The Reserve Bank of Australia (RBA) will meet on Tuesday to once again make a decision on the country’s cash rate, as part of the central bank’s monetary policy decision process. This is a highly-anticipated ritual repeated on the first Tuesday of every month except January.
So what exactly is the cash rate? Why is it relevant? How does it work?
The cash rate is the interest rate on overnight loans in the money market, where financial institutions lend and borrow cash daily to meet their needs. Ultimately, the RBA is able to enforce the cash rate by trading bonds with financial institutions to control the daily volume of cash in the hands of the market.
In a (very) simplified example, let’s say the RBA decides to reduce the cash rate from 5% to 0%. Before the rate drop, the market is trading for $100 a government bond that will pay $105 in a year’s time, which means an implied return of $5 – that is, a cash rate of 5%.
In order to decrease the cash rate to 0%, the RBA starts to buy bonds from financial institutions. The increased demand from the central bank for bonds eventually raises the price of bonds to $105, which means an implied zero-dollar return in a year’s time – i.e. a 0% cash rate.
This example outlines the triangular relationship between cash rates, bonds and volume of money. As financial institutions receive fresh money from selling bonds to the RBA, the amount of money in the market increases in tandem with the decrease in the cash rate, boosting all sort of markets – such as housing mortgages, credit card lines and stock prices. This is why the cash rate is so important: it essentially constitutes the benchmark interest rate for the overall economy (which includes you).
Unfortunately, whether the RBA maintains or reduces the cash rate this coming Tuesday, not much will change this time. The truth is that global forces have recently made it difficult for the RBA to influence the economy through cash rates. As a result, the best alternative to boost our economy rests on implementing clever productivity-enhancing policies. Shall we?
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Cash rate: what, why and how?
The Reserve Bank of Australia (RBA) will meet on Tuesday to once again make a decision on the country’s cash rate, as part of the central bank’s monetary policy decision process. This is a highly-anticipated ritual repeated on the first Tuesday of every month except January.
So what exactly is the cash rate? Why is it relevant? How does it work?
The cash rate is the interest rate on overnight loans in the money market, where financial institutions lend and borrow cash daily to meet their needs. Ultimately, the RBA is able to enforce the cash rate by trading bonds with financial institutions to control the daily volume of cash in the hands of the market.
In a (very) simplified example, let’s say the RBA decides to reduce the cash rate from 5% to 0%. Before the rate drop, the market is trading for $100 a government bond that will pay $105 in a year’s time, which means an implied return of $5 – that is, a cash rate of 5%.
In order to decrease the cash rate to 0%, the RBA starts to buy bonds from financial institutions. The increased demand from the central bank for bonds eventually raises the price of bonds to $105, which means an implied zero-dollar return in a year’s time – i.e. a 0% cash rate.
This example outlines the triangular relationship between cash rates, bonds and volume of money. As financial institutions receive fresh money from selling bonds to the RBA, the amount of money in the market increases in tandem with the decrease in the cash rate, boosting all sort of markets – such as housing mortgages, credit card lines and stock prices. This is why the cash rate is so important: it essentially constitutes the benchmark interest rate for the overall economy (which includes you).
Unfortunately, whether the RBA maintains or reduces the cash rate this coming Tuesday, not much will change this time. The truth is that global forces have recently made it difficult for the RBA to influence the economy through cash rates. As a result, the best alternative to boost our economy rests on implementing clever productivity-enhancing policies. Shall we?
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