Banks’ rate claim is plain wrong

Anew month, another meeting of the Reserve Bank board on the first Tuesday. Tomorrow, in fact. You beaut, another bout of speculation. Will they or won’t they cut the official interest rate?
Nanjing Night Net

Thankfully, the speculation is a bit half-hearted this month. Having cut the rate two months in a row, most observers aren’t expecting another cut this month.

So let’s take the opportunity to discuss a more cerebral question: with the banks now going their own way on the interest rates they charge home buyers and business, does it still matter what the Reserve decides on interest rates?

In theory, it uses changes in its official interest rate to bring about changes in the market rates the banks charge households and businesses. It cuts rates when it wants to encourage borrowing and spending, and thus speed up the economy; it raises rates when it wants to discourage borrowing and spending, and thus slow down the economy.

It manipulates interest rates so as to achieve its inflation target – to hold the inflation rate between 2 and 3 per cent, on average, over the medium term – while also keeping unemployment low. Economists call this manipulation ”monetary policy”. But with the banks doing their own thing, is monetary policy still effective? If you listen to some bank spokesmen, moves in what the market prefers to call the ”cash rate” no longer have a big effect on the decisions banks make about the rates they charge.

Don’t you believe it. They’re trying to justify their actions, not explain how interest rates work.

The cash rate is the cost of borrowing overnight in the money market; the rate at which the banks lend to each other. The Reserve keeps the cash rate under very tight control by means of ”open market operations” – buying or selling second-hand government bonds to the banks.

Between 1999 and 2007, it was easy to see how the Reserve’s ability to change the cash rate led to changes in the rates the banks charged on home mortgages and borrowing by businesses: any change in the cash rate – whether up or down – was soon passed on by the banks to their customers.

But from 2007, in the early days of the global financial crisis, that simple relationship broke down and the banks began making ”unofficial” rate changes, usually in association with official changes. Why did things change? Because of the money-market disruption and changed relationships brought about by the crisis.

The cash rate is regarded as the risk-free rate of borrowing overnight and it thus forms the ”anchor” for all other short-term and variable interest rates in the market. The other rates will usually be higher than the cash rate, with those other rates’ margin (or ”spread”) above the cash rate, reflecting the extra reward to lenders for the various risks they have taken on: the ”credit risk” (of not being repaid), the ”liquidity risk” (of being unable to sell the debt security without loss because of limited demand for that security) and the ”term risk” (of having your money tied up for a longer period).

During the period up to the start of the financial crisis, all these risks, and hence margins, stayed steady. So a change in the risk-free anchor could be passed on mechanically to the banks’ borrowers.

But the crisis made people in various international markets a lot more conscious of the risks they were running, thus increasing the spreads they were demanding. Some markets actually ceased to operate for a time.

This wiped out our banks’ chief competitors, the mortgage originators, which ended up being bought out by the banks. Later on, the prudential supervisors and the rating agencies decided our banks had made themselves too vulnerable to events such as the GFC by relying too heavily on short-term borrowing from overseas money markets.

So the banks began trying to lengthen the maturity of their foreign borrowing and also began competing with each other to attract more domestic deposits, particularly term deposits.

These changed conditions meant that, though the cash rate – the risk-free anchor for interest rates – remained the largest single influence over the banks’ cost of funds, that cost was also influenced by other factors, such as the changing spreads required by foreign long-term lenders to our banks and by the higher rates needed to attract more term deposits from Australian savers.

Anxious to preserve their existing (very generous) ”net interest margin” – the difference been the banks’ average cost of funds and the average rate they charge their borrowers – the banks have become emboldened to pass any increase in their cost of funds on to their customers independent of changes in the cash rate.

After the Reserve’s cut in the cash rate of 25 basis points in June, the banks decided to pass on about 20 or 21 basis points, thus demonstrating that the cash rate remains the dominant influence over market rates (in this example, 84 per cent), notwithstanding the change in the banks’ circumstances and behaviour.

The more fundamental reason the effectiveness of monetary policy has not been reduced is the Reserve’s repeated statements that the interest rates it cares about are those actually being paid by households and businesses, not the cash rate. So it makes whatever changes to the cash rate are necessary to get mortgage rates and business borrowing rates where it wants them to be.

Many people are highly disapproving of the banks’ efforts to preserve their profitability by increasing the spread between the cash rate and the mortgage rate. But don’t confuse the question of whether you approve of the banks’ behaviour with the question of whether monetary policy has become less effective. It hasn’t.

Twitter: @1RossGittins

This story Administrator ready to work first appeared on Nanjing Night Net.

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