Insight: RBA Would Lower Rate on ES Balances If Cash Rate Target Cut

• Published on
• 31 Jul 2020, 01:13 PM

By Sophia Rodrigues

The Reserve Bank of Australia is likely to lower the interest rate on Exchange Settlement balances from the current 10bps if it lowers the cash rate target to 0.10%.

Whether the new rate on ES balance will be 5bps or zero is unclear but what is likely is the width of the RBA’s corridor system around the cash rate would be reduced further from the current 40bps.

In March, when the RBA lowered the cash rate target to 0.25%, it also narrowed the width of the corridor system from 50bps to 40bps. This was done by effecting only 15bps reduction in the rate on ES balances and not 25bps as doing the latter would increase the costs to the banking system.

CB-Intel has been flagging the possibility of a reduction in the RBA’s cash rate target for some time, and earlier this month also said the RBA is likely to reduce not just the cash rate target but also the target on three-year government bond yield and the rate on Term Funding Facility.

https://centralbankintel.com/newsdetails/insight-rba-open-to-lowering-3-yr-yield-target-to-010

Any reduction in the interest rate on ES balances is important because it would determine how far the interbank overnight cash rate would fall when the cash rate target is reduced. For example, if the ES interest rate is lowered to 5bps, and the cash rate target is cut to 10bps, the interbank overnight rate is likely to fall to 6bps-8bps given ample liquidity in the system.

The interbank overnight rate has been at 13bps since July 3.

A fall in interbank overnight rate could potentially lead to a further fall in the bank bill rate, and overnight indexed swap rates.

NOT EFFECTIVE LOWER BOUND YET

On March 19, when the cash rate was lowered to 25bps, Governor Philip Lowe said the RBA “will maintain the current setting of interest rates until a strong recovery is in place and the achievement of our objectives is clearly in sight.”

The same day Lowe also reiterated that the effective lower bound for the cash rate target was 0.25% “We’ve done all we can do on the cash rate, so we’ve got to look elsewhere now.”

However, in the past Lowe’s definition of effective lower bound was based on the interest rate paid on surplus balances at the RBA which would be zero at the 0.25% cash rate target if the historical corridor width were maintained.

This means that with the corridor narrowed to 40bps because of 10bps rate on ES balances, the zero-interest rate that defined the lower bound has not been reached.

The effective lower bound as per Lowe’s definition would be reached only when the interest rate on ES balances is cut to zero.

RBA TUNE CHANGED LAST WEEK

But the RBA has until recently showed no inclination to fine-tune the cash rate target.

This changed on July 21 when for the first time Lowe said it was possible “the various interest rates currently at 25 basis points could have been set lower, at say 10 basis points.”

The “various” interest rates he referred to are the cash rate target, the yield on three-year government bonds and the rate on Term Funding Facility.

At the last board meeting, the RBA decided there was no need to adjust the rates but at every board meeting from now that remains a possibility, and when that happens, the rate on ES balances would also drop further.

--Contact: Sophia@centralbankintel.com