The Reserve Bank could start cutting official interest rates within a few months. But what happens if the trading banks don’t cut their rates with the same enthusiasm they have shown for raising them over the past 12 months? Apart from upsetting borrowers, this would make it harder to reverse any slide towards a recessionthatmight appear later in the year. It would also be most unwelcome news for the Treasurer, Wayne Swan, who is pinning his hopes on a soft landing.
Since last July, the banks have increased housing interest rate by about 0.55 percentage points more than needed to just kept pace with the Reserve’s lift in its official cash rate. The average standard mortgage rate is now a little over 9.6 percent compared to the Reserve’s official cash rate of 7.25 percent. A year ago, standard mortgage rates averaged 8.05 percent compared to 6.25 percent for the cash rate.
The common assumption is that the banks will movedown in lock step once the Reserve starts cutting rates, as its Governor, Glenn Stevens, last week indicated will happen as inflation and economic growth slows in Australia. Obviously, the banks would find if easier to sell new loans if they cut their rates faster than the Reserve cuts the official rate – just as they raised them faster on the way up. But this assumes the banks cost of borrowings will fall fast enough to let them do so.
No one knows for sure what will happen. But it would be a brave soul who assumes that money will be become easier to borrow in the US financial markets. Australian banks used to raise large amounts of relatively cheap money in the US, until the "sub-prime" home lending crisis began in the mid-2007. Then it belatedly became clear that it was not really a brilliant banking practice to give no-deposit loans to people with no jobs and no other capacity to repay the debt. After that, the pool of available money either dried up or became dearer to access.
Since then analysts have alternated between announcing the sub prime crisis is over and warning about how it is spreading to supposedly respectable institutions. Last week Australians saw television pictures of Americans queuing up outside a tottering Californian bank, Indy Mac Bancor,in adesperate attempt to take their money out. The Bush Administration them effectively nationalised this mid-sized bank.
But this leavesa more disturbing question mark over the fate of two giant mortgage guarantors whose business practices have not been nearly as innocent as their names, Freddie Mac and Fannie Mae. The US Treasury and the Federal Reserve Bank have said they won’t let these behemoths fall over. This might be easier said than done while George Bush is running a massive budget deficit and Feddie and Fannie's $6 trillion in debt has to be guaranteed — that’s over five times Australia’s national income.
The US Federal Reserve has been boosting liquidity for struggling financial institutions. The intention is not to make it easier for Australian banks to borrow in the American market. As a result, the Australians have been forced to pay more for borrowing locally. Westpac recently issued securities paying 10.1 percent. Suncorp and Macquarie issued others paying 10.9 percent and 11.095 respectively.
Clearly,housing rates can't remain below 10 percent if all the banks’ funds cost over 10 percent. Fortunately, they don’t. Many people still have cheque accounts paying close to zero. However, there’s no way of knowing what overall funding costs the banks will face if the economy slows down, as Glenn Stevens last week indicated was starting to happen.
Swan could try to arrest a severe slow down by letting his budget surplus fall below its promised 1.5 percent of gross national product. But he would obviously like to see a clear contribution from cuts in bank lending rates.
The prospect of a serious slow down may seem rather odd when the government still stresses how commodity exports are boosting national income, particularly in WA and Queensland. But Stevens said last week that he saw signs than growth was slowing enough for the Reserve to meet its goal of bringing inflation below an annual 3.0 percent.
This process has been helped by the credit crunch caused by the sub prime crisis, despiteStevens saying in Januarythat it was not affecting the Australian financial system. It was. Luckily for Stevens it made his job easier. Instead of bigger increases in officialrates to crush inflation, the trading banks did the job by expanding the gap between their rates and the Reserve’s.
Stevens clearly hinted last week that the next movement in rates will be down. To his credit, he said, "You shouldn't be waiting till it's really obvious inflation's gone all the way down to where we'd like it to be before you conclude you've got to start easing”.
Even if the trading banks enthusiastically switch from lifting to cutting rates, this still leaves the problem that the desired slow down could easily turn nastier than intended. If so, it won’t be the first time an attempt to fine tune growth turns into a recession.
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