Rising tides will lift the RBA’s rates

The Reserve Bank is pleased with the strength of household finances and bank lending. Now the market should prepare for a rate hike cycle to begin within six months.

Australia’s financial system is in sound shape, with the main risks coming from offshore and maybe housing, although on the latter point the Reserve Bank is comfortable with the current state of play in lending and household finances. Those were the key points from the Reserve Bank’s semi-annual Financial Stability Review.

While the release of the FSR is not usually a market-moving event, this one contains a number of issues which has some potential policy implications.

While the financial system remains strong, the Reserve Bank noted that “the relatively modest rate of growth in credit, and hence bank balance sheets, poses a strategic challenge for Australian banks. Of particular importance is that banks maintain prudent risk appetite and lending practices, especially in the current low interest rate environment”.

In other words, the Reserve Bank is on alert for any unwelcome relaxation in lending standards which banks may pursue, given sluggish growth in the banking sector’s balance sheet.

According to the Reserve, there are few signs of this occurring at the moment. But like an air traffic controller surveying the radar, it is on the lookout in case conditions change.

The RBA noted the strength of household finances, saying that “the higher rate of saving and slower pace of credit growth have been in place for some time now, although surveys of households suggest that their risk appetite has increased a little, as would be expected in an environment of low interest rates and recovering asset prices”.

This suggests the Reserve Bank may be increasingly uncomfortable with the current level of interest rates. Or perhaps the Reserve is hinting that the current easy stance of monetary policy has worked in supporting growth and spending and that no more interest rate cuts are needed. Either way, the market should be preparing for the start of an interest rate hiking cycle at some stage within the next six months.

This assessment is only reinforced by the board noting in the FRS that “the risk profile of new household borrowing remains reasonably sound and indicators of household financial stress are low. The continued high rate of excess repayments on home loans is consistent with low rates of financial stress among households with mortgages”.

In a warning that has been delivered by the Reserve Bank over several decades, it noted that “it is important that those purchasing property do so with realistic expectations of future dwelling price growth”. In other words, the recent acceleration house price growth may not or will not be sustained over the medium term, especially when interest rates return to more normal levels, some 100 to 200 basis points above current rates. The bank is saying house prices can go down as well as up.

Perhaps the main aspect of the Reserve Bank's FSR was – and it is worth quoting at some length with my emphasis added – that because of subdued credit growth, “banks are therefore having to adapt to an environment where their balance sheets grow more in line with borrowers’ incomes and the broader economy. It is important that they do not respond to pressures to boost revenue by imprudently loosening their lending standards, or by making ill-considered moves into new markets or products. Based on the available evidence, these responses do not appear to be occurring at this stage”.

Currently, the banks are prudent. They implicitly have an eye on the lessons of the financial crisis. The Reserve Bank has no concerns that the Australian banks are going down the path of slack and adventurous lending, as was the case in the US and UK prior to the crisis.

Australia’s banks have been well managed, well regulated and have benefited from many years of pragmatic and prudent macroeconomic policy management.

With the Reserve and the regulators flagging risks (and the banks hopefully heeding this advice), it is likely that the financial system will remain healthy for some time to come.

The economy is doing well and the financial system is in good shape. That said, the Reserve Bank knows that this owes a lot to very easy monetary policy settings that have been in place for the past year or so. While there is no overt comment on the monetary policy outlook in the FRS, a close reading of the whole document should lead one to an assessment that the bank has a scenario in mind where interest rates will need to rise. The only questions are when and by how much.

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