This week’s Australian consumer price inflation figures revealed a 0.4% increase for the March quarter, and 1.9% for the last 12 months. The March quarter figure was below market expectations of 0.5%, and also the previous (December quarter) figure of 0.6%. Education prices were up 2.6% on the quarter, and health prices up 2.2% (or 4.2% for the year to March 2018).
This puts inflation still below the Reserve Bank of Australia’s (RBA) target band of 2-3%. That band, of course, has been in place since the early 1990s – beginning with this speech by then governor Bernie Fraser.
Numerous central banks around the world have a similar approach. The basic idea is that a central bank can build a reputation over time to commit to monetary policy such that inflation lies in the band.
Now there are pros and cons to this approach to monetary policy, and it has its critics. But that is another tale for another day.
Just assuming that inflation targeting is the correct objective, how is the RBA doing? Well, one small hitch in the plan is that inflation has been outside the band for a long time now (basically since 2014), as the RBA’s own figures show.
Given the level of unemployment in Australia, low wages growth, and stubbornly low inflation, the RBA probably should have cut rates further a fair while back. But they seem, probably rightly, terrified of further fuelling a potential housing bubble.
Meanwhile, the credibility of their commitment to the inflation target withers. If only the regulation of our banking and finance sector had been better for the last, say, decade or two.
Speaking of such regulation, RBA assistant governor Chris Kent gave a speech Tuesday about the important issue of interest-only loans. Kent’s speech was significant because it followed up on remarks in the RBA minutes about the same issue that I discussed in this column last week.
It seems that the RBA “house view” on interest only loans is as follows. There could be a problem but the Australian Prudential Regulation Authority (APRA) stepped in and the banks have voluntarily tightened lending standards recently. Also because the average household with an interest only loan has a buffer of savings, everything will be fine. Nothing to see here.
I hope the RBA’s conclusion is right, but I know for sure that the reasoning is not. It’s actually the marginal household’s financial position and behaviour that matters, not the average household.
The average United States borrower with an adjustable-rate mortgage did not default in 2007, 2008 or 2009. But these mortgages were a huge contributor to the financial crisis, along with subprime mortgages.
Kent dutifully laid out the risks from interest only loans, saying:
Because there’s no need to pay down principal initially, the required payments are lower during the interest-only period. But when that ends, there is a significant step-up in required payments (unless the interest-only loans are rolled over).
Indeed, unless they can be rolled over. Which they can’t now because of APRA and the banks finally doing something.
Now, prices (interest rates) on interest only loans have gone up as part of the bank response. This has led a bunch of folks to shift to amortising loans, where the principal of the loan is paid down over the life of the loan. So those borrowers who haven’t shifted to these loans already, really don’t want to.
Maybe they can’t afford to because of the increased repayments, that can jump 30% or more per month.
So what does happen? First Kent says many borrowers save ahead of time, expecting a rise in repayments. Yes, the prudent ones.
But how many non-prudent borrowers have their been in the Australian property market in recent years? Hint: a lot.
Kent also points to borrowers who seek to refinance their interest only loan. But banks don’t really want to, and APRA doesn’t want to let them. And who is going to be able to? The safer borrowers who did save and so don’t really need to avoid amortisation. The risky borrowers can’t refinance.
Kent says some borrowers will have to cut their spending. Chuckle, chuckle. And the final option is to sell their house.
Sure, no problem, unless lots of folks want to do that all at once. Then it’s a fire sale that detonates the housing market.
I really do hope we escape the interest only debacle unscathed. But if we do it will be pure, dumb luck, not a consequence of good design or sound regulation.
It definitely doesn’t justify the RBA’s house view in Kent’s concluding remarks that:
The substantial transition away from interest-only loans over the past year has been relatively smooth overall, and is likely to remain so. Nevertheless, it is something that we will continue to monitor closely.
Perhaps a there should have been a little more monitoring before interest only loans got to be 40% of all loans and more than half of the loan book of one of our biggest banks.
Author: Richard Holden, Professor of Economics and PLuS Alliance Fellow, UNSW
Last February and March – yes just 1 year ago – the heads of two of our top financial regulators (APRA & ASIC) described our housing market as a bubble! And Phil Lowe still recounts other central bankers telling him we were crazy for allowing 40+% of mortgages to be on interest only terms. Truley extraordinary stuff from typically understated and staid senior public servants!
So here we are one year later supposed to be believe that all is fine and been dealt with!
I would suggest that is akin to being asked to believe that with a blizzard hitting you 100 ft from the summit of Everest you will be safe if you stop climbing (I am picturing Preston Blake having reached the peak in Adam Sandler’s “Mr Deeds”.)
Nope. That doesn’t pass the laugh test.
Now for a real life example of how lending conditions have changed quickly. I have a mortgage split between 2 fixed loans (both 5 yr terms). In January I refixed (ahead of schedule) one of the loans and it took 1 day. With BBSW increasing, and the risk of interest rates increasing, I thought it was opportune to refix the other one – that was 10 business days ago and it is still not done! (I have called a few times – first was told now taking 8 bus days, then 9, then 10). My lender is not one of the Big 4 but is a large mainstram lender, and by chance it has the market leading rate for 5 year terms (which may be generating extra business) but the drop did not occur until 3 days post submitting our application (so should not have affected our processing times much).
Finally, I have mentioned here and on Rogermontgomery.com the deteriorating business conditions here in middle-inner Brisbane (which marries well with Martin’s work). I believe that the secondary effects are now becoming visible (eg patronage at my regular Friday lunch – with a margharita! – inside my local Westfield has clearly dropped off very substantially and my guess is it is due to retail workers become fearful for their jobs).
The regulators may be fearful that they might be seen to have pricked the bubble, and it will be interesting to see how the media writes the history of the RC when all is said and done, but the politicians and financial services industry have carried us onwards and upwards, and we have no options left – we are very exposed and this time the blizzard is of our own making!
On reflection, that last phrase should read “this time the blizzard is patently of our own making!”
Last time we formed a good blizzard of our own, but a super cell came in from the east and not only disguised it but provided cover for a rescue operation that sheltered us and took us a little down the mountain. Anyone wishing to understand the metaphor should go looking through Glenn Stevens’ speeches from around 2011/12 (and the Q&A sessions) where he was saying things like (and I’m paraphrasing) “Australians don’t presently have an appetite to increase leverage and that’s not a bad thing since international creditors tend to be happy to provide credit until all of sudden they are not”, and think about that in relation to where we are now…
It will be interesting when the helicopter approaches the flagpole at the summit, once the blizzard has cleared, to see whose fingers are frozen wrapped around it – Howard/Costello (first home owners grant, CGT reduction, leverage within super), Rudd (first home owners boost and other measures aimed at bailing out banks during GFC – eg. committed liquidity facility which remains in place even though the amount of Government bonds on offer is now around 3x during the GFC), or Abbott/Turnbull/Hockey/Morrison (isn’t it strange how people have certain views on housing policy which metamorphose once assuming or relinquishing an opportunity to actually do something about it eg. negative gearing!)… Or perhaps it will be Glenn with palm card reading another joke about why Macroprudential would prove ineffective….