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AUSTRALIA’S central bank will switch to a new system for the implementation of monetary policy as passive quantitative tightening leads to a decline in reserves in the banking system, assistant governor Christopher Kent said on Tuesday (Apr 2).
At its March meeting, the Reserve Bank of Australia’s (RBA) rate-setting board considered three options for the future framework for implementing monetary policy, Kent said in a speech at the Bloomberg Australia Briefing. These options were:
1. Maintain the current “floor” system with an excess of reserves
2. Return to a “corridor” system with scarce reserves, as used prior to the pandemic
3. Transition to a new system of ample reserves that lies somewhere between these two
The board endorsed the third option to move to an ample reserves system with full allotment repurchase agreement or repo auctions for its open market operations (OMO), Kent said. The Bank of England, the European Central Bank and the Swedish Riksbank have announced they will be operating similar systems.
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“I want to emphasise that this decision has no implications for the current or future stance of monetary policy,” said Kent, who oversees financial markets at the RBA. “Rather, it is only relevant to the way in which we will achieve the desired stance of monetary policy through our operations. Nor does it have a bearing on the board’s current approach to quantitative tightening.”
The next steps are for the RBA to determine the more detailed aspects of the system, including: the pricing, frequency and other aspects of our OMO repos; and what other instruments it might use to supply reserves.
The RBA signalled at its meeting last month that it has likely concluded its policy tightening campaign after raising the cash rate to a 12-year high of 4.35 per cent in a series of rapid steps since May 2022.
Kent’s remarks come as the central bank’s balance sheet is set to shrink by more than A$100 billion (S$88 billion) with bonds purchased during the RBA’s Covid-era stimulus programme now maturing.
A cheap funding facility provided to lenders during the pandemic expires at the end of June; and a bond used for the yield-target programme during Covid will mature this month.
The RBA’s decision reflects a fundamental shift in how central banks implement monetary policy as they try to strike a balance between operating with a smaller balance sheet and reducing their footprint in financial markets, while avoiding liquidity shortages in the system that may damage financial stability and impair monetary transmission.
The RBA’s move follows an ECB review of its operational framework, which preserves its current system of steering interest rates while giving banks more of a say over how much liquidity they need to operate.
Huge amounts of cash are still sloshing around – excess liquidity in Australia is still more than A$300 billion, according to the RBA.
As the transition to the new system occurs, the RBA expects to see cash market activity increase, perhaps with some rise in the cash rate, and potentially some pressure in other money markets, Kent said.
“By design, however, any such pressures should, to a large extent, be tempered as banks naturally respond to higher market interest rates by borrowing more at OMO repo at the price set by the RBA,” he added.
The RBA raised rates 13 times between May 2022 and November last year. At the same time, its balance sheet remains sizable, mainly due to the unconventional policy deployed to support the economy during the pandemic.
But a large proportion of the central bank’s A$527 billion in assets is now gradually rolling off as the table below shows.
The RBA’s implementation of monetary policy is an area of confusion for professional economists, commentators and educators alike, particularly following the pandemic.
Prior to the Covid era, the market automatically traded at the new cash rate target following a change to monetary policy. This was achieved by the RBA’s interest rate corridor, which reset around the new cash rate target, and with banks having no incentive to trade outside of this corridor.
In addition, the RBA used its open market operations on a daily basis to manage liquidity in the system. Since the pandemic, the RBA has not needed to conduct OMOs every day as the system is already flush with cash.
Kent said the RBA board sees a number of advantages with the planned new approach:
- Since the supply of reserves from the RBA will respond to changes in demand, it does not need to accurately estimate demand nor control the quantity of reserves; in short, it is simpler to operate than a scarce reserves or excess reserves system.
- An ample reserves system reduces the risk of unnecessary volatility or disruption to conditions in money markets.
- It is more resilient to any future expansion in the RBA’s balance sheet.
- With the supply of reserves just sufficient to satisfy underlying demand, the RBA’s balance sheet will be no larger than it needs to be in order to implement monetary policy, and its footprint in financial markets will be smaller than in an excess reserves system. BLOOMBERG
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