How other interest rates respond to a change in the cash rate
Assume that the RBA has tightened monetary policy by increasing the cash rate . The price of money that is close to cash (e.g. 30 day bank bills or deposits) will also increase, otherwise lenders (or depositors) will be less inclined to invest in Bank Bills (or bank deposits) and more inclined to invest in the cash market. Similarly, other interest rates will also move up in order to retain market share. Accordingly, the competition for funds forces other rates to increase in line with the increase in the cash rate. Similarly, if the cash rate increases, the cost of funds increases for lenders of money in the 30 - 90 day market. As they essentially face higher costs of production, they pass on this increase in the form of higher interest rates. This process continues to affect longer term rates in the economy.
Given that market rates of interests are determined primarily by the demand and supply for funds in each particular debt market, their movement will not always coincide precisely with movements in the target cash rate (sometimes referred to as the policy rate). For example, over 2009-10, banks increased average interest rates more than the corresponding increases in the target cash rate, while over 2011-13 the banks reduced their rates by less than the reduction in the target cash rate. This occurred because the banks experienced higher cost pressures from abroad (i.e. they needed to pay more for debt on international markets given the financial crises that occurred in Europe). This illustrates that the RBA has only indirect control over interest rates. In comments to the Standing Committee on Economics in February 2012, the RBA Governor noted that:
The chart below highlights the relationship between the cash rate and the home loan rate. It clearly shows the almost perfect correlation between changes in the cash rate and the home loan rate up until 2009. Since then, a widening of the gap between the home loan rate and cash rate began to emerge (from 1.85 percentage points to 3.7), highlighting the fact that market rates of interest rates can and do move independently of changes to monetary policy. This necessarily has implications for monetary policy settings.