A Call for Rates Down Under to Go Down

When Australia’s Reserve Bank board meets on Melbourne Mug day next week, the question at hand is whether the RBA will seek to offset recent bank rate raises with a cut towards the cash rate. With a cut, the hope is banks will reverse their decision and get mortgage rates back to where we were before.

First Westpac, then Commonwealth Bank, now all of the big four have raised their variable rates on mortgages rising, purportedly in response to more stringent capital requirements imposed upon them.

In the wake of the 2008, financial crisis regulators around the world concluded banks did not hold enough capital as a barrier against potential losses.

The Murray report wisely suggested banks ought to hold more capital, but it does not come free. The actual investors who provide this need payment – which enhances the question: “by whom?”

Bank investors might accept a lower rate of return on their investment. Indeed, because the extra capital requirements help to make banks safer this might ‘t be unreasonable: the risk-return tradeoff has changed.

However, the big four have decided their clients should pay. Costs go up, and they are passing those costs (or perhaps a bit more) on to home loan customers. Kudos to Malcolm Turnbull for pointing this away last week.

Time to cut

I am upon record as suggesting the RBA should and probably will cut rates at least once in the coming months. That comes from my view that Australia is suffering from “secular stagnation” – the idea that the rate limit of the economy (or even more technically, the equilibrium real interest rate) has changed because, throughout the world, there are too many savings chasing after too few productive investment possibilities. This is enough of a reason to cut rates in and of itself, but the large four-rate hike makes it all the more likely, and important.

That is all not so difficult, but it raises two essential questions: (i) what are the implications for the RBA; and (ii) exactly what does this say about the banking system and the regulation of it. The common thread in the answer to those questions is the B-word: “bubble.”

For the RBA, cutting rates by 25 basis factors would offset the big four’utes recent hikes (not quite precisely, but close enough). Nevertheless, of course, the big four’s adjustable mortgage rates are not the only things impacted by the cash rate. A 25bp cut should flow into commercial lending and it should permit cuts by other mortgage providers. That would stimulate the actual economy.

Still, the RBA is obviously balancing the desire to promote the economy through reduce rates, and concerns about asset price bubbles – particularly in residential property. In that regard, the big 4 move is good and bad. It should cool the possibly overheated property market, it forces the RBA’s hands. In addition, it takes away the stimulatory effect a cut would have had; absent the big four’utes preemptive move.

The second, and deeper question, is what all this states about the competitiveness of our banking system. The fact that customers, not shareholders, are on the receiving end of the cost of keeping more buffer capital exhibits how much market power the big four have.

That is not necessarily a terrible thing – spreads upon home loans are a little, but not particularly high by international requirements. It is not easy to make the case that the big four is tearing off the Australian public.

They have been willing to lend people a lot of money, relative to their earnings, to purchase residential property. Go to the big four’s online hand calculators and see how much you can borrow together with your income, and then try the same thing at a large American bank (like Bank of America). Australian banks will lend you plenty.

Therein lies the rub. It is one thing to raise prices a bit, and then have those counteract by an RBA rate cut. That will have little or absolutely no effect on borrowing behaviour. It is quite another to reform financing practices and stop letting individuals borrow staggering sums against frothy assets.

Moreover, we should concentrate on the latter practice.

The RBA should reduce rates, but not because the banking institutions are upping them is republished with permission from The Conversation