The volatility and pressures in global financial markets over recent weeks have placed significant upward pressure on the funding costs of banks and lending institutions in general. In a world where accommodating monetary conditions are still needed, including in Australia, the lift in funding costs is moving rapidly to the point where banks see pressing need to lift their lending interest rates without any move to tighten monetary policy by the central banks.
Australian banks have already lifted their variable rate home lending interest rates by between 15 and 20 basis points back in November 2015. Those moves were viewed by the RBA as give-back for some of the discounting of home loan interest rates over the previous year or so, not really representing an effective tightening of monetary policy. Pressure is building rapidly on Australian banks to lift their home loan interest rates another 20 basis points or so. If banks do raise their lending interest rates again will that still be viewed by the RBA as not constituting an effective tightening of monetary conditions?
What is clear is that RBA wants Australian monetary conditions to stay accommodating and it talks of the capacity to lower the cash further if needed to support flagging demand.
The forces impacting household demand (consumption and housing expenditure), by far the biggest component of spending in the Australian economy are very finely balanced at present. Household income growth is weak limited by very soft wages growth combined with continuing constraints on growth in transfer payments and benefits from government.
One saving grace is that employment has been growing quite strongly adding some impetus to growth in household income, although the strongest phase of employment growth may have passed on the basis of softer monthly readings for December (-800) and January (-7,900).
Earlier strong employment growth translating to a falling unemployment rate has also been important in assisting households to become more confident about their own financial position and prospects. In turn, households have been prepared to save a little less out of each dollar of income and spend a little more. This running down of the household savings ratio from relatively high levels built up in the uncertain environment in the wake of the global financial crisis has been crucial in helping household spending to rise. In an income constrained environment it remains crucial if household spending is continue growing at the pace needed to sustain reasonable economic growth.
In this context, the apparent halting of the slide in the unemployment rate in January – it lifted to 6.0% from 5.8% in December – is a worrying development. If the unemployment rate continues to edge higher it becomes much less likely that households continue to run down the proportion of their income that they save. In turn, growth in household consumption and growth in spending on housing starts to slip and the RBA has strong cause to lower its cash rate.
Returning to the issue of higher bank funding costs increasing pressure on banks to increase their lending rates, another rise in home loan interest rates, even if again it is comparatively small, is coming at a time when the fine-balance influencing households desire to spend is starting to come under pressure.
Whether the RBA chooses to offset the de facto tightening of monetary policy likely to be caused by the approaching lift in bank lending interest rates is a moot point. It passed back in November, but as argued above the circumstances are more concerning relating to household spending this time. Having said that, it is a slippery path when the RBA responds with the cash rate to an issue which is essentially one of increasing credit spreads. The RBA has no leverage over the factors causing the widening credit spreads also it cannot be sure whether banks will pass through some or any of the cash rate cut to lending rates.
More likely, the RBA may choose to wait until there is clear evidence in the economic data that spending is softer than previously expected. The problem with this course of action is that the easing of policy is effectively lagging the start of the weakening phase in spending. It may also occur after a de facto tightening of policy has occurred – net result the cash rate cut needs to be substantial to ensure any effective easing of monetary conditions.
Our view remains that the cash rate is likely to be cut towards mid-year, probably with 25bps cuts in May and June taking the cash rate down to 1.50%. For many borrowers the 1.50% cash rate will feel little different from the current 2.00% cash rate given in our view that between now and May the banks are likely to lift their lending interest rates again.