Institutional framework

The RBA sets monetary policy with the objective of maintaining price stability, full employment, and contributing to the economic prosperity and welfare of the Australian people. To achieve these objectives, the RBA has an 'inflation target' and seeks to keep consumer price inflation in the economy to 2-3 per cent, on average, over time.

To implement its monetary policy objectives, the RBA sets a target for the cash rate, the interest rate on overnight unsecured loans between banks. The cash rate influences other interest rates in the economy, affecting the behaviour of borrowers and lenders, economic activity and ultimately the rate of inflation.

The cash rate target is determined by the RBA Board, which meets on the first Tuesday of each calendar month, except January. The Board's monetary policy decision is announced in a media release which is distributed through market data services and published on the RBA's website at 2.30 pm on the day of each Board meeting. Any change to the cash rate target is effective the following day. The RBA's domestic market operations are designed to ensure that the actual cash rate remains close to the cash rate target.

Key features of the monetary policy implementation framework

On a day-to-day basis, the cash rate is determined by the supply and demand for exchange settlement (ES) funds. Banks (and a small number of other financial institutions) hold ES funds in their accounts at the RBA to meet their payment obligations. Every day, and during the course of the day, banks must maintain a positive balance of ES funds. The RBA does not operate a reserves averaging framework or use reserves maintenance periods.

While the RBA does not require banks to hold a pre-specified amount of ES funds (eg minimum reserves), some banks maintain a certain amount of ES funds as a buffer against payments that settle after the interbank market has officially closed. These buffers are agreed in advance with the RBA and funds held for this purpose are remunerated at the cash rate target (this is discussed below under the standing facilities).

To maintain incentives for banks to trade their ES balances in the interbank market, the RBA operates an interest rate corridor. Overnight ES funds held by banks are remunerated 25 basis points below the cash rate. Where banks require use of RBA overnight repo, a margin of 25 basis points over the cash rate applies. Banks are not expected to make frequent use of the overnight lending facility and instead source funds in the interbank market.

To ensure that the cash rate trades closely to the cash rate target, the RBA gauges the demand for ES funds and conducts open market operations (OMOs) almost every day to keep the supply of ES funds at the right level. This is because transactions between the RBA (and its customers) and banks (and their customers) change the supply of ES funds. As the Australian Government is a customer of the RBA, these gross flows can be very large. In deciding when and how much to transact in its OMOs, the RBA seeks to offset the impact of all its other payment obligations and those of its clients. This liquidity forecasting and management helps the RBA maintain the supply of ES funds at the appropriate level.

Each morning, the RBA announces its OMO dealing intentions, inviting eligible counterparties to submit approaches. OMOs are conducted as fixed amount, variable repo rate tenders, with pre-specified terms that suit the RBA's liquidity management (generally between 1-week and up to 6-months).

There is no limit on the size or number of approaches a counterparty can make (counterparties with multiple approaches can set an aggregate limit). Where successful, counterparties must collateralise their transactions by selling highly rated debt securities to the RBA either under repo or outright sale (only short-term Australian government securities can be sold outright). More information on the RBA's collateral framework can be found in The Reserve Bank's Collateral Framework - December Quarter 2017. Eligible OMO counterparties include banks with ES accounts, but also other financial institutions that are not ES account holders. The RBA publishes counterparty eligibility rules on its website, see Eligible Counterparties.

At 5.10 pm each afternoon, the RBA announces whether an additional OMO is required, for example in the case where liquidity forecast errors result in the amount of aggregate ES funds being to large or too small, thus potentially disrupting orderly trading conditions in the interbank market. To prevent such an outcome, the RBA conducts additional OMOs to either drain or replenish aggregate ES funds, giving banks the opportunity, respectively, to lend undesired funds to the RBA or borrow required funds, on a secured basis. The RBA assesses the need for these additional rounds on a system-wide basis, not on the position of individual ES account holders, thereby preserving the incentives for banks to participate in the interbank market. Detailed information on OMOs is available on the RBA website, see Open Market Operations.

To fine-tune its liquidity management, the RBA also uses foreign exchange (FX) swaps in its domestic market operations. Unlike OMOs which are contracted for same-day value of funds, FX swaps are contracted for deferred settlement (generally T+1 to T+3) with maximum terms of up to 3-months. FX swaps are contracted bilaterally with pre-approved counterparties. FX swaps supplement the range of financial instruments used by the RBA to manage Australian dollar liquidity and are particularly useful to offset lumpy liquidity flows, such as the maturity of Australian Government Securities, or large Government flows (taxes and outlays).

Separate to OMOs which support the implementation of monetary policy, the RBA also provides standing facilities (SFs) to eligible counterparties, which include mostly ES account holders. SFs are designed to support the smooth functioning of the payments system. Banks access SFs by contracting repos against high-quality collateral. The RBA specifies in advance the price and terms of repos used in its SFs. Intraday repos are free of charge and allow banks to raise ES funds in order to make payments ahead of receiving covering funds later in the day. This smooths the volume of payments settlements throughout the day, avoiding gridlock in the payments system. If a bank fails to unwind an intraday repo, the RBA provides overnight repos, applying a margin of 25 basis points over the cash rate as a disincentive to use the facility. As mentioned above, banks are expected to source funds in the interbank market and not make frequent use of overnight repos.

Banks can also have open repo arrangements, ie repos without a specified maturity date. Open repos allow banks to hold a certain amount of ES funds that can be used to settle payments that occur outside of normal business hours. These arrangements support the trend for 24/7 payments as payments systems become more sophisticated and real-time. In Australia, examples of such 24/7 payments include those made under the New Payments Platform - infrastructure that enables Australian consumers, businesses and Government agencies to make real-time payments between accounts at participating banks. NPP payments are settled across banks' ES accounts via the RBA's Fast Settlement System.