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Cash rate not the only tool in RBA’s kitbag

By Kev Toohey
4 minute read

Instead of asking by how much or whether the Reserve Bank of Australia (RBA) should increase cash rates, we should be asking why it controls cash rates at all!

Cash rates have only been controlled since the floating of the dollar back in 1983.

Before then, the currency was fixed, against the trade-weighted index (TWI), by the RBA; lending by banks was restricted, and house loan rates were subject to a cap.

The cash rate — which is more of a “target” than a stated rate — is arguably the most important base interest rate in the nation, and substantially determines the interest rate on products such as home loans, savings, accounts, term deposits, and more.


While the RBA’s purpose/mission/remit is in flux at the moment, it remains the case that promoting the financial stability of Australian households and also keeping a lid on inflation are very high on the central bank’s priority list. In simple terms, high inflation is simply too much money chasing too few goods. This then drives prices up. The RBA likes underlying inflation (headline inflation minus seasonal or short-term spikes) to be in the 2–3 per cent annual band.

A major way — many might say, the bank’s go-to method, the lever it considers easiest to pull — in which the RBA can control inflation is to lift the cash rate.

To continue with the current system, we should be able to say it works, i.e. it achieves its objectives without serious unwanted side effects.

How well does it work?

Er, not very well. A series of rate rises can take many months, if not years, to do its job and then it can overshoot. And “overshooting” on the cash rate usually means a recession.

Fixed cash rates guarantee liquidity at all times. This has the effect of collapsing the spread between highly liquid assets such as treasury notes, and illiquid assets, such as mortgage-backed securities (MBS). For the same reason, credit spreads also tend to narrow. But this ensures that when things go wrong — as in the GFC — they really go wrong.

Prolonged periods when interest rates are at a non-economic level result in major inefficiencies in markets. There’s no stronger evidence for this than the current housing market, which hoovered up investors’ capital like a black hole when rates were at all-time lows.

What is the alternative?

No-one wants to see a return to fixed foreign exchange rates. Rather, a return to measures that restrict the creation of credit, not just set the price, could do the job that interest rate hikes do. The RBA lost the power to restrict the creation of credit to the newly created Australian Prudential Regulation Authority (APRA) in 1998. With hindsight, this would appear to be a false step that needs correction.

Armed with the power to restrict the creation of credit, either with quantitative controls or gearing restrictions on the major banks, the RBA could let cash rates fluctuate more in line with market conditions.

The stability of the foreign exchange markets would also improve from this move as speculators would not be able to tap unlimited amounts of $A currency to short-sell; or loans to buy $A speculatively.

Some restriction on bank lending would be a small price to pay for market stability and efficiency.

Kev Toohey, principal, Atchison Consultants