Has monetary policy lost it oomph?

Successive rate cuts to record lows have done very little to spur credit growth.

Summary: The Reserve Bank’s efforts to stimulate credit growth through successive interest rate cuts have done little so far, and the property sector remains subdued. Is Australia’s monetary policy transmission mechanism broken, or is there another cause?
Key take-out: The US experience shows us that policy will kick in eventually ... and property investors can profit by entering the market now rather than waiting for the inevitable turnaround.
Key beneficiaries: General investors. Category: Economics and strategy.

In the build-up to the Reserve Bank of Australia’s recent rate cut there was a plethora of commentary arguing that further reductions would have little to no effect on growth. ANZ CEO Mike Smith was certainly of that opinion, and something does seem to be wrong with the transmission mechanism. Even the RBA noted, as it cut, that credit growth “remained subdued” despite the lowest interest rates in a generation.

Noting that credit growth was relatively subdued is an understatement for sure. As I’ve noted previously (The trouble with the bubble call) credit growth is at recessionary rates and elsewhere we’re not seeing much in the way of a lift from the 175bp (now 200bp) worth of RBA rate cuts. Take a look at charts 1 and 2.


In chart 1 you can see new home lending over the last 13 years. The areas shaded in blue are interest rate low points and, as you can see, lending normally surged at these points. Even straight after the GFC, lending surged with the cash rate at 3%. Now we’re seeing nothing, and the truth is lending growth is lower now than what it was prior to the commencement of the easing cycle.

Approvals (shown in chart 2) are highly volatile, as you can see. Again I’ve showed the rate cycle low in blue, while the red shaded area is where the central bank has started tightening rates. Private housing approvals are the largest and most important component and rate cuts have again done nothing here – approvals are still very weak following a post GFC surge.

Noting this, I guess the question is whether it’s time to adjust my bullish outlook for the housing sector? Monetary policy appears to be ineffective.

As tempting as that is, I think there is evidence to suggest that while the monetary transmission mechanism does look broken, it is in fact still in operation. It is just lying dormant for the moment. An example of this can be found by looking over at the US.

It’s one of the more bizarre features of this global recovery that US credit growth is travelling back to average rates faster than Australia. Fair to say that in absolute terms, growth is faster here, but the acceleration, or the rebound, is faster in the US. In Australia, by contrast, we have seen stagnant growth rates since 2010. More than that, we know the momentum is building in the US. Recent house price data has shown that US house price growth for the 20 largest cities is at its strongest in seven years. Some US cities are experiencing record growth rates, for example Atlanta.

So what gives?

Many might argue that it is the additional stimulus that the Federal Reserve is providing, but this is a misnomer. Mortgage lending rates between the US and Australia only differ by 1-1.5% points. And while that additional percentage point  might matter at high rates, when you are at the lowest lending rates on record, respectively, it is an insignificant difference. Put it this way: a 4% lending rate as opposed to a 5% lending rate isn’t going to do much more in terms of persuading someone to get a loan.

Indeed, the fact is the fundamentals for monetary policy – for the monetary policy transmission mechanism – are much better in Australia. In other words, there are better reasons for policy to gain traction here rather than in the US.

For a start, credit outstanding is lower in Australia, as you can see in chart 4.

Chart 4 shows total credit outstanding as a percentage of GDP for the private sector and, as you can see, it’s markedly lower in Australia than in the US (the top line) and even the OECD average (the middle blue line). If you think about that, credit growth could expand another 30 percentage points relative to GDP – another boom – and we’d only be at the OECD average, like every other rich nation.

Household debt ratios to GDP are similar, perhaps a bit higher in Australia (85% to 93%), although having said that household debt servicing ratios are about the same as in the US at 10-11%. While no additional benefit, it isn’t an impediment to monetary policy. What does give us an additional benefit though is our lower unemployment rate. At 5.5%, our unemployment rate isn’t too far from what economists like to call the natural rate of unemployment – i.e., the unemployment that you can’t do anything about, as people leave jobs, take time out etc. Anyway, this gives us nationwide a much better ability to service debt. We also can’t forget that nonperforming loans in the US are pretty much double the rate here – roughly 4% versus 2%. Actual foreclosures are still around 3.5-3.75% in the US, while in Australia that’s more like 0.5%.

I would argue then that if the monetary policy transmission mechanism can work in the US, a country that’s fresh out of a credit crisis, then it will work here too. We didn’t have sub-prime lending, and I’ve noted all the positive factors for the Australia credit market before. There is low household debt on average, and of those with debt at least half are well advanced in repayments etc – some by a year or so. Noting all of that, if there is nothing wrong with the monetary policy transmission mechanism in the US, and there isn’t, then it is even less likely that the transmission mechanism is broken here.

To assume that monetary policy doesn’t work, or is less effective, you have to nominate a reason. Some would say that house prices are high, too high, and one of the most expensive in the world. This may be true, although it may not. Plenty argue against it, and really I’m not going to engage in the argument. It’s become too subjective, and everyone’s got their own opinion backed by ‘facts”. As I’ve argued before, it doesn’t matter though. Prices may be high, but this doesn’t preclude the possibility that they may push higher if people can take on the debt and service it – and they can.

I remain very confident then that the housing market – both construction and price – will pick up here eventually, and I stand by my previous research. The fact is, though, I have to acknowledge that the turnaround is taking longer by the looks. This doesn’t mean monetary policy doesn’t work - it’s just being hampered, and I suspect that is due to very low confidence here.

I think the RBA’s easing cycle is itself weighing on confidence. People genuinely think something is wrong – even in the face of strong data. “What does the RBA know that we don’t?” is the common question. Nothing is my answer. Policy has been politicised, and a weaker $A is the target. The price is that confidence is struggling to pick-up though. Whatever is hampering confidence it won’t last forever – and that’s when we’ll see monetary policy kick in aggressively.

I think one thing that supports my case is the tendency for building approvals to keep on falling during an easing cycle (see chart 2), and it often only seems to pick up once the tightening cycle has started – off a low base sure. That is the power of confidence.

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