RBA may react to tighter financial conditions: Westpac's Bill Evans
GUEST OBSERVER
Markets are on alert for an unexpected near term rate cut from the RBA in response to Westpac’s decision to raise the variable mortgage rate by 20 basis points.
Markets are asking the question as to whether the RBA will move to offset that tightening by cutting rates as early as the next Board meeting on November 3. The market probability for a cut in November has increased from 25% to 40% since the Westpac announcement.
Below we assess the history of the Reserve Bank’s policy in relation to banks’ pricing. We conclude that based purely on history the most likely outcome is that financial conditions are likely to tighten further, although the exact degree of tightening and its timing is uncertain.
We expect that the RBA will await this information on the effective change in financial conditions before making a decision as well as assessing any early signs of the impact of this tightening on the economic outlook.
When this information becomes clearer we will reassess our current view, which, at this stage is for no policy change in 2015 or 2016.
2008
During 2008 the banks were severely impacted by the rise in funding costs as the cost of wholesale funding blew out sharply.
In January 2008 all four majors raised mortgage rates independently of any move by the RBA. First to move was BANK 3 with 12 basis points followed by the others in a 5–7 day window with a range of 10 – 20 basis points.
The RBA tightened by 25 basis points in both February and March with the banks raising rates by 55 – 65 basis points.
Later in March and then again in April and July all banks raised rates independently in tranches of around 10 – 15 basis points and by 26 – 34 basis points overall.
Over that January to July period the banks raised mortgage rates by 101 (BANK 1); 104 (BANK 2); 104 (BANK 3) and 114 (BANK 4) basis points respectively while the RBA raised the cash rate by 50 basis points.
Observations from that period were that all banks moved closely in step and their moves were in the same direction as the RBA’s moves. Arguably because the banks were supporting the RBA’s policy of tightening there was no move by the RBA to offset any of these bank moves.
Later in 2008 when the RBA reacted to the GFC with cuts of 25 basis points (September); 100 basis points (October); 75 basis points (November); and 100 basis points (December) the banks clawed back some of these cuts reducing the mortgage rates by 259 (BANK 1); 271 (BANK 4); 272 (BANK 2) and 287 (BANK 3).
2009
In 2009 the RBA cut by 100 basis points in February which was fully passed on by the banks and 25 basis points in April, where BANK 3 who had cut more aggressively through 2008 passed on nothing and the other 3 banks only passed on 10 basis points.
When rates started to rise, the banks once again supported the RBA’s tightening by raising rates by more than the RBA tightening. From October to December the RBA raised rates by 75 basis points and the banks tightened by 95 (BANK 2); 87 basis points (BANK 1); 85 basis points (BANK 4); and 75 basis points (BANK 3).
2010
In March; April and May the RBA tightened by 75 basis points and the banks raised their mortgage rates accordingly.
With funding conditions still oppressive the banks raised rates in November by 35 (BANK 2); 39 (BANK 4); 43 (BANK 3); and 45 (BANK 1) basis points respectively in response to an RBA rate increase of 25 basis points.
2011
In the early stages of the easing cycle the banks passed on the full 25 basis points in RBA cuts in November and December.
2012
Tight funding was still pressuring the banks and in February 2012 BANK 4 raised their mortgage rates by 6 basis points to be followed three days later by BANK 3 (9); BANK 1 (10); and BANK 2 (10).
In April BANK 4 “caught up” with a further 6 basis points increase.
In May the RBA surprised markets by cutting the cash rate by 50 basis points. BANK 1 (40); BANK 2 (37); BANK 4 (36); and BANK 3 (32), passed on some of the cut.
The net effect between December 2011 and June 2012 was for the mortgage rate to fall by around 25 basis points despite a 50 basis point cut by the RBA.
Following 25 basis point cuts by the RBA in October and December the banks passed on an average of 20 basis points on each occasion.
2013
In 2013 the RBA continued its easing cycle with cuts in May and August with the banks cutting the mortgage rates by 25 basis points on each occasion.
2014
RBA and mortgage rates held steady throughout the year.
2015
RBA eased by 25 basis points in both February and May. Banks passed on an average of 30 basis points in February and 20 basis points in May.
In July one bank raised its rates on investment property loans by 0.27%; the other banks quickly followed although one restricted the move to “interest only” loans (0.29%).
With investment property loans representing around 38% of total mortgages this lift could be equated with a 10 basis point increase in across the board in mortgage rates.
Some Observations
The historical evidence is that the banks have tended to move in similar, although not identical tranches.
Most of these moves have been at the time of an RBA interest rate adjustment although there have been 2 periods – 2008 (H1) and 2012 (H1) when the banks have moved independently of an RBA move.
Overall the banks tightened by a little over 100 basis points in 2008 ( H1) while the RBA tightened by only 50 basis points. However there was no apparent move by the RBA to offset any of that tightening. That was probably because the Reserve Bank favoured tightening policy. As late as June 2008 the Governor noted, “Inflation appears to be in the upper half of the target zone over the next year”. Arguably this could be interpreted as a tightening bias.
The second period of banks moving out of step with the RBA was in 2012 (H1). After easing by 25 basis points in November and December with the banks passing the cut on fully we saw independent increases by the banks in February: BANK 4 (6) and three days later BANK 3 (9); BANK 2 (10) and BANK 1 (10).
In February; March; and April the Bank had an explicit easing bias. Each statement from the Governor included, “Inflation outlook would provide scope for easier monetary policy”. Yet the board did not decide to cut rates until May when it cut by 50 basis points noting “In considering the appropriate size of adjustment to the cash rate at today’s meeting the Board judged it desirable that financial conditions be easier than those that prevailed in December”.
The Banks duly “delivered” 40 (BANK 1); 32 (BANK 3); 36 (BANK 4); and 37 (BANK 2) in mortgage cuts. The net result over 2012 H1 was that the RBA cut by 50 basis points with mortgage rates falling by around a net 25 basis points.
Arguably, without the banks’ independent tightening, a 25 basis point easing would have been delivered by the Bank in May given its clear easing bias.
How do those previous periods compare with today?
Firstly only one bank ( around 12% of total mortgages) has moved (by 20 basis points). History (2008 and 2012) would point to all the majors eventually moving but certainly not by exactly the same amount.
Secondly, in 2008 the RBA’s bias was in the same direction as the banks’ moves so there was no action from the RBA to offset their independent moves.
Thirdly, in 2012 the Bank had an explicit easing bias yet it waited for two meetings to respond to a tightening by the banks. Eventually it moved to not only offset the banks’ moves but provide a net easing of policy, consistent with the bias.
This time the RBA does not have an explicit easing bias. The stance could be described as a “soft” easing bias with various officials’ statements supporting the view that if rates do move further it will be down rather than up although the central position appears to be “rates on hold”. It has been our view that the current policy settings and associated financial conditions are “about right”.
If there was a marked across the board increase in retail interest rates , indicating a sharp tightening in financial conditions, then the Bank may see the need to offset that move.
It will be mindful that a cut in the overnight cash rate is likely to impact a broader spectrum of interest rates including business rates and deposit rates and the AUD. All these factors can be expected to ease financial conditions by more than the tightening represented by the rise in the mortgage rate. However, the Bank will have another degree of uncertainty associated with the degree to which the banks pass on any rate cut. These issues will be weighed by the RBA in making its policy decision.
Were it to occur,the timing of such a decision is unclear. In 2012, despite an explicit easing bias, the Bank waited nearly three months before easing. But on that occasion it moved not only to offset the banks’ tightening but also provide a net easing consistent with the bias. Presumably, this time it would be seeking to return financial conditions to those that prevailed at the time of the October Board meeting.
If, for instance, it opted for November when it will produce its Statement on Monetary Policy and will review its forecasts it would also have to indicate that the tightening of financial conditions prompted a downward revision to its growth forecast in 2016.
At present the Bank is forecasting growth in 2016 of 3.0% (around 0.25 percentage points above its estimated trend growth rate).We expect that it is likely to cut its growth forecast for 2016 to 2.75% before taking into account the impact of a tightening in financial conditions. The implication might be that without an offset to these tighter financial conditions growth was at risk of falling back to a below trend 2.5% in 2016 . An offsetting easing in conditions would allow the growth forecast to be restored to 2.75% – around trend.
Conclusion
History has showed us that banks tend to move close in time, but in differing amounts, when operating out of cycle with the Reserve Bank. This reflects the common nature of the funding and regulatory shocks that drive such decisions. However it is by no means certain that history will necessarily repeat itself.
History also showed us that even when the banks tightened and the Reserve Bank had an explicit easing bias it still took 3 board meetings to decide to offset the effect of the banks’ moves.
Our position is that the case for the type of net easing we saw in 2012 is not strong but the Reserve Bank, which targets retail interest rates, may decide at some point to offset any tightening by the banks to restore retail rates to those prevailing at the time of the October Board meeting when the Bank was comfortable with financial conditions and policy settings.
If we are to predict a near term rate cut on the basis of an unexpected tightening of financial conditions then we need to assess the full extent of that tightening and signs of its impact on the real economy. To date that information is not yet available.
For now, we retain our call for rates to remain on hold in both 2015 and 2016.
Bill Evans is chief economist of Westpac.