Why the banks have passed on the May RBA Rate Cut
In May, the Reserve Bank of Australia (RBA) cut interest rates to its recorded lowest and many banks passed on the cut.
May 2016 rate cut
NOTE: This story refers to the rate cut in May 2013. See how lenders are responding to the May 2016 cut here.
The RBA's movement in interest rates and everyone's curiosity regarding the reasons behind the moves was assuaged, of sorts, by the quarterly Statement on Monetary Policy that was later released. The Statement on Monetary Policy covers the RBA's most recent forecasts as well as its outlook for the economy and rates.
The report showed how the Australian dollar had maintained a significant high over the previous 18 months and, furthermore, how the inflation rate had stayed quite low, which was a surprise considering the strength of the dollar.
The dollar's value seemed to be the main reason the Reserve chose to cut rates and, thanks to the low rate of inflation, it could be done with little worry in terms of maintaining the two to three per cent inflation target the bank has.
The forecasts for the near future show that there is likely little reason for the bank to change its approach of easing bias. In fact, it's quite likely that the bank will further cut rates, especially seeing as business investment in sectors other than the mining industry is still relatively weak. Furthermore, there is worry regarding how quickly investments in resources will drop from their peak and exactly how far they will drop.
The Reserve is also being careful because they are taking into account how government budget cuts will affect household earnings and demand. Additionally, since there is some possibility of further changes to policies throughout the year, this only makes matters even more uncertain.
Despite this, the Reserve is aware of certain risks over the medium term that could require them to quickly put the brakes on and move things in the opposite direction from the current historic low in rates.
One of these risks is that the prices from homes might increase faster than expected, this is a problem for the Reserve for two reasons. Firstly, there are financial risks involved because higher home prices will lead to a higher level of household debt, which would make the economy even more susceptible to an increase in unemployment rates and to any potential global financial shocks.
After all, the higher the level of debt per household, the more vulnerable people will be to losing their jobs. Job loss will affect earnings, making it harder for people to make their repayments. This might lead to an increase in the number of people defaulting on their loans, which will force lenders to foreclose on their properties.
In turn, this will lead to two things. Firstly, interest rates on home loans will increase as lenders try to cover their losses. Secondly, lenders will become stricter when it comes to giving out loans. In other words, credit will become more expensive and harder to get. This will lead to a drop in demand for properties, which will cause a drop in prices. Additionally, if lenders have a large portfolio of foreclosed properties, they will attempt to sell them to recover their funds, which will also drive property prices down.
This is where the vicious cycle begins. Property prices fall, an increasing number of people will have underwater mortgages, which will eventually lead to more people defaulting on their loans. More defaults mean even more expensive credit and a higher rate of foreclosures and we start going round and round.
Many people might think that Australia will be unaffected by another global financial collapse but the fact is that if exports fall, then Australian jobs could be at risk. This is why it is so risky in the medium term for the RBA to cut rates. Lower rates mean cheaper credit, which will lead to a higher demand for property. This increased demand will lead to property prices climbing and people having to take out larger loans to purchase a home and herein lies the problem. The more people owe, the more at risk the economy is.
Another issue is that higher property prices means people will have more cash available. This could be because they sell their property for a profit or because they take out an equity loan. Regardless, the idea is that people will have more money to spend, which is exactly what they will do. Increased expenditure will mean an increase in prices for consumer goods, which will translate into a higher level of inflation. Unfortunately for the RBA, the bank is mandated to maintain the inflation rate below 3% over the economic cycle.
There is also the risk that the dollar stabilising slightly above parity, or its potential drop if these rate cuts lead to a decrease in demand for Australian financial assets, could actually lead to a rise in inflation. This will mean that the RBA will have to increase rates in the future to make it more expensive for people to access financing, which will eventually curb spending somewhat and drive the inflation back down as demand drops.
The problem is that the RBA has continuously found that one of the main reasons inflation has been kept in check and in the bottom half of its two to three per cent target is the fact that the price of imported goods has kept on failing. But once the dollar becomes stable, the effect of the prices of imported goods will no longer be as strong. Even worse, if the dollar's value begins to drop, it could have the exact opposite effect and drive inflation higher.
The Reserve also noted that retail prices for durable consumer items, such as cars, clothing, furniture and electronics, have dropped over the past two years much more than any fall in price owed to currency fluctuations. This is especially true for cars, toys, books, leisure products and electrical items. In other words, prices have dropped far more than can be explained by the decline of the dollar. In fact, the price to import furniture, clothes and footwear actually increased during this timeframe but retail prices still crept down.
The RBA feels that the most likely reason for this is the higher level of competition from both domestic and overseas online stores. They claim that the decrease of retail prices is probably owed to a higher level of retailer efficiency, smaller profit margins and lower rents on retail properties.
The problem is that there is little chance of all of these factors continuing as they are forever, which is why the RBA is expecting for inflation related to 'tradables' to increase either in the medium or long-term.
The bank further states that the inflation on non-tradables, which include a variety of services such as healthcare, education and hospitality, will have to be regulated from the level it is currently at to balance the increase in price of consumer goods. If this doesn't happen, inflation could start a serious climb and might have to be contained.
There also is a risk that the drop in employment participation, which has helped ensure Australia's unemployment rate stays around 5.5%, might be more enduring than the bank currently believes. This could lead to stronger economic growth, thanks to the low interest rate levels, which would mean a lower unemployment rate, higher wages and, higher inflation that it expects because people will have more money to spend.
Despite all of these risks, the RBA adamantly states that inflation is well under control at the moment. In fact, it lowered its inflation forecast for the June quarter to 2.25%, which is lower by 0.75 percentage points from its forecast in February. The underlying inflation forecast was also cut 2.25%.
Furthermore, the RBA stated that they expect the end of the year to show a two per cent headline inflation and 2.25% for the underlying consumer price index, meaning that the RBA is quite confident, seeing as their forecasts are towards the lower end of the two to three per cent inflation range.
Note that in terms of growth, the RBA's forecasts remained practically the same.
Banks fall in line with rba's cuts but ANZ one-ups the competition
After the RBA cut rates, Australia and New Zealand Banking Group decided to issue a challenge to the competition by cutting its standard variable mortgage rate by 2 basis points more than the RBA's cut. This is the first time a major bank has cut rates by more than the RBA since October 2008.
Experts believe that since mortgages are a profitable business for banks, despite the slow growth environment, it makes more sense for banks to reduce their profit margins a bit and grow their mortgage market share faster instead of attempting to compete to an even greater degree in the institutional space.
Thus, ANZ's current variable mortgage rate has dropped to 6.13%, which is equivalent to National Australia Bank and a little below the 6.15% Commonwealth Bank of Australia charges and Westpac's 6.26%.
This means that you can save approximately $60 per month or $750 per year if you take out an ANZ home loan of approximately $280,000.
On the other hand, ANZ's business clients didn't get such a significant decrease, as ANZ cut the rate for small business loans by 25 basis points, in line with RBA's cuts.
Westpac, CBA and NAB cut home loan rates by 25 basis points, after RBA's surprise move that led to a cash rate of 2.75%, which is the lowest it's been in 53 years.
The Greater Building Society, however, cut rates on home loans by 30 basis points but it is a relatively small player on the market. Police Bank reduced variable rates by 20 basis points while Community First Credit Union's reduction in rates was 22 basis points.
The decision ANZ made is not really surprising seeing as the Big Four banks announced record interim cash profits of $13.4 billion, which is more than 7% higher than the same time frame of last year.
Philip Chronican, ANZ Australia's chief executive, explained that the bank's decision was based by the fact that their cost of getting funding from wholesale debt markets dropped by half over the past nine months. He went on to state that despite the fact that competition on attracting deposits is still strong, the overall cost of funding allowed them to drop rates by 0.27% per annum. He also claimed that the decision ANZ made showed how the bank approaches the retail lending side of the business, which includes reviewing rates on a monthly basis.
Despite this cut, ANZ will still see strong competition from NAB, which has been throwing everything it has at growing its market share, which is why it has maintained the lowest rate for almost four years. In fact, many believe that one of the reasons behind ANZ's decision was to dethrone NAB from being the cheapest lender on the mortgage market. However, it shouldn't come as a surprise if NAB makes a move soon to counter ANZ's offer with a better one of their own.
Cameron Clyne, NAB's chief executive, stated that it would be more difficult for banks to keep a portion of the RBA's official interest rate moves from homeowners. Last year, banks were able to grow their profits by holding back some of the cuts the RBA made.
The fact is that if competition on deposits remains 'benign' and wholesale funding markets show moderation, it shouldn't be a surprise for customers to see further cuts in interest rates. In fact, M.r Clyne feels that customers are enjoying lower rates mainly due to cheaper funding.
In the near future, the RBA will likely maintain its policy of keeping interest rates at a record low, which will mean more attractive rates on home loans. However, cheaper credit means that demand for property will increase, which means a higher market value. For homeowners, this is definitely positive but it can negatively impact home buyers. So, if you are considering purchasing property, it may be a good time while rates are low and property prices haven't had a chance to increase as a reaction to the greater level of demand.