Putting The Brakes On Too Hard And Too Fast

The Age
13 August 2008

The Reserve Bank has indicated it may lower rates as the economy slows down, but will the major banks take any notice?

HOPE has been in the air this week. The reason? The Reserve Bank said economic conditions were such that it might do something in the near future. Specifically, in releasing its August statement of monetary policy, it said this: "On the assumption that the subdued demand conditions are likely to continue, scope to move to a less restrictive monetary policy stance in the period ahead is increasing." This is bankspeak for "more than likely we will cut the cash rate".

At this point, Australians with mortgages should be hopeful of some relief, but this year has seen a notable severing of Reserve Bank policy and major banks' policy towards interest rates. As the RBA acknowledged, the banks in the past 12 months have raised rates by 150 basis points, of which only 100 were the result of rises in the cash rate. The banks argue that they have needed to lift rates independently of the Reserve because of funding costs brought about by the global credit crunch. There is no guarantee they will reduce rates by the same proportion as the Reserve if it cuts the cash rate.

Indeed, the banks in recent weeks have been explicit in saying they now consider other factors in setting rates. This is an historic shift, and its ramifications are likely to flow not only through the economy, but into politics. Households have had to absorb steadily rising costs this year, particularly in petrol and food. Voters, when faced with bad economic news, have a habit of blaming the government of the day. The comments of Prime Minister Kevin Rudd in Beijing last week, as a warning to the banks, were tepid. "I say to the commercial banks in Australia that they have a responsibility to ensure that action by the Reserve Bank is reflected in the interest-rate posture adopted by those commercial banks."

A responsibility to adopt a posture? After 12 RBA rate rises of 25 basis points since 2002, and the commercial banks' rises this year, mortgage holders should expect something a bit bolder from the PM or Treasurer Wayne Swan. What the public got on Monday was the central bank warning that because of a slowing economy (added to by it putting the brakes on) the prospects of rising unemployment were real. The annual rate of job growth at present is 2.3%. However, the RBA forecasts this is going to fall to 0.75%; by the end of next year unemployment may reach 6% (which is about midway among jobless rates of the OECD countries).

After being preoccupied with reining in inflation, a political football that is kicked around by both major parties, the Reserve now sees growth as its main worry. While it does not see a falling of the inflation rate to the preferred band of between 2% and 3% until 2010 (its forecast for this year is 5%), it predicts economic growth, outside of the agriculture and mining sectors, to be only 1%. With those two industries, growth would be 2% in 2008.

Mr Swan was right about one thing this week when he said the world economy was more integrated. It used to be that when the US sneezed the world caught cold. Now developing nations such as China could be added to the equation, and how their economy is travelling has an effect, through our exporting of resources, on Australia.

Yesterday an NAB survey of business confirmed the Reserve's sentiments. Business confidence has slumped to its lowest level since the immediate aftermath of the September 11, 2001, attacks on America. Higher interest rates have hit consumer confidence and demand. If rates do not fall, and unemployment kicks in as the Reserve has predicted, then households are going to find it increasingly harder to service not only their mortgages but all other debts, especially that of credit cards, on which Australians owe $44 billion. Australia is no longer a nation of savers; we have embraced debt. In tough times, this embrace may turn to strangulation. Household debt-to-assets ratio has risen from 9% in 1985 to more than 18% this year.

The Reserve Bank, having spent the past six months dampening down a roaring economy, now has to administer a stimulant in the form of rate cuts. Should it have foreseen the rapid impact of its rates rises? Up to a point. The subprime crisis in the US and the ensuing credit crunch were beyond its control and predictions.

However, in the dry language of this week's monetary statement, there is a worrying subtext: that the Reserve was spooked into acting too precipitately on tightening rates. No one should take comfort from that.

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