The Reserve Bank of Australia is widely expected to leave the cash rate and the three-year government bond targets unchanged when it meets later today for its monthly board meeting that is likely to be full of interesting discussions.

One such discussion would be whether there is a need to make further adjustment to the corridor system for monetary policy. An increase in the rate on Exchange Settlement (ES) balances is a possibility so the overnight rate remains as close to the cash rate target as possible.

Another will be on financial stability ahead of the release of the Financial Stability Review on April 9.

There is also likely to be discussions on the yield target policy, including consideration on how often and under what circumstances bond purchases need to be done.

OVERNIGHT RATE DROPPING AMID EXCESS LIQUIDITY

The board meeting is taking place a little over two weeks after the RBA lowered the cash rate target to the Effective Lower Bound of 0.25% at an ad hoc meeting. The RBA also made other announcements, including setting a target of 0.25% for three-year government bonds. This rate is now effectively a second monetary policy instrument that is likely to be at the RBA’s disposal for the next 2-3 years at least.

When lowering the cash rate to 0.25%, the RBA also narrowed the width of its overnight rate corridor to 40bps from 50bps earlier. It did this by raising the interest rate on deposits in the ES by 10bps to 0.1%, from zero per cent if the existing width was maintained.

The RBA said it was doing so to alleviate cost pressures in the banking system arising from the historically low cash rate. In reality, however, a narrower width helps the overnight rate stay closer to the cash rate target when the system is flush with liquidity as is currently the case.

In recent days, the overnight rate has been steadily falling and was 0.18% on Friday compared with the RBA’s 0.25% cash rate target. The lowest rate at which overnight funds were dealt was 0.17%.

The deviation in the overnight rate from the target was expected from the RBA and Governor Philip Lowe said he was “prepared to adjust arrangement if the situation requires.”

“The increase in settlement balances is also expected to change the way that the cash market operates. In other countries, where there have been large increases in balances at the central bank, the cash rate equivalent has drifted below the target and transaction volumes in the cash market have declined. It is likely that we will see the same outcome in Australia,” Lowe said in his March 20 speech.

On the same day, Lowe said the RBA doesn’t expect to reduce or change the cash rate any further. “I think we’ve done as much as we can there,” he said.

RAISE RATE ON ES BALANCES

Given this comment and given the deviation in the overnight rate from the cash rate, it is likely the board will debate whether the deposit rate on the ES balance needs to be raised further. The argument is strengthened by the fact that ES balances are likely to increase due to RBA’s bond purchases, putting further downward pressure on the overnight rate.

The RBA could potentially raise it by another 10bps to 20bps. This would ensure the overnight rate stays within the 0.20% to 0.25% range, and thus closer to the 0.25% cash rate target.

Doing this would mean monetary policy is being conducted using the “corridor” system that has been in use in Australia over many years.

This would also be similar to how the Federal Reserve conducts monetary policy with one key difference. The Fed sets its target for the federal funds rate as a range (currently at zero to 0.25%), rather than a single number (0.25%) that the RBA sets.

The RBA also has an option of going the Bank of Canada or the Reserve Bank of New Zealand way, and raise the rate on ES balances to 0.25%.

The Bank of Canada always conducted monetary policy using the corridor system but when it lowered the policy rate to 0.25% last month, it switched to the “floor system.”

Under the floor system, deposits are remunerated at the policy rate. In Canada, the overnight rate target is now at 0.25%, the bank rate is at 0.5% and the deposit rate is 0.25%.

The Reserve Bank of New Zealand used a mix of floor and corridor system, where the deposits on cash balances up to an allocated limit earned the official cash rate, and the excess balances earned 100bps below that.

When the RBNZ lowered the OCR to 0.25% last month, it initially changed the deposit rate on excess balances to 25bps below OCR. But three days later it moved to a full floor system where all deposits on cash balances earn the OCR rate.

BANK OF ENGLAND STYLE CUT UNLIKELY

The RBA could go the Bank of England way by cutting the cash rate target to 0.10% and switching to floor system.

But given Lowe has signalled no change in the cash rate, it is unlikely he would consider a cut in the cash rate. At least not now or in the near future.

FINANCIAL STABILITY

The discussion on financial stability will be an interesting and challenging one given the uncertainty surrounding the coronavirus.

Of most interest would be comments about the property market – both residential and commercial, which are likely to form part of the statement today.

YIELD TARGET POLICY

The RBA’s target for three-year bonds is currently its main monetary policy instrument and therefore more time is likely to be spent on this. But this will mainly involve taking stock of how the purchases have gone so far and how far the RBA has been successful in meeting the yield target and in smoothening the volatility in the bond market.

It is unlikely the RBA will give any insight into how and how much bond purchases it would do in the future. The RBA might just reiterate the yield target and that it will continue to support the bond market as long as it is needed.

Something around these lines is likely:

“How much we need to purchase, and when we need to enter the market, will depend upon market conditions and prices.”