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Lesson M06.L02: The Cash Rate Target and Open Market Operations

Module: The Reserve Bank, Monetary Policy and the Economy Level: intro Duration: 30 minutes Learning Objective: Explain how the RBA sets the overnight cash rate through open market operations and the exchange settlement system. Data as of: 2024 Provenance: RBA Education | RBA | OpenStax Macro 3e

Explanation

The cash rate is the interest rate on overnight unsecured loans between banks in Australia's interbank market. When banks need short-term funds (because their Exchange Settlement Account at the RBA is short), they borrow from other banks overnight. The rate on these loans is the cash rate.

The RBA's Monetary Policy Board announces a cash rate target at each policy meeting (approximately 8 times per year). The target is the RBA's desired level for the cash rate. As of November 2023, the cash rate peaked at 4.35% — the highest in over a decade — before the RBA began easing in 2025.

How the RBA hits its target — Open Market Operations (OMOs):

The RBA uses open market operations to keep the actual cash rate in line with its target. OMOs involve the RBA buying or selling securities (typically short-term government bonds or repurchase agreements — repos) in the open market:

  • If the cash rate is above target: Banks are short of liquidity. The RBA buys securities from banks, crediting their Exchange Settlement Accounts (ESAs). More reserves in the system mean banks have less need to borrow overnight → interest rates fall toward target.
  • If the cash rate is below target: Banks have excess liquidity. The RBA sells securities to banks, debiting their ESAs. Fewer reserves → banks need to borrow more → rates rise toward target.

The RBA also maintains a corridor system: it pays interest on ESA balances at 0.25 percentage points below the cash rate target (floor), and charges 0.25 percentage points above (ceiling). This corridor automatically keeps the overnight rate near the target — banks won't lend to each other at a rate outside the corridor when they can deal with the RBA instead.

Worked Example

Scenario: The RBA announces it is raising the cash rate target from 4.10% to 4.35%. Trace the mechanism.

Step 1 – Policy announcement: On 7 November 2023, the RBA Board announces the new cash rate target is 4.35%.

Step 2 – Update the corridor: - New deposit rate (floor): 4.35% − 0.25% = 4.10% (interest the RBA pays on ESA balances) - New lending rate (ceiling): 4.35% + 0.25% = 4.60% (rate the RBA charges for overnight loans)

Step 3 – Open market operation: If the actual interbank rate is still trading at 4.10% (the old target), banks are holding excess reserves. The RBA sells securities (repos) to drain liquidity from the system.

  • Banks pay for the securities by having their ESAs debited.
  • With less reserve cash available, banks must borrow more overnight from each other.
  • Competition for overnight funds pushes the rate up toward 4.35%.

Step 4 – Rate settles at target: Arbitrage ensures the rate settles at 4.35%. No bank will borrow at more than 4.60% (they'd just use the RBA's lending facility) or lend at less than 4.10% (they'd just leave the money in their ESA earning 4.10%).

Conclusion: The RBA hits its cash rate target through OMOs that adjust the supply of reserves in the Exchange Settlement system, anchored by the interest rate corridor.

Common Misconception

Misconception: "When the RBA raises the cash rate, it directly orders commercial banks to charge higher mortgage rates."

Correction: The RBA does not set commercial mortgage rates or lending rates — banks set those themselves. What the RBA controls is the overnight interbank cash rate through open market operations. When the overnight borrowing cost for banks rises, banks pass this cost on to their lending and deposit products (mortgages, savings accounts, business loans) because higher funding costs make lending at old rates unprofitable. The transmission is market-driven, not directed.

Practice Prompts

  1. What is the "corridor system" in the RBA's interest rate framework, and how does it keep the cash rate near target? → Answer: The corridor system sets a floor (the deposit rate = cash rate target − 0.25%) and a ceiling (the lending rate = cash rate target + 0.25%). Banks won't lend to each other below the floor (they'd prefer to earn the RBA's deposit rate) or borrow above the ceiling (they'd use the RBA's lending facility). This bounds the interbank rate within 0.25% either side of the target.

  2. The overnight cash rate is trading at 3.70%, but the RBA's target is 3.85%. What open market operation would the RBA use to push the rate toward target? → Answer: The cash rate is below target, suggesting banks have excess reserves. The RBA would sell securities (conduct a repo sale / drain liquidity) to reduce the supply of reserves. With less cash in the system, banks must compete more for overnight funds, pushing the cash rate up toward 3.85%.

  3. If the RBA cash rate target is 4.35%, what is the interest rate the RBA pays on Exchange Settlement Account balances? → Answer: The deposit rate (floor of the corridor) = 4.35% − 0.25% = 4.10%.

Further Resources