Where did reserve banks come from – and what’s monetary policy?

How did the RBA evolve? What is monetary policy? And what’s jawboning?

By Shane Wright  -  APRIL 5, 2021

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It is Australia’s most important bank but it doesn’t have any customers. You can’t open an account with this bank, it’s unlikely you’ll ever meet the manager and it doesn’t even have ATMs.

But the Reserve Bank of Australia is pivotal to the national economy. From house prices to wages, the Reserve (RBA) influences even the smallest financial transaction in the country. It does this through monetary policy – the interest rate set by the bank once a month that affects the cost of money.

Anyone with a note or two in their wallet also has a reminder of the Reserve Bank’s other key function. The signature of the bank’s governor is on every note – it is the RBA that prints our colourful collection of currency.

Over the past year, the bank has been forced into lowering interest rates to an all-time low of just 0.1 per cent. It has also started buying government debt, creating close to $200 billion (with more to come) as it tries to strengthen the economy (see the section on jawboning, below).

But ahead of the coronavirus recession, the bank was in trouble. It had failed to meet its key metric – of holding inflation between 2 and 3 per cent – for almost six years while wages growth had slumped to near record lows.

Now there are questions about the RBA’s performance, its inflation target and whether it needs to change to deal with the post-coronavirus recession recovery. It has signalled rates will remain around their current level for years while it may extend its quantitative easing program into next year to help support the economy.

So where did the Reserve Bank come from – have we always had one? What is central banking? And what is monetary policy?

What is a central or reserve bank?

Globally, there are more than 170 central banks. Across the EU, there is the European Central Bank, which sets monetary policy across the union while individual members have their own banks. The world’s oldest central bank is the 352-year-old Riksbank of Sweden. It emerged from the ruins of the Stockholms Banco, the first bank in Europe to print banknotes in 1661.

Central banks have three core functions.

First, they control a nation’s money supply. They traditionally do this by being the only institution in any given country to produce its banknotes, although the advent of computers means central banks now don’t necessarily need printing presses to accomplish this. (The RBA prints the nation’s notes but the Royal Australian Mint produces the country’s coins.) How money works its way through the economy is heavily influenced by a nation’s official interest rate, which is set by the central bank. In Australia we know this as the “cash rate” while in other countries it goes by other names. The United States technically has 12 separate central banks, but they come together through the US Federal Reserve to set one interest rate for America.

Second, central banks act as the banker to the government (and to commercial banks). The Bank of England was founded in July 1694, primarily to fund the English crown’s war against France. King William and Queen Mary were two of its original stockholders.

Third, in many cases central banks also act as a lender of last resort to private banks or other financially important institutions that may find themselves in financial trouble. During the global financial crisis, the United States’ Federal Reserve took over insurance and financial giant American International Group over fears its collapse could irreparably cripple the global economy.

Central banks also help regulate the financial system. In Australia, since 1998 most direct banking regulation has fallen to the Australian Prudential Regulation Authority, but the RBA is also closely involved in overseeing the financial system.

How is a central bank different to a commercial bank?

Commercial banks take deposits from members of the public and loan money to customers. They also have shareholders, making them private companies.

While many central banks, such as the Bank of England and the Riksbank, started as private businesses, they gradually became government entities (more on that later). The RBA’s single shareholder is the Australian government.

Commercial banks, most importantly, seek to maximise their profits. A central bank aims to maximise the performance of an entire economy. Sometimes that means slowing the economy or making it more difficult to take out a loan, or adopting policies that undermine the profit-making efforts of commercial banks.

Central banks can also play the role of honest broker with commercial banks if there are issues that need to be resolved among competitors.

So central banks control monetary policy – what’s that?

Monetary policy is the movement of the cost of money. Commercial banks lend and borrow money among themselves in the “cash market”. The price on that money is the “cash rate”, targeted by the RBA – it cut the cash rate target to a record low 0.1 per cent last November.

The monies traded in the cash market are called “exchange settlement” balances, and are used to cover financial transactions between banks.

Instead of banks sitting around a large table, working out every day how much they owe each other and then handing over great wads of cash, they use exchange settlement accounts at the RBA, which records their value.

The sums in these settlement balances can vary wildly. In late March this year, there was almost $190 billion. In early March last year, they held a little under $30 billion.

Every day, the RBA estimates the demand for these settlement balances. For instance, a bank may need to borrow money from another bank to cover a loan or a payment for a very short period of time.

The Reserve manages the supply of exchange settlement balances. During conventional monetary policy times, the supply of these balances are set to meet demand as close as possible to the RBA’s cash rate target.

The bank manages that supply through “open market operations”. Those operations include the purchase or sales of bonds, repurchase agreements (where the RBA may lend exchange settlement balances in return for a bond from a commercial bank and then this transaction is later reversed) or foreign exchange swaps (such as a repurchase agreement but instead of a bond it is done through foreign currencies such as US dollars).

The cash rate influences almost every other interest rate across the economy. Most home borrowers see it via changes in the interest on their mortgage while those with money see it in changes in their deposit rates.

The RBA’s charter requires it to ensure monetary and banking policy is aimed at the stability of the currency, the maintenance of full employment and “the economic prosperity and welfare of the people of Australia”.

A separate “statement on the conduct of monetary policy” between the bank’s governor and the federal treasurer outlines in more detail how to meet the charter. In Australia, the bank (with the treasurer) aims to hold inflation between 2 and 3 per cent on average, over time, as the best way to fulfil the charter.

Most central banks believe that keeping inflation at a particular level delivers key economic outcomes such as moderate wages growth and a stable currency. By keeping inflation in this tight band, businesses (and workers) can have confidence that price rises or falls won’t disproportionately affect any decision they may make.

The cash rate is pushed up if inflation is too high – by late 1989, the cash rate was close to 18.5 per cent as inflation had reached 8 per cent and rising. The cash rate is pushed down if inflation is too low and the economy is weak.

Most central banks target a particular inflation rate. Some may be broad such as “between zero and 2 per cent” or a hard target such as 1 per cent.

What’s jawboning?

Central banks don’t have to move the cash rate to get their way. Another part of monetary policy is called “jawboning”. This involves a bank making public commentary to influence markets that may be betting on a rate change one way or the other (which in turn can influence things such as the value of the currency).

Through most of 2018, Reserve Bank governor Philip Lowe would say interest rates were more likely to go up than down when asked about the direction of monetary policy. This was effectively a warning to financial markets, businesses and people wanting to buy a home to expect a lift in borrowing costs.

Interest rate movements and jawboning form the key elements of “conventional monetary policy”. The world has seen the other side of that coin over the past 12 months – so-called unconventional monetary policy. This can include taking official interest rates below zero (as a number of countries across the globe have done) or engaging in what is known as quantitative easing. This involves a central bank printing money to buy assets - usually government debt - in a bid to reduce interest rates on this type of debt. The money printed for the asset then flows into the economy where it, hopefully, increases overall economic activity.

The aim is to make money so cheap, for an extended period of time, that businesses and consumers start investing and spending so that economic activity starts to increase.

Why does the bank have a 2 to 3 per cent inflation target?

The Reserve Bank’s inflation target is only a relatively recent phenomenon. Put in place by then governor Bernie Fraser in the early 1990s, it was formally codified by treasurer Peter Costello soon after he took office in 1996.

The Reserve Bank of New Zealand was the first central bank to set an inflation target in the late 1980s. Other countries quickly followed the Kiwi lead and today about 67 central banks have a formal inflation target.

Explainer:  Interest rates

What is quantitative easing? What is helicopter money?

Before this, central banking went through two major phases. Between 1945 and 1971, the Australian dollar was “pegged” to its US counterpart. Interest rates and the currency (which was controlled by the federal government) were changed to ensure the Australian dollar moved in line with the US dollar.

But the system broke down in the early 1970s. From 1976, the bank decided to target the money supply. This was based on the theory that inflation was linked to the growth of the money supply.

Most other central banks took this approach but by the early 1980s, largely due to the deregulation of the financial system (caps on mortgage and interest rates were ended, foreign banks were allowed into Australia in 1985), and the system also effectively collapsed.

This left all central banks looking for a particular target against which to measure their efforts to set monetary policy.

Internal research by the RBA through the later part of the 1980s backed what other central banks were discovering – an inflation target was key to interest rate setting.

How did Australia’s Reserve Bank evolve?

When the Commonwealth started on January 1, 1901, currency was produced by private banks and by the Queensland government. There was no central bank.

The Labor government of Andrew Fisher passed laws giving it control of our currency in 1910, outlawing state governments from printing notes and taxing private banks that did so. The next year, the government created its own trading and savings bank – the Commonwealth Bank. Within three years, it was taking up one of the key roles of a central bank by securing loans from overseas to help pay for Australia’s involvement in World War I. The first note – for 10 shillings – was printed in early 1913 on a press in Flinders Street, Melbourne.

In 1920, the responsibility for bank notes was shifted from Treasury to an independent Australian Notes Board, a separate department of the Commonwealth Bank and chaired by the bank’s governor. Four years later, treasurer Earle Page amended the bank’s legislation with the intention of turning it into a proper central bank. There was only one problem – Page did not really explain to the Commonwealth Bank what he wanted.

According to political economist Lyndhurst Giblin, when the bank’s board of directors were appointed by Page in 1924, they were given a blank sheet of paper to map out Australian monetary policy. “Both the aims and the methods of central banking were left undefined and the whole problem was put upon the new bank board, referred to hopefully as ‘the experts’,” he wrote in a book on the early history of the bank.

The problem was that the board of directors (including Sir Samuel Hordern, president of the NSW Royal Agricultural Society and after whom Sydney’s well-known Hordern Pavilion is named) believed they were experts. The bank itself was made up mostly of people versed in day-to-day banking. They had little knowledge of central banking.

Giblin notes this situation went on for some time. “For some years the Board seemed to be blissfully unconscious of the need of help and almost to have resented the idea of any technical assistance as beneath its dignity,” he wrote.

So confused was the bank that it asked the governor of the Bank of England to visit Australia. He turned down the chance, but sent a senior official out in 1927.

The election of the Scullin government, just days before the Black Friday collapse of Wall Street in October 1929 that precipitated the Great Depression, resulted in a renewed effort to set up Australia’s central bank.

New treasurer Ted Theodore proposed the day-to-day trading activities of the Commonwealth Bank be hived off into a new entity, leaving a standalone central reserve bank to focus on monetary policy and the circulation of notes.

He also proposed the bank board have nine members: the governor, no more than two deputy governors, the Treasury secretary and five outside individuals who would be, or had been, actively engaged in agriculture, commerce, finance, industry and labour.

The entire plan went down in the Senate where the then conservative opposition feared this new, broader board would extend the powers of the central bank.

The bank itself was uncomfortable with the Scullin government’s planned response to the Great Depression with Theodore proposing a series of public works that the Commonwealth Bank would have to fund.

A royal commission into the banking system in 1937 argued the bank’s actions, including pushing up the value of Australia’s currency, had worsened the depression’s impact.

It would take another 30 years before the Reserve Bank was separated from its private day-to-day banking activities. But the notion of a board made up of senior executives and people from the broader economy overseeing the bank had been planted and remains today.

The Curtin and then Chifley governments were the first to openly confirm the Commonwealth Bank was the nation’s central bank as part of sweeping changes they introduced in 1945.

Through the 1950s, the Menzies government took a series of steps that ultimately led to the Commonwealth losing its central banking roles to a brand new institution – the Reserve Bank of Australia that started operations on January 14, 1960.

By 1965, it had established its current headquarters in Martin Place, Sydney.

Is the bank under the government’s control?

While the RBA was created by government, it is certainly not under its thumb. The Treasurer of the day appoints the bank governor for a seven-year term. The bank and Treasury have a list of possible board members but, ultimately, the choice sits with the treasurer.

But after that the government has almost no control over the bank and its decisions. Australian treasurers have taken to rarely making direct comment on the RBA’s actions, especially around the setting of interest rates.

There is scrutiny of the bank. Twice a year, the governor and senior staff face the House of Representatives’ Economics Committee for three hours of questioning. But in most cases, this turns more into a political point-scoring effort by the assembled MPs rather than a deep inquisition of monetary policy settings.

Senior staff take questions from the public after the many speeches they present through the year. But it was only in 2020 that the governor faced a press conference - albeit two virtual ones - to answer questions about major policy changes.

Through the 1970s and 1980s, the importance of monetary policy being set independently of politicians became clear to economists, academics and, finally, the political class. Central banks have since used this independence to make tough calls that have caused politicians plenty of problems.

Just days out from the 2007 federal election, the Reserve Bank used its traditional Melbourne Cup Day meeting to lift official interest rates by a quarter percentage point to 6.75 per cent.

It was the first time a bank had increased rates during an election campaign, one in which the Howard government was arguing interest rates would go up under Kevin Rudd’s Labor Party. Then treasurer Peter Costello, in his autobiography, noted that prior to him taking the job, the treasurer of the day would announce an interest rate change.

“And no treasurer would announce a rate rise during a campaign,” he wrote. “The fact that the RBA made its announcement in the feverish last weeks of an election campaign demonstrated, once and for all, its independence.”

What can’t central banks control?

Central bankers can get blamed for all sorts of things. Current governor Philip Lowe has noted on many occasions the letters of complaint he receives from people who have savings, upset at another cut in deposit rates.

Interest rate settings have a substantial impact on house prices, prompting concerns it has added to the nation’s housing affordability crisis.

And then there are bananas.

In 2006, Cyclone Larry wiped out large parts of the nation’s banana crop. This contributed towards an uptick in inflation with the Reserve Bank increasing official interest rates on three separate occasions that year.

Then governor Ian Macfarlane, facing the House Economics Committee in August of that year, rejected complaints from members of the government and the public that monetary policy was being held hostage by high-priced bananas.

“We actually know what the price of bananas are,” he said, becoming the only RBA governor to ever comment directly on banana prices.