Analysis: Pressure Growing On RBA to Cut Cash Rate Target

• Published on
• 13 May 2020, 09:19 AM

By Sophia Rodrigues

The Reserve Bank of Australia’s cash rate could soon lose its fight for survival amid ample liquidity, forcing the policymaker to either lower the target to keep it meaningful or find a sustainable alternative to back it.

Since the RBA lowered the cash rate target to 0.25%, the rate has deviated from the target and in the past month it has been at least 10bps below that on a consistent basis.

But more than that, the volume in the overnight interbank cash market has reduced significantly, leading to three occasions in the last five where the rate could not be calculated.  In these instances, the RBA had to use fallback provisions to set the rate based on the last published rate.

On Monday, volume dropped to a record low A$127 million, and there is now a real possibility volume could stay below A$500 million for multiple days. It is also possible there would be no transactions or zero volume for many days.

If this happens, it would be meaningless to use the fallback provision of the last published cash rate because that last rate could be several days before.

In any case, such a rate would no longer represent the rate paid by banks for unsecured overnight cash because there would be little or no volume to back it.

That would mean the RBA’s cash rate – once its crowning glory – would be a rate pulled out of thin air because its relationship with the target has already become distant.

According to the fallback provisions, apart from using the last published cash rate, the RBA could announce a new cash rate target or an interest rate relevant to unsecured overnight funds for cash market participants based on market conditions.

It is difficult to think of an unsecured overnight rate that is not independent of the cash rate. The Bank Bill Swap Rate or the Overnight Indexed Swap Rate are derivatives of the cash rate, and they are also not overnight rates.

If there is such a rate, it is likely the RBA might use it under the fallback provisions if required and based on market conditions.

A simpler alternative is to resort to the other fallback provision and set a new cash rate target at 0.10%. While it may not revive volume in the overnight interbank cash market, the RBA could simultaneously change its fallback provision to publish the cash rate as the target in future.

With the cash rate currently trading at 0.14% and expected to remain around this level for some time, the case to lower it is already strong. The argument becomes stronger because keeping it as a range like the Fed doesn’t work because unlike the Fed, there is no trading volume in Australia to back a rate within the range.

It is possible that RBA itself has used 14bps, and not 25bps, in its assumption for the cash rate while drawing forecasts for the economy.

After all, the RBA has never said it “will not lower” the cash rate. All it has said is it will not increase the cash rate target until it makes progress towards its goals.

--Contact: sophia@centralbankintel.com