RBA highlights pressure on bank funding

RBA Board minutes

• At the last Reserve Bank board meeting members took some time to consider bank funding costs. Members explicitly stated that there was a possibility that banks would increase interest rates on loans by more than the cash rate due to funding cost pressures.
• “Members noted that lending rates might increase by more than the cash rate, but this tendency would not be lessened by delaying a change in the cash rate. Lending rates had been rising relative to the cash rate since the global financial crisis, and the Board had taken this into account in setting the cash rate.”
• The decision to lift interest rates in November was clearly touch and go. Consumer spending was soft, housing had turned down, business conditions were mixed and inflation was under control. But the Reserve Bank judged that economic conditions were more likely to improve with inflation trending higher, justifying a pre-emptive rate hike.
• The Reserve Bank has explicitly noted that the higher rates by banks will be taken into account in future rate decisions, suggesting that rates are now on hold until February 2011.

What does it all mean?

• The latest Reserve Bank board minutes reveal that the decision to lift interest rates was certainly not taken lightly. Rather the result was finely balanced given the soft near term conditions in consumer spending, business investment and housing activity. Most of the discussion in the latest board minutes has unsurprisingly portrayed a similar view to the Statement on Monetary Policy, which was released a few days after the last board meeting, however the dialogue on banking funding costs was certainly revealing.
• Board members discussed the pressure on bank funding costs, highlighting that there was a case for banks to lift interest rates on mortgages by more than the cash rate. And interestingly board members came to the conclusion that had interest rates remained on hold it was unlikely to alter the fact that funding pressures remained an ongoing issue for the banks.
• Federal politicians would do well to read the Reserve Bank comments on bank funding costs. The Reserve Bank explicitly states that there was a case for banks to lift rates by more than the cash rate. The Treasurer must now explain whether the Government fundamentally disagrees with the Reserve Bank.
• The minutes suggest that board members were if anything a touch optimistic about the global recovery that was taking place. And more encouragingly the central bank had become more comfortable with the Chinese growth story. Members noted that downside risks to China were diminishing and a further degree of uncertainty had been removed from the global economy. The robust growth in the Asian region strength in commodity prices, will continue to boost Australia’s term of trade and in turn strength growth and activity in the mid-term – essentially highlighting the reason why the Reserve Bank decided to raise interest rate in a pre-emptive strike against future inflation.
• On the domestic front Board members were conscious that the domestic economy was already responding to the previous interest rate hikes. There were clear signs that the demand in the housing market was showing signs of easing, with house prices tracking sideways. CommSec expects further consolidation in the housing sector given the sharp slide in housing finance over the past year and the expected increase in the supply of new homes in coming months.
• In terms of the Australian dollar the central bank is well aware that the Australian dollar is effectively acting as a quasi rate hike – curbing exports receipts, while slowing manufacturing activity and having a detrimental impact Economic Insights RBA highlights pressure on bank funding on the tourism sector. Encouragingly the strength of the Aussie will support the Reserve Bank’s efforts in keeping
  inflation low.
• Looking forward the limited spare capacity in the labour market, and the resulting growth in wages will be central to the trajectory of rate hikes over the coming year – especially given that the domestic recovery is only in its infancy. In recent times wage growth had remained solid and while it has not had a major impact on the inflationary front it is likely to be an area that the Reserve Bank monitors closely over the coming year. CommSec would expect labour shortages are likely to become more prominent over the coming year.
• All in all the latest minutes highlights that the latest rate hike has provided the Reserve Bank a degree of flexibility on the interest rate front. And while the near term domestic data looks patchy the Reserve Bank remains confident about the outlook.
• Looking forward, CommSec believes that a pause at the next board meeting would be the best outcome. And the latest minutes suggest the Reserve Bank is comfortable with the current interest rate settings. It is clear that the Reserve Bank is unlikely to move on interest rates until more robust economic data is available.

What do the figures show?

Minutes from the November 2010 Reserve Bank Board meeting

Consumer spending & housing

• While liaison and recent data on retail trade provided a picture of varied conditions across the different segments of the retail market, they mostly suggested that consumers were still cautious in their spending and that discounting was extensive.
• In the housing market, conditions had softened relative to earlier in the year, with national housing prices broadly flat over recent months. Auction clearance rates remained around long-run average levels. Loan approvals had drifted down over the course of the year and growth in housing credit had been moderate over recent months. Other forms of household credit had been flat recently and liaison with retailers had noted a pick-up in cash payments relative to credit cards.

Mixed business conditions

• Business conditions remained generally favourable, although there were clear differences across sectors and regions. Indicators of investment intentions were mostly positive, particularly for the resources sector, where the pipeline of work to be done was large.

Bank funding costs

• Domestically, the most recent data showed a continuation of the trends in bank funding that had been apparent for some time. The shares of relatively high cost funds, such as domestic deposits and long-term debt, had continued to rise, while the share of short-term debt had continued to fall. Members were briefed on developments in funding costs. Most banks had reported a small reduction in net interest margins in their most recent half-yearly accounts, though some had experienced an increase. Deposit competition appeared to have levelled off in recent months. In debt markets, spreads on short-term bank bills had narrowed to be not far above pre-crisis levels. Spreads on longer-term bank debt had stabilised at levels that were significantly higher than before the crisis. This was slowly adding to the banks’ cost of funds as banks rolled over debt issued earlier at lower spreads. Members noted that there was a possibility that banks would increase interest rates on loans by more than any move in the cash rate.

Domestic Economy & inflation

• Overall, members considered that developments in terms of activity and inflation were broadly consistent with the central scenario the Bank had envisaged for some months. The outlook for growth in the resources sector was very strong and GDP growth was expected to rise gradually. While inflation had moderated, it was likely that the decline was now largely complete; inflation was expected to remain around the current level for several quarters, but was likely to move higher thereafter.

Finely balanced decision

• As in October, a case could be made for waiting a little longer: the expected pick-up in domestic growth would be only in its early stages; the latest CPI outcome had been relatively good; and credit growth and housing prices were subdued. In addition, the exchange rate had appreciated over the past month, and quite significantly over a longer period, which would dampen inflation pressures somewhat. There might also be a case for waiting to see if the Federal Reserve’s upcoming announcement had a significant further effect on the exchange rate.
• On the other hand, some of the uncertainties that had been a reason to keep interest rates steady over the past few months had lessened recently, even though they had not dissipated completely. Compared with several months ago, downside risks to the global economy had still not materialised in any significant way. Indeed, the uncertainty regarding the outlook for the Chinese economy had lessened, commodity markets had strengthened and the outlook for investment had firmed. With only a relatively modest amount of spare capacity in the economy, a gradual upward trend in inflation remained likely over the medium term. If monetary policy was to be conducted in a forward-looking way, these developments meant there was a case for increasing interest rates at the current meeting.

The decision

• Members considered that the arguments were finely balanced. However, with the flow of information over the past month generally suggesting that the medium-term economic outlook remained one of strengthening economic activity and gradually rising inflation, the Board judged that the balance of risks had shifted to the point where a modest tightening of monetary policy was prudent. Members noted that lending rates might increase by more than the cash rate, but this tendency would not be lessened by delaying a change in the cash rate. Lending rates had been rising relative to the cash rate since the global financial crisis, and the Board had taken this into account in setting the cash rate. It would continue to take account of any changes in margins in its decisions in the period ahead.

What is the importance of the economic data?

• The Reserve Bank releases minutes of its monthly Board meeting a fortnight after the event. The minutes give a guide to Reserve Bank thinking on interest rate settings.

What are the implications for interest rates and investors?

• Board members are cautiously optimistic on the recovery in the global economy, highlighting that downside risks are diminishing. However the recent interest rate hike is likely to result in a softer domestic economy in the near term. The latest rate hike has given the central bank a degree of flexibility in future interest rate decisions and as such CommSec expects interest rates to remain on hold well into the New Year.