.If we exclude transactions involving other countries and inolving RBA or governments the loss for one bank will be a gain for another one. So it should be OK to borrow in the interbank market.
Frederique Bracoud
banks need that type of money to perform their duties in the payment system. Becasue they manage the money held by customers in their deposit account, banks make payments on our behalf all the time. Every transaction that we do from our bank account requires our bank to do the same with their account at the central bank. let's illustrate that idea with this simple example.Will who has a bank account in bank B needs to pay his bill to his mobile phone provider who has an account in bank C. In order for the money to go from Will to the provider, the bank of will has to do an equivalent payment to the bank of the provider. Payments in our money are mirrored behind the scene by payments in central bank money.
What if Bank B has not enough money?
Bank C
Payment system
RBA
Bank B
Bank A
Interbank Market
Frederique Bracoud
We can now go back to the loan between banks. The reason why a bank borrows from another bank is becasuse they do not have enough central bank money to meet their duties in the payment system.if bank b does not have enough central bank money to pay bank C then bank b needs to borrow from another bank.the cash rate is the interest rate that bank B will need t pay to bank A.
Interbank rate is a major cost for banks banks
When the RBA changes the cash rate,
█ the costs of banks are affected █ banks need to adjust the rates on their loans
(housing loans, personal loans, student loans….)
in order to maintain their profit margins.
Frederique Bracoud
remove RBA in 2015
Historical low 2.00%
High 7.50%
Your life
Frederique Bracoud
next year put the highest or 2008.decrease the life span to 17 year old.
Frederique Bracoud
It is clear from this diagram that the interest rates on new housing loans represented by the green line or interest rate on existing loan by the grey line are following very closely the movements of the cash rate represented by the red line. When the cash rate increases the interest rate on mortgages increases as well and vice versa.May I ask you in which year you were born?What about you? here is my students life pan, yours is shorter obviously. You have however witnessed very extreme levels. In your childhood the cash rate increased above 6%, and 7.25% when you started college while now as maturing teenager it is at 2.5%,. You may not be aware of it but you are actuallycurrently living an historical moment as 2.5% is the lowest level everrecorded for the cash rate. 7.25% in 2008 was high but was far from being a record high. To put this diagram in perspective I should tell you that In January 90 the cash rate was 17.50%! I am sure that your teachers here, and your parents still have a painful memory of these days! Ask them tonight at dinner...you may have a very interesting conversation.[You have also witnessed a record decrease in the cash rate with a 400 basis poitn decrease in less than 5 months end 2008 beginning 2009. this naturally coincides with the collapse of lenman brothersand AIG two giant financial institutions in the US.]I guess this does not speak too much to you, and I am sure you have more interesting things to do than worrying about the changes in the mortgage rate. Fair enough... There are some aspects nevertheless that may be quite relevant to you.let s wait and see....
Frederique Bracoud
Let's speak about more interesting topics. Christmas? That's a god one18TH July-25 th december. Only five months before Christmas. It is about time you think about your wish list: is it going to be GIVE 3 EXAMPLES OF TRENDY GIFT and THREE EXAMPLES OF VERY BORING TRADITIONAL CHEAP ONES?But the question is will Santa - I mean will your parents - agree to provide these beautiful gifts?Well as a matter of fact the answer to that question may well depend on the cash rate! The freaky (??) news I have for you today is that The decision of which gift you may get next Christams may be in the hands of the governor of the Reserve bank of Australia.
Your Samsung Galaxy S6 may be at risk!If your parents have a $300,000 mortgage loan,
an increase in the loan rate by 0.50 percentage point
will cost your parents approximately
█ an extra $100 a month in repayments
█ an extra $500 dollars in repayments between August and Christmas!
Your parents may decide to buy you SOCKS instead of a Samsung Galaxy S6!
Frederique Bracoud
You understand that the result is that your parents will reduce their consumption.Another consequence is that people will not buy houses so easilyThe spending of the economy my decrease affecting economy activity.The seller of iphone may be affected, the supermarkets will be affected, the local restaurants will be affected, etc etc....
Frederique Bracoud
or they may buy you the iPhone and save on food shopping or dining out.The decrease in spending will affect the economic activity.
Transmission of monetary policy
Cash rate
Bank interest
rates
Exchange rate $
Financial markets
rates
Consumption spending
Economic growth
Inflation
Business spending
Net exports
Spending on new Housing
Frederique Bracoud
Let's take a wider view.In a period of slow economic activity as it has been the case during the GFC, a decrease in the official rate is likely to be the decision taken by the central bank.let's see how it works.
Who decides the cash rate?
Commercial banks freely choose the cash rate.
The RBA cannot impose the cash rate on private contracts.
What’s the trick then?
Frederique Bracoud
Wait a minute! In hte previous slide I said that this was the key component of monetary policy and now I saying that the RBA cannot impose it on banks! Am I suffering for short term memory problems?
Frederique Bracoud
We still have not mentioned the RBA involvement in the cash rate detarmination.The cash rate is the interest rate in a private contract between two commercial banks in a free market. The RBA does not have any authority to impose the terms of a private contract.
The trick█ The RBA does not choose the cash rate in the private █ contract but chooses a target, a desired level
█ The RBA manipulates the stock of central bank money every day
█ The RBA can create situations where banks do not have enough or where banks have too much central money
█ The RBA affects the conditions in the interbank market and the cash rate
RBA
Frederique Bracoud
If not enough central bank money banks will fight to get it and they will be prepared to pay a high cash rate for borrowing. If too much they will be prepared to lend at a lower rate.
Demand and supply of central money
Cash rate
Quantity of central bank money
Cash rate target: 2.00%
Cash rate chosen by
banks
SS
SD
S
Frederique Bracoud
You know economists cannot think without using demand and supply curves. so here they come.On the vertical axis is the cash rate; on the horizontal axis is the quantity of central bank money. The suply curve is the quantity of central bank money available in the banking system while the demand curve represents what banks would like to have. In my course I explain in depth why the demand curve has a negative slope but I will spare you the details today. The interest rate on bank loan will need to be at the intersection of the two curves. If the cash rate was higher than the intersection level if the supply was higher than the demand then banks would have too many reserves for their taste and would try to get rid of tehm by lending them to other banks. however, because in aggregate there is too much supply there is no way that banks can find enough banks to borrow from them. This creates a pressure down on the cash rate to try to get rid of the reserves and at the end of the process the cash rate has decreased so that banks are actually happy with what they have, and the cash rate stays there. There is no guarantee that this process brings the cash rate on target. It may be too high compared to the target. That's what has happened in September 2008 after hte collapse of the Lehman Brother the big US investment bank.You have the diagram in front of you in the handout you received. Can you think of a way you could make the two rates coincide? Give it a go....Any suggestion? One cannot change the demand curve as this has to do with the preferences of the commercial banks. Shifting the suply curve to the right is the solution. The RBA needs to increase the amount of central bank money available in the banking system.How the RBA shifts the supply curve is another fascinating story which I may have the opportunity to tell you one day. In the meantime... let's summarize our findings.
The fuss about the cash rate is because…
… the cash rate is the first target of monetary policy.
It affects the interest rates and the exchange rate
and ultimately the economic activity and inflation.
Tuesday 4th August 2015
Be prepared!
1.5%, 2.00% or 2.5%?or
Frederique Bracoud
When the RBA board meets on 5th August you will know that their decision matters to the Australian economy and to you!Will the RBA keeps the cash rate target on hold confirming the market expectations that the cash rate will remain at that level for another 12 months.Will the RBA decrease the cash rate? A decrease could be justified by the slow growth of non resources sectors or the slow improvement of unemployment rate and a too strong dollar?Will the RBA start increasing hte rate? An increase could be supported by the fact that othercountries have started increasing their rates like new Zealand and the US is slowly moving away from quantitative easing.be prepared! the RBA decision on hte 4th August may influence what santa claus will bring you at christmas, the samsung galxy S6 or the lovely socks!thank you for your attention.
