ECON141: The cash rate and interest rates

Hi ECON141 students.  Unlike ECON130 there isn’t weekly material on this site, with lecture notes being provided instead.  However, I will add the occasional piece to help give what we are doing some context – so that it can be used to understand what is currently happening.

In that vein, today we are going to talk about how the central bank does influence the nominal interest rate in New Zealand (as compared to our still useful discussion of bond purchases in class).  By doing so we will also be able to ask about “negative interest rates” in a later post.

It should be noted that none of the content I cover here is assessed – you will be assessed on what we do in class and in the lecture notes and readings. Instead the purpose of this is to add a bit more detail about things for students who are interested.

Cash rates and interest rates

A history of monetary policy implementation in New Zealand is given by the RBNZ here.  However, we will abstract from most of that and just look at where things are right now.  For this the RBNZ provides an excellent teaching resource on settlement cash accounts rate here, and the RBA also provides a nice explanation of the market here.

The corridor described in these pieces refers to the gap between the rate paid to those who deposit funds in the settlement cash account (the ESAS) and the rate changed to those who borrow from the settlement cash account.  There have been significant changes recently in the corridor set around the OCR (due to COVID) – so we will assume our own corridor for simplicity below. 

Across the banking system as a whole we would expect the funds deposited in financial institutions (for simplicity I’ll call them all banks – even though there are many other types of institutions) and the funds lent out to be equal.  We described this process when looking at the money multiplier in class.  However, there will be individual banks who temporarily have deposits that are greater than the loans they’ve written and vice-versa.  The settlement cash account provides a mechanism to help these banks balance the books.

The “cash rate” we are then discussing is the rate that determines these rates from the settlement cash account.  The rate for deposits will be lower than the rate for loans, implying that the central bank earns a “margin” from their settlement activity.  Furthermore, they will lend or borrow as much as necessary at this rate.

This is the background we need to work out how this cash rate influences the lending and deposit rate of banks.  If, at the end of a day, a bank has lent more out than it has brought in with deposits it can borrow the difference from the central bank at the settlement cash lending rate.  If instead they have brought in more in deposits than they have lent out, they can leave the remainder in the settlement cash account and earn the deposit rate.

Given the recent rate corridor changes, let’s use an example where OCR + 25 basis points is charged for someone borrowing from settlement cash, and OCR – 25 basis points is charged for someone lending to settlement cash.  

Take an OCR of 2% (200 basis points), here a bank who is expecting to have to borrow from their settlement account knows that financing will cost 2.25%.  As a result, if a new borrower comes to them they will not charge below a (risk adjusted) 2.25% to lend to that borrower as the cash rate determines their opportunity cost.

Similarly, someone who looks like they are going to have a credit in their settlement cash account may see a new depositor turn up.  They know that they could earn 1.75% putting that money in the settlement cash account and so would not be willing to offer a higher interest rate to that depositor.

Now take things a step further.  One of these banks is lending and one of them is borrowing.  They could essentially transact with each other, through interbank lending, in order to benefit from closing this margin.  For example, the bank that is borrowing from settlement cash could offer 2% to borrow from the other bank that has excess deposits, and the other bank would be keen to take it.

In this way, the settlement cash rate influences the opportunity cost of lending and borrowing for financial institutions, and in turn influences the interest rates they charge lenders, provide to depositors, and choose to interact with each other.

But what happens when the cash rate goes negative?  We will think about that more in a future post.