The Future System for Monetary Policy Implementation

Speech

Notes

The Future System for Monetary Policy Implementation Christopher Kent [ * ] Assistant Governor (Financial Markets) Bloomberg Australia Briefing Sydney – 2 April 2024 Audio 45.9MB Q&A Transcript Download 658KB Watch video: The Future System for Monetary Policy Implementation I’d like to start by thanking Bloomberg for hosting this event. Today, I’ll be speaking about the future system for monetary policy implementation – that is,
the method by which the Reserve Bank of Australia (RBA) controls the cash rate. Planning for the future
system is important given that the unwinding of unconventional monetary policies is leading to a decline
in Exchange Settlement (ES) balances – otherwise known as reserves (Graph 1). Reserves held by
banks in their ES accounts at the RBA play a central role in policy implementation. Banks use these funds
to settle payments with other banks and with the RBA. They can also lend surplus funds to other banks in
the overnight cash market. Those transactions go into the determination of the cash rate. Graph 1 At its March meeting, the Reserve Bank Board considered three options for the future system for the
implementation of monetary policy: maintain the current ‘floor’ system with an excess of reserves; return to a ‘corridor’ system with scarce reserves, as used prior to the pandemic; or transition to a new system of ample reserves that lies somewhere between these two. The Board endorsed a plan to move to an ample reserves system with full allotment repurchase agreement
(repo) auctions for our Open Market Operations (OMOs). The Bank of England, the European Central Bank and
the Swedish Riksbank have announced they will be operating similar systems. ¹ I want to emphasise that this decision has no implications for the current or future stance of monetary
policy. 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, which is to allow bonds purchased during the pandemic to run down as they mature
and to periodically review the case to actively sell bonds. Today I’ll explain the three options for policy implementation, discuss some of the reasons why the
Board has chosen to pursue the ample reserves system, and lay out the next steps as we move to that
approach. Three options for policy implementation Option 1: A floor system with excess reserves – Our current approach One option is to stay with the current approach. Namely, an excess supply of reserves that leads the cash
rate to be close to a floor. This floor is the rate paid to banks on funds left overnight in their ES
accounts – the ES rate. The shift to this approach from the earlier system of scarce reserves began in mid-March 2020, as growing
concerns about the economic effects of the pandemic led to stresses in global financial systems,
including in Australia. As a first response, the RBA increased the extent of liquidity we were providing
to banks (Graph 1; Graph 2; Graph 3). ² Settlement balances quickly ramped up as the
RBA met additional demand at our daily OMOs and bought government bonds in support of the functioning of
those markets. Reserves grew further with the advent of the Term Funding Facility (TFF) and bond
purchases in support of the yield target, and then later in 2020 through the bond purchase program. ³ Graph 2 Graph 3 As ES balances rose to high levels and the initial financial stresses in markets eased, most banks found
they had a surplus of funds in their ES accounts. Therefore, the demand from banks to borrow from one
another in the cash market to meet their payments and other needs declined. As a result, the cash rate
became closely anchored to the ES rate and activity in the cash market fell away markedly. ⁴ ES balances stabilised at around $460 billion in 2022, following the end of the bond purchase
program, and since February 2023 have been declining as some of the bonds held have matured and the first
tranche of the TFF was repaid by September 2023. ES balances will decline further when the remaining
$96 billion of the TFF is repaid by the middle of this year, and as the RBA’s bond portfolio
continues to decline. We are confident that the current high level of ES balances is still well in excess of what the banking
system as a whole needs to satisfy underlying demand (to meet banks’ payment and minimum liquidity
needs). But as ES balances decline further, there will come a point where reserves are no longer in
excess of underlying demand. Some central banks have decided to retain a system of excess reserves. ⁵ To ensure that reserves remain in
excess of underlying demand, at some point these central banks will need to offset the decline in
reserves associated with the unwinding of their unconventional monetary policies. They can do this in a
number of ways, but in general they will need to buy assets, such as government bonds (either outright or
under repurchase agreements) or through foreign exchange transactions (e.g. via FX swaps). These central
banks will work to maintain a buffer of reserves over and above the underlying demand for reserves. If
the buffer isn’t sufficient, it could lead to volatility in a range of money markets. ⁶ To avoid
that, these central banks will be monitoring conditions in money markets very closely and responding if
needed, noting demand can change over time and sometimes quite quickly. The Board has decided not to maintain the current floor system with excess reserves. One reason is that it
would require the RBA to hold a sizeable buffer of reserves over underlying demand, necessitating a
relatively large balance sheet on an ongoing basis. Compared with the other options, this implies some
additional risk to the RBA (such as interest rate risk) and a more sizeable footprint in markets. Option 2: An interest rate corridor with scarce reserves – Our pre-pandemic approach What about the option of returning to our earlier system of scarce reserves to guide the cash rate to the
target? This system was in use for many years before March 2020. ⁷ It entails the central bank supplying just
enough reserves to meet the underlying demand of the banking system, and providing standing facilities to
ensure that the policy rate trades in a corridor around the target. In Australia, banks with surplus
reserves could leave them on deposit with the RBA at the ES rate, which used to be 25 basis points
below the cash rate target. Banks with a shortage of reserves could borrow them overnight from the RBA at
a rate that was 25 basis points above the target. Banks had no reason to pay a rate above the top of
the corridor for borrowed reserves, nor would they lend reserves at a rate below the floor of the
corridor. To keep the cash rate near the target, the RBA needed to accurately estimate the demand for reserves,
forecast changes in the supply of reserves, and conduct OMOs daily (and sometimes more than once in a
day). The system worked well for many years, with the cash rate almost always at the cash rate target. Compared
with the other two options, this system has a couple of attractive features. Because it entails a smaller
balance sheet than under excess or ample reserves systems, it naturally implies lower interest rate risk
for the RBA. Similarly, it implies a smaller footprint of the RBA in financial markets. Indeed, this
system supports more cash market activity than the other options because on any given day it is more
likely that some banks are facing a shortage of reserves and need to borrow from other banks to meet
their needs. Despite these benefits, the Board has decided not to return to a scarce reserves system. Such a system
entails the highest risk of the banking system running into liquidity shortages. A scarce reserves system
requires the central bank to have accurate estimates of reserve demand and supply on a daily basis and
respond actively to short-term fluctuations as needed. In the past, this appeared to be very successful,
with only a few trivial deviations in the cash rate from the target (Graph 4). However, a large part
of that may have been because of the convention by cash market participants to almost always conduct
trades in the cash market at the target rate set by the Board. Having moved away from that environment,
such a convention may not re-emerge. Graph 4 Moreover, even though the cash rate in the past would trade close to target, there were lengthy periods
when liquidity was tight in broader money markets, such as for repo and bank bills. This was evident when
market rates traded noticeably above the cash rate or overnight index swaps (which measure expectations
for the future cash rate), even though the cash rate was trading at the target (Graph 5). This
tightening in financial conditions reflected, in part, the fact that some money market participants did
not have access to the cash market and borrowed in other short-term markets. At the same time, banks were
often reluctant to lend large volumes of reserves in money markets until late in the day, once they were
confident in their capacity to meet their own liquidity needs. ⁸ Graph 5 Having moved away from scarce reserves after the onset of the pandemic, banks appear to have adapted their
operations to an environment of higher reserves, simplifying their liquidity management and facilitating
smoother daily payment processes. ⁹ In other words, the underlying demand for reserves is
likely to have increased compared with pre-pandemic days. It is difficult to accurately estimate
underlying demand in any system, but small errors of estimation would be more problematic in a system of
scarce reserves, since they can lead to considerable volatility in cash and other money markets (without
very active responses from the central bank). Another issue is that a scarce reserves system is not resilient in the face of a sharp rise in the demand
for liquidity in the banking system during occasions of considerable financial market stress. The RBA may
be faced with such a scenario in the future and need to provide a large increase in reserves. This
occurred at the onset of the pandemic when the RBA met all reasonable demands for liquidity from
participants at our OMOs, much like the way in which our full allotment auctions work currently. Reserves
also increased with the RBA’s purchases of bonds to address the dysfunction in government bond
markets at the time. In short, scarce reserves systems are ill-suited to environments where demand for reserves is volatile and
difficult to estimate accurately and where supply may change substantially depending on the need for the
central bank to use balance sheet policies. For all these reasons, no other advanced economy central bank
has indicated a return to a scarce reserves system. Option 3: Ample reserves with full allotment OMO – A new approach The third option, which the Board has endorsed, is an ample reserves system in which banks’ demands
for reserves are satisfied via open market repo operations at a price near the cash rate target, in what
are known as full allotment auctions. Together with the floor provided by the ES rate, these operations
should keep the cash rate close to target. Setting the price of reserves in this way is in contrast with
the scarce and excess reserve systems, where the central bank sets the quantity of reserves in order to
affect the price. Under the ample reserves system, the supply of reserves can rise and fall in line with
changes in demand, with minimal effects on the cash rate and other money market rates. The Board sees a number of advantages with this new approach. Since the supply of reserves from the RBA
will respond to changes in demand, we do 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 also reduces the risk of unnecessary volatility or disruption to conditions in
money markets. Similarly, it is more resilient to any future expansion in the RBA’s balance sheet
if, for example, there was a need to address extreme stresses affecting bond markets, such as at the
onset of the pandemic. That said, in this system, banks will still need to ensure they manage their
liquidity carefully, including by obtaining sufficient liquidity at OMOs. An ample reserves system is likely to lead to more activity in cash and other money markets compared with
an excess reserves system, although not as much as under scarce reserves. 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 our footprint in financial markets will be smaller
than in an excess reserves system. The RBA will use repurchase agreements to supply reserves, which as of February this year are based on a
floating rate (as a spread to the cash rate target), thereby removing interest rate risk for the RBA.
Other operations could also be used to supply reserves, such as purchases of short-dated government bonds
and/or FX swaps. We used these types of operations prior to the pandemic and they can also be structured
to minimise interest rate risk. This is in contrast with an excess reserves system, for which it may be
more difficult to supply sufficient reserves while also limiting the interest rate risk held on the
RBA’s balance sheet and avoiding an overly large footprint in some markets. ¹⁰ The transition from excess to ample reserves The RBA has been running full allotment OMO repo auctions since shortly after the onset of the pandemic,
so from our counterparties’ perspective there will be no immediate changes in our operations. Currently, the supply of reserves is in excess of underlying demand, which means that most banks have no
need to obtain liquidity through OMOs. Participation is therefore relatively low compared with
pre-pandemic levels (Graph 6). As the level of reserves falls, however, we will at some point
transition from an excess of reserves to an environment of ample reserves. As this happens, we expect to
see cash market activity increase, perhaps with some rise in the cash rate, and potentially some pressure
in other money markets. 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. As always, the RBA will be monitoring market conditons closely, particularly around the upcoming
maturity of the TFF. And we have the ability to respond to market stresses if the need arises, including
by conducting OMO more frequently than once a week. Graph 6 What’s next? The Board has endorsed a plan to move to an ample reserves framework with full allotment OMO repo as the
RBA’s future monetary policy implementation system. 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 we might use to supply reserves. In addition to repo via full allotment
auctions, the demand for reserves could be accommodated via a mix of FX swaps and purchases of
short-dated government bonds. Among other considerations, this will depend on how the RBA wants to
structure the composition of its balance sheet over the medium term. Also, a range of instruments would
help to avoid an overly large presence in any single market, which might otherwise crowd out private
sector activity. Under the earlier system of scarce reserves, all of these means of managing reserves
– repo, FX swaps and outright bond holdings – were commonplace, though the outstanding
balances for these instruments may well be greater under ample reserves. One issue we will be looking at closely is how banks adjust to the progressive withdrawal of liquidity
implied by the run down in reserves. Hence, the accessibility of reserves at OMO, and in particular the
price to borrow reserves under repo, will be a point of interest, including because it involves
trade-offs. For example, an OMO repo rate with a low spread over the ES rate will provide banks with an
incentive to demand more reserves than otherwise, which may facilitate more efficient payments and reduce
risks to financial stability. However, this will reduce the incentives for banks to source liquidity from
private markets (including the overnight cash market), with the RBA having a larger footprint in markets
and a larger balance sheet. Conversely, an OMO rate further above the ES rate will provide banks with an
incentive to hold fewer reserves than otherwise and obtain more liquidity from private markets, including
in the cash market. But this could leave banks with smaller buffers to deal with sudden and unexpected
increases in their need for reserves and result in more volatility in money markets. The Board will consider these issues in due course, aided by the results of a public consultation and
liaison with market participants that will commence shortly. In the meantime, our operations in financial
markets will continue as they are. Namely, weekly full allotment repo OMO operations at a 28-day term and
priced at a floating rate of 5 basis points above the cash rate target. Finally, let me stress again that all of this is about the plumbing underpinning the monetary system. It
is not about the stance of monetary policy. Endnotes I thank Sean Dowling, Gian-piero Lovicu and Sam
Batchelor for their excellent assistance in helping me to prepare this speech. [*] See Ramsden D (2018), ‘Finding the Right
Balance’, Speech at the Society of Professional Economists Annual Conference, London,
28 September; Schnabel I (2024), ‘The Eurosystem’s Operational Framework’,
Speech at the Money Market Contact Group, Frankfurt, 14 March; Riksbank (2019), ‘The
Riksbank’s New Operational Framework for the Implementation of Monetary Policy’, July.
¹ See Kent C (2022), ‘ Changes to the Reserve Bank’s Open Market
Operations ’, Remarks to the Australian Financial Markets Association, Sydney,
22 February. ² Debelle G (2021), ‘ Monetary Policy During COVID ’, Shann
Memorial Lecture, Online, 6 May. ³ We had reduced the gap between the ES rate and
the cash rate target to 10 basis points, from 25 basis points under the earlier
corridor system. So by design the cash rate, anchored to the ES rate, was close to the cash rate
target. ⁴ The US Federal Reserve, Bank of Canada and
Reserve Bank of New Zealand all intend to operate floor systems with excess reserves. See US
Federal Reserve (2022), ‘Principles for Reducing the Size of the Federal Reserve’s
Balance Sheet’, Press Release, 26 January; Jefferson PN (2023), ‘Implementation
and Transmission of Monetary Policy’, H Parker Willis Lecture, Virginia, 27 March; Bank
of Canada (2022), ‘Bank of Canada Provides Operational Details for Quantitative Tightening
and Announces that it Will Continue to Implement Monetary Policy Using a Floor System’,
Notice, 13 April; Gravelle T (2024), ‘Going Back to Normal: The Bank of Canada’s
Balance Sheet After Quantitative Tightening’, Remarks at the CFA Society, Toronto,
21 March; RBNZ (2022), ‘Reserve Bank Optimising New Zealand’s Monetary Policy
Implementation Framework’, Media Release, 6 May; Callaghan M, C Haworth and K Poskitt
(2023), ‘How the Reserve Bank Implements Monetary Policy’, RBNZ Bulletin ,
June. ⁵ As was the case in the United States during
September 2019. For a comprehensive account of this episode, see Afonso G et al
(2021), ‘The Market Events of Mid-September 2019’, Economic Policy Review ,
27(2). ⁶ Debelle, n 3. For a fuller explanation of the
RBA’s pre-pandemic system for implementing monetary policy, see Domestic Markets Department
(2019), ‘ The
Framework for Monetary Policy Implementation in Australia ’, RBA Bulletin , June. ⁷ In principle, they could have lent earlier if
borrowing cash overnight from the RBA was treated similarly to leaving cash on deposit with the
RBA – after all, the pricing of both was symmetric, at 25 basis points away from the
cash rate target. But in reality borrowing from the RBA overnight was discouraged, and banks
avoided this when they could. That is, arbitrage between the cash market and other money markets
was somewhat limited, which resulted in other money market rates sometimes diverging materially
from the cash rate. ⁸ This is evident in Australia and other advanced
economies. For discussions on the increase in banks’ demand for reserves in the Euro Area
and United States, respectively, see Schnabel I (2023), ‘Back to Normal? Balance Sheet Size
and Interest Rate Control’, Speech at Columbia University and SGH Macro Advisor, New York,
27 March; Acharya VV and R Rajan (2023), ‘Liquidity, Liquidity Everywhere, Not a Drop
to Use – Why Flooding Banks with Central Bank Reserves May Not Expand Liquidity’, NBER
Working Paper No 29680. For discussion on how changes to US banks’ liquidity management
preferences during a period of excess reserves may have increased their underlying demand for
liquidity, see Lopez-Salido D and A Vissing-Jorgensen (2023), ‘Reserve Demand, Interest Rate
Control, and Quantitative Tightening’, 27 February. There is also evidence that more
reserves have led to faster settlement of payments in the United States (see Bech ML and RJ
Garratt (2012), ‘Illiquidity in the Interbank Payment System Following Wide-scale
Disruptions’, Journal of Money, Credit and Banking , 44(5),
pp 903–929). Payments efficiency has also increased in Australia, albeit to a lesser
extent than the United States, since operating with a higher level of reserves (see Kopec K and C
Rao (2022), ‘ The
Evolution of Interbank Settlement in Australia ’, RBA Bulletin , March).
⁹ In particular, under an excess reserves system
the supply of reserves is greater than the underlying demand of the banks, and so a central bank
cannot rely on demand at OMO operations to push the supply into ‘excess’ territory. To
do this, the central bank may need to either buy a large share of short-dated bonds (with risks
to market functioning) or buy longer dated bonds (with the associated interest rate risk). ¹⁰