Read my Property Observer column on this today. A quick extract is here:
"While most economists currently expect the RBA to stay its hand in December, the financial markets have been pricing in a 100% probability of a cut for some time.
The interest rate debate is swirling around what experts think is the RBA’s “policy of least regret.”
In this context, there is universal agreement that the chief near-term risk Australia faces is to the funding of our banking system, with the wholesale finance markets that supply about 40% of total bank funding temporarily closed.
The concern is that if the banks feel they cannot fund themselves, they will ration credit, and, by doing so, rather myopically kill off economic growth. Of course, we have been here before during the GFC, and know that contrary to some predictions, the banking system did not fall in a heap.
Why? Because the Government decided to lend its pristine AAA credit rating to all ADIs by providing a taxpayer guarantee of deposits, which make up 50-60% of total bank funding, and through an offer of a taxpayer guarantee of the banks’ wholesale debts. In addition to these two insurance policies, the RBA also lent directly and very cheaply to the banks to provide them with enough funds to meet their day-to-day liabilities. Had the Government and the RBA not acted in this way, many Australian banks would have ended up trading insolvent.
The good news for the banks is that the RBA is in the process of launching another, more formal, bail-out program called the Committed Liquidity Facility, which will furnish banks with a line of credit that they can tap during liquidity crises such as the current one.
The RBA is the first to admit that it does not know what is going to happen in Europe, and what, if any, adverse economic shocks might be sent Australia’s way. It has ample time to watch how things unfold.
If the “nowcasting” Glenn Stevens is increasingly fond of reveals that the economy is about to come to a grinding halt, and if unemployment starts to rise at a surprising rate, he can comfortably cut rates.
Yet dropping rates today in response to bank funding problems prior to his nowcasting telling him to do so is foolish for at least two reasons.
First, there are many much more direct policy measures that can be used to immediately cauterize these issues, such as the assorted taxpayer guarantees and RBA liquidity facilities discussed above.
A cut in interest rates, on the other hand, is likely to be almost entirely absorbed by the banks in the form of margin expansion, which they would argue they need in order to vouchsafe their profitability.
This has two adverse consequences for the RBA and taxpayers.
The first is that if the RBA cuts its cash rate, and the banks don’t pass it on, this undermines the effectiveness of the RBA’s conventional monetary policy instrument. There is a zero lower bound on how far the RBA’s cash rate can go.
If you assume that banks want to maintain, as a minimum, net interest margins of around 2.5%, it is hard to see how mortgage rates can fall below circa 3% to 3.5%. And that assumes no further margin expansion by the banks along the way, which is heroic. So the RBA probably has the ability to reduce actual lending rates by about 300 basis points, give or take.
The point is that the RBA wants to be very careful to disentangle the policy solutions to bank funding problems and those required to stop an economy heading into recession (especially when fiscal policy is purportedly out-of-action).
Confusing the two could hamper your ability to lower market lending rates and thus stimulate the wider economy. Put differently, the RBA should preserve its policy firepower for when it needs it rather than using it to subsidise bank margins.
The issue for households is that if banks absorb RBA cash rate cuts via margin expansion, the RBA is, in effect, facilitating a wealth transfer from the 5 million families with mortgages, who will not get the benefit of lower rates, to bank executives and bank shareholders.
Don't get me wrong. A sustained deterioration in global economic conditions would absolutely warrant deep cuts by the RBA. Yet unlike its peers overseas, the RBA is in the fortunate position of having most domestic debt being issued in ‘variable rate’ form. This means the RBA can make immediate and very significant changes to household cash-flows through adjustments to its policy rate. In many other countries, such as the US and UK, most household debt is fixed-rate and not, therefore, controlled as closely or immediately by the local central bank.
Australia does indeed have an economic insurance policy, or a “Stevens’ Put” as I described it in an earlier column. But instead of trading some of that insurance away to vocal bankers and financial market investors, the RBA should preserve it for the maximum benefit of all Australian households."
