A bother over banks

The government and the RBA cannot claim the banks are undermining their efforts to stimulate the economy. If the RBA thinks rates need to fall to give the economy a boost, then it needs to do the cutting itself.

The public vilification of banks by politicians and others for raising mortgage interest rates ignores a fundamental fact. The direction of Australian interest rates is determined not by local banks, or even by the Reserve Bank, but by global markets.

The Reserve Bank’s monetary policy already takes into account developments in market-determined interest rates for domestic borrowers. In August 2006, the RBA said that it was tightening interest rates in part because retail lending margins over the cash rate had contracted.

After the credit crisis began in August 2007, the RBA raised its official cash rate by less than would have otherwise been the case if market-led increases in interest rates were not already doing some of its tightening work for it.

The big cuts in official interest rates since September last year reflected the Reserve Bank’s expectation that banks would not be in a position to fully pass on reductions in official interest rates, given adverse conditions in global credit markets.

In its quarterly statements, the RBA carefully evaluates the impact of both official and market-led changes in interest rates for the overall level of credit conditions in the economy.

The government is wrong to argue that market-led increases in interest rates are undermining the government’s and Reserve Bank’s efforts to stimulate the economy. The Commonwealth Bank ceased being Australia’s central bank in 1959. If there is insufficient interest rates stimulus in the economy, it is incumbent upon the Reserve Bank to provide more.

Australian banks have been able to pass on a larger share of the reductions in official interest rates to their customers than banks in comparable countries.

The fact that interest rates have been left on hold since April suggests that the RBA is comfortable with the current amount of interest rate stimulus – but there is always scope to do more if needed.

However, even the RBA’s influence over interest rates is limited. While the Reserve Bank sets the interest rate in the overnight interbank lending market, it is the market-determined interest rates on mortgages and other debt instruments that matter most for the economy.

As a small economy with an open capital account, the direction of Australian interest rates is determined in world rather than domestic markets. Australia is a price-taker in global capital markets, and our interest rates are highly correlated with foreign interest rates.

Interest rates have been rising throughout the world. In the US, Treasury bond yields are at their highest since October last year. It is these global influences that are putting upward pressure on local interest rates, not the supposed selfishness of Australian banks.

There is considerable debate over what is driving this increase in interest rates around the world.

Monetary policy works in part by steepening the yield curve, raising long-term interest rates relative to short-term rates. Rising interest rates, along with rising commodity prices, can be taken as an indication that the economic outlook is improving. As economic recovery takes hold, inflation will rise and central banks will have to re-tighten monetary policy. Debt markets are now pricing-in this eventuality.

A key issue is whether central banks take back monetary stimulus in a timely fashion. The aggressive easing in monetary policy around the world (in response to the global economic downturn) is likely to be matched by equally aggressive policy tightening as central banks seek to head-off future inflation pressures. The increases in interest rates we are now seeing is just a taste of the policy tightening that will soon be required to prevent rising inflation.

Interest rates may also be rising due to a reduction in the current account surpluses of depressed East Asian and other developing economies. The flow of saving from these economies into developed country debt markets has been an important influence on interest rates in recent years. Indeed, as Alan Greenspan notes, it has arguably been a much bigger influence on global interest rates and credit conditions than the monetary policies of central banks.

There is also debate over whether expansionary fiscal policy has a role in driving higher interest rates. In the case of the US, which is an effective price-maker in global capital markets, one could make a case that the US government’s call on global saving could make a difference to global interest rates.

This could be due to the ‘crowding-out’ effect of US government borrowing in global capital markets. But it could also be due to rising interest rate risk premiums related to fears of future government default or the inflationary effects of debt monetisation. These are only some of the many influences on global interest rates.

Whatever the cause of rising global bond yields, these increases in interest rates will inevitably be passed on to Australian borrowers. It would be a sign of political maturity if Australian politicians were acknowledge this reality, rather than taking refuge in the shameless populism of bank-bashing.

Dr Stephen Kirchner is a Research Fellow at the Centre for Independent Studies.

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