DebtWatch No 26 September 2008: Losing control of the margin?

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Late last year on SBS News, when Stan Grant asked me which way the RBA would move rates in 2008, I replied “Up, and then down”, Stan quipped “Spo­ken like a true economist–an even hand­ed answer!”–to which I replied “More down than up”.

I expect­ed the intial rate ris­es because of the RBA’s focus on the rate of infla­tion, and a sub­se­quent fall, not because infla­tion would be head­ing down, but because the econ­o­my would be–and the RBA rate would be forced to fol­low it

That day seems to be immi­nent, with the “sur­prise” 1% fall in retail sales, and the first signs of a taper­ing in cred­it demand as well. The RBA is now no longer focus­ing exclu­sive­ly on infla­tion, but also on an appar­ent­ly stalling econ­o­my. All mar­ket econ­o­mists have now joined with me in expect­ing a rate cut this month–despite infla­tion still being above the RBA’s tar­get range.

Until last mon­th’s sur­prise announce­ment by the Nation­al Bank, it seemed that the only thing that would­n’t be head­ing down was the mort­gage rate. Now, espe­cial­ly after Wiz­ard’s pre-emp­tive cut on Sun­day, it’s fair­ly cer­tain that all lenders will pass on Tues­day’s expect­ed RBA cut. But there are good rea­sons why this is unlike­ly to be the case for sub­se­quent cuts.

The idea that there is some sta­ble rela­tion­ship between the RBA rate and the mort­gage rate is a fur­phy. When the RBA attempt­ed to man­age the econ­o­my by try­ing to con­trol the mon­ey sup­ply, the gap between the aver­age mort­gage rate and the RBA’s overnight rate fluc­tu­at­ed wild­ly between minus 5.5 per­cent and plus 2.5 (see Fig­ure 1).

Figure 1

Margin between average mortgage rate and the RBA Rate

Mar­gin between aver­age mort­gage rate and the RBA Rate

After the RBA aban­doned tar­get­ting the mon­ey sup­ply, and instead adopt­ed a pol­i­cy of try­ing to con­trol short term inter­est rates, a sta­ble rela­tion­ship of sorts did devel­op. The gap set­tled down to about 4 per­cent, once the econ­o­my recov­ered from the 1990s reces­sion.

This was rough­ly equal to the his­tor­i­cal aver­age gap between the rate banks charge for loans and the rate they offered for deposits–and banks, after all, make their mon­ey out of the spread between loan and deposit rates. Inter­est rate tar­get­ting “worked” because it con­trolled the banks’ costs of funds–as is evi­dent from Fig­ure 2, which shows that the 90 day bank bill rate has been very sta­ble rel­a­tive to the RBA rate since 1990 (though even this link is break­ing down now–the mar­gin between bank bill rates and the RBA rate is an indi­ca­tor of how much banks trust each oth­er, and they trust each oth­er rather less now than in the recent past).

Figure 2

Margin between 90 Day Bank Bill and RBA Rate

Mar­gin between 90 Day Bank Bill and RBA Rate

The gap between mort­gage and the RBA rate plunged from 4 per­cent in 1994 to 1.8 per­cent by mid 1997, as com­pe­ti­tion over mar­ket share broke out between banks and the new wave of non-bank secu­ri­tised lenders.

It should now painful­ly obvi­ous to every­one that this was not nec­es­sar­i­ly a good thing.

Those low­er mar­gins were dri­ven pri­mar­i­ly by low­er­ing lend­ing stan­dards, rather than effi­cien­cies, or the much-hyped won­ders of com­pe­ti­tion. It there­fore stands to rea­son that the mar­gin will now rise, as the worst excess­es of sub­prime and “low doc” lend­ing are being dri­ven from the mar­ket by the cred­it crunch.

The mar­gin has already risen to 2.35 per­cent, as banks have increased mort­gage rates above and beyond the RBA’s recent rate ris­es. But even that mar­gin is still a long way short of the 4 per­cent gap that applied before lend­ing stan­dard plum­met­ed with deregulation–and even of the 3 per­cent mar­gin that applied at the time of the Wal­lis Com­mit­tee.

The odds are that this mar­gin will rise back to at least 3 per­cent, and pos­si­bly even 4 per­cent, as the RBA is forced to cut rates as the econ­o­my falls into reces­sion. So the RBA may have to reduce its rate to 2 per­cent to ensure a mort­gage rate of no more than 6 per­cent.

The RBA’s dilem­ma is triv­ial com­pared to its US coun­ter­parts, how­ev­er. US mort­gage rates have risen in the last year, even though the Fed­er­al Reserve has reduced its rate from 5.25 to 2 per­cent (see Fig­ures 3 and 4). The Fed­er­al Reserve has become almost impo­tent with respect to loan rates–and that impo­ten­cy has got more extreme with time.

Figure 3

US Interest rates and the Federal Reserve rate

US Inter­est rates and the Fed­er­al Reserve rate

When the Fed cut its rate from 6.5% in 2001 to 1% in 2004, mort­gage rates fell from 8.5% to 5.5%–so just over half of the rate cut was passed on to mort­gagors. This time round, the Fed has cut its rate from 5.25% to 2%, only to see mort­gage rates bare­ly move–from 6.7% to 6.4%.

Much the same sto­ry applies to cor­po­rate bor­row­ers. Aaa cor­po­rate bond rates now are the same as when the Fed­er­al Reserve rate was 3.5% high­er. The US Fed can do some­thing to restore the prof­itabil­i­ty of finan­cial institutions–by increas­ing the gap between lend­ing and bor­row­ing rates–but it can do pre­cious lit­tle to take the finan­cial pres­sure off US house­hold­ers and cor­po­ra­tions.

The dan­ger for banks of course, is that their long run prof­itabil­i­ty depends not just on the spread between loan and deposit rates, but on bor­row­ers actu­al­ly meet­ing their com­mit­ments. A prof­itable spread means noth­ing if your bor­row­ers are send­ing you jin­gle mail rather than mon­ey.

Figure 4

US interest rates--the last 5 years

US inter­est rates–the last 5 years

It thus appears that one oth­er casu­al­ty of the Cred­it Crunch has been the capac­i­ty of Cen­tral Banks to
manip­u­late the mar­ket inter­est rate. They can still con­trol the short term rates–things like 90 Day Bank Bills here, and the Prime Short Term Busi­ness Rate in the USA (see Fig­ure 5)–that set the banks’ cost of funds. But they have lost their capac­i­ty to influ­ence long term rates, the price that banks charge their lenders. The days of inter­est rate tar­get­ting by Cen­tral Banks may well be over.

Figure 5

US Interest rates minus the Reserve rate

US Inter­est rates minus the Reserve rate

The US Fed­er­al Reserve is start­ing to appre­ci­ate this, as offi­cial rate moves have done bug­ger all to reduce lend­ing costs–in con­trast to Aus­trali­a’s record, where mort­gage rates have until recent­ly close­ly tracked move­ments in offi­cial rates (see Fig­ure 6).

Figure 6


Mortgage rate margins above Central Bank rate, USA and Australia

Mort­gage rate mar­gins above Cen­tral Bank rate, USA and Aus­tralia

But after this mon­th’s com­pli­ance, lenders will start to use some of the future falls in the RBA rate
to restore their mar­gins between loan and deposit rates. Impru­dent lend­ing drove the mar­gin down to unsus­tain­ably low lev­els, and it has to rise in future to make respon­si­ble bank­ing prof­itable once more.

Figure 7


Australian interest rates

Aus­tralian inter­est rates

Figure 8


Margins above RBA rate of mortgages and 90 Day Bank Bills

Mar­gins above RBA rate of mort­gages and 90 Day Bank Bills

Comments on the Data

The turn­around in cred­it growth seems to be under­way. Though the month­ly data is volatile, and sub­ject to revision–last mon­th’s pre­lim­i­nary fig­ures of cred­it growth have been revised upwards, from 5 bil­lion to 22 billion–there is clear evi­dence of a break from decades of debt grow­ing faster than income, to debt grow­ing more slow­ly than income.

Monthly change in private debt (business+household)

Month­ly change in pri­vate debt (business+household)

Though this is nec­es­sary in the long term to wean Aus­tralia off its debt depen­dence, in the medi­um term it will cause a sub­stan­tial slow­down in the economy–and it will push the econ­o­my into a deep reces­sion.

This is because aggre­gate demand is the sum of income plus change in debt. For the last decade, the lat­ter fac­tor has been adding to demand–and aggre­gate sup­ply, asset prices, and our import bill have adjust­ed upwards to suit. But as the change in debt drops and ulti­mate­ly turns neg­a­tive, it will sub­tract from demand–and sup­ply (read employ­ment), asset prices and imports will fol­low it down.

Contribution that the annual change in debt makes to aggregate demand

Con­tri­bu­tion that the annu­al change in debt makes to aggre­gate demand

It seems prob­a­ble that the Debt to GDP ratio will peak at about 166% of GDP. If Aus­tralians decid­ed to reduce their debt to income ratio by 10% each year–to get back to the 25% lev­el that applied back in the 1960s (before this long-term spec­u­la­tive bub­ble took off)–it would take rough­ly 15 years to get there.

Australias 45 year long debt bubble seems to be reaching a peak of 167% of GDP

Aus­trali­a’s 45 year long debt bub­ble seems to be reach­ing a peak of 167% of GDP

Australias Debt to GDP ratio--the long term view

Aus­trali­a’s Debt to GDP ratio–the long term view

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About Steve Keen

I am Professor of Economics and Head of Economics, History and Politics at Kingston University London, and a long time critic of conventional economic thought. As well as attacking mainstream thought in Debunking Economics, I am also developing an alternative dynamic approach to economic modelling. The key issue I am tackling here is the prospect for a debt-deflation on the back of the enormous private debts accumulated globally, and our very low rate of inflation.