RBA – Page 75 – Digital Finance Analytics (DFA) Blog

RBA On China

RBA’s Christopher Kent Assistant Governor (Economic) has been talking about China, and some of the implications for Australia. Commodity prices will remain under pressure, but the potential demand for services offers new export opportunities.

The easing in the growth of the Chinese economy over the past year or so has two related parts. The economy is slowing as it matures, and this is to be expected. Overlaying that, there has been a substantial slowing in the industrial sector, linked in part to earlier excesses in construction. How all of this will play out and the effects on the Australian economy are uncertain. I’ll briefly highlight some possibilities. Let me be clear though, many of these have positive implications for our economy.

It is natural for the speed of China’s economic development to ease and for its nature to evolve:

Part of this reflects slower growth of the working-age population, which is now in decline. Other than increasing the retirement age, there is little that can be done to alter that in the coming years, notwithstanding the ending of the one-child policy.

However, growth continues to be supported by the process of urbanisation, which uses commodities intensively. This has further to run, albeit at a more gradual pace.

Productivity growth appears to be slowing as windfall gains from earlier reforms have waned. But there remains a large gap between productivity in China and in advanced economies. That gap could be closed more quickly via additional reforms to allow a greater role for market forces in allocating productive resources. The authorities have expressed support for such reforms.

The authorities would also like to see growth rebalancing from investment towards consumption. That is happening gradually. It is also being accompanied by a rise in the share of activity accounted for by the services sector as the economy develops and household incomes rise.

While these longer-run changes imply a decline in the growth rates of investment and industrial production, both have also experienced a noticeable cyclical slowing over the past year or more. As earlier excesses in residential construction gave rise to a large stock of unsold housing, house prices declined and so too did housing construction. Sales and prices have recovered a bit since the start of this year, but there is little sign to date of a sustained improvement in construction activity.

Weakness in construction has been accompanied by declines in output of a range of manufactured products over the past year. Steel is one obvious example. Mining activity in China has also been affected. Indeed, a further decline in the output of unprofitable Chinese mines would provide some support to commodity prices, and would benefit other producers, including in Australia.

Although the weakness in China’s property and manufacturing sectors is clearly of concern to commodity exporters like Australia, there are a number of countervailing forces supporting broader activity in China.

First, growth in the services sector has been resilient, and should continue to be assisted by a shift in demand toward services as incomes rise.

Second, growth in household consumption has also been stable in recent quarters aided by the growth of new jobs. Of course, such outcomes cannot be taken for granted; if the industrial weakness is sustained, it might eventually affect household incomes and spending.

Third, Chinese policymakers have responded to lower growth by easing monetary policy and approving additional infrastructure investment projects. They have scope to provide further support if needed, although they may be reticent to do too much if that compromises longer-term goals, such as placing the financial system on a more sustainable footing.

There are two key implications of the slowing in China’s growth for Australia.

First, the substantial slowing in industrial production has contributed to a further decline in commodity prices over the course of this year. (This is in addition to the contribution from the substantial increase in the supply of commodities, including from Australia.) We’ve detailed the effect of the decline in commodity prices on Australia’s economy elsewhere. I would just add that commodity prices remain relatively high. The Bank’s index of commodity prices has fallen by about 50 per cent from its peak, but is still almost 80 per cent above early 2000 levels. Clearly, conditions in the industrial sector in China, and Asia more broadly, will have an important influence on the path of commodity prices over the near term. Beyond that, the changing nature of China’s development implies that the potential for commodity prices to rise from here is somewhat limited.

Second, the shift in demand towards services and agricultural products within China and the Asian region more broadly presents new opportunities for Australian exporters. While our comparative advantages in service industries are perhaps less obvious than they are for mineral resources, the rise in the demand for services from a large and increasingly wealthier populace in our region will no doubt be to our benefit.

Central banks can deliver on a ‘divine coincidence’ – but…

… Glenn Stevens is a not a miracle worker. From The Conversation.

Inflation-targeting central banks usually benefit from what some economists have labelled a “divine coincidence”.

This is when the best policy response to inflation also turns out to be the best response to unemployment. A central bank should raise its policy rate when inflation is high and the unemployment rate is low — and vice versa. All else equal, the effect of such a policy response is that inflation and unemployment will return to their long-run levels.

An absence of a trade-off in achieving an inflation target and stabilising unemployment makes the lives of central bankers relatively easy — most of the time. But, alas, this divine coincidence doesn’t always hold.

The stagflating ‘70s

In the 1970s, central bankers faced a dilemma due to massive spikes in oil prices that resulted in less-than-divine sounding “stagflation” – that is, simultaneously high inflation and unemployment. If central banks pushed interest rates high enough to put a lid on inflation, they would increase unemployment further. But if they tried to hold interest rates down, they risked inflation spiralling out of control.

Most economists believe that central banks were too timid in the 1970s and inflation targeting was developed in the late 1980s and early 1990s as a way to make sure central bankers would keep their eye on the inflation ball whenever the divine coincidence failed again.

A surprising downside to the divine coincidence

The divine coincidence hasn’t really failed since the 1970s. For example, the recent global financial crisis led to lower inflation and higher unemployment in most countries. In this case, central bankers faced no dilemma in pushing interest rates downwards. Their only dilemma was what to do after their policy rates hit the zero lower bound.

But there is a surprising downside to the divine coincidence holding over the past quarter century. It seems to have lulled most everyone into thinking central bankers are miracle workers who can hit two targets with one arrow.

Worse yet, if central bankers can hit two targets, why not ask for more? Shouldn’t they also keep house prices under control? Stock prices? The exchange rate? Bank lending rates?

This idea of targeting bank lending rates has received much attention over the past few weeks in Australia, where the major banks have raised their mortgage rates, supposedly to cover increased costs related to changing capital requirements from Basel III.

Following this increase in bank lending rates, there were public calls for the Reserve Bank of Australia (RBA) to cut its policy rate to help bring mortgage rates back down. The RBA wisely chose not to listen.

But it is notable how easily the (implicit) idea that the RBA should target mortgage rate spreads could become such a focus of the public discussion surrounding monetary policy.

What’s the problem?

Public officials should want to cool an overheating housing market. They should want to minimise anti-competitive practices in the banking industry. And surely they should want a low and stable rate of inflation.

But they just can’t use one instrument – that is, the policy rate — to achieve all of these wonderful outcomes at the same time.

In the absence of more widespread divine coincidences, different desired outcomes will always require different policy instruments. And most practical tools to achieve outcomes other than just low and stable inflation have big distributional consequences.

For example, if policymakers really want to prevent an overheated housing market, they need to design tax and planning policies that influence demand and supply of housing. These have very different effects on homeowners and renters and are clearly more the domain of governments (national and local), rather than a central bank.

Likewise, if policymakers really want to make the banking system more competitive, they should do so via the regulatory environment. To be sure, any policy changes along these lines ought to involve consultation with the central bank given that there is a likely trade-off between a more competitive banking system and greater systemic risks, at least if the recent experience of the global financial crisis is any indication.

But the point is that such policy should not be conducted by a central bank alone. And it definitely shouldn’t be done by adjustments to the policy rate. This would be a misguided “duct tape” solution to a more serious architectural flaw.

Who is steering the ship?

Inflation targeting central bankers need to focus on their main objective of stabilising inflation and not be sidetracked into trying to correct all other macroeconomic and financial problems. They are not miracle workers — although they have generally delivered on their inflation targets.

To the extent the divine coincidence has held, inflation targeting central bankers have been lucky enough to also help stabilise unemployment. But they should not be expected to offset the effects of an uncompetitive banking system — or ill-conceived fiscal policy, for that matter. Their objective of low and stable inflation should always guide their decisions, not a response to the decisions of others with different objectives.

We should expect central banks to be focused on the inflation horizon, not to be divine.

Author: James Morley, Professor of Economics and Associate Dean (Research), UNSW Australia

Domestic Risks To Banking

Malcolm Edey, Assistant Governor, RBA has been speaking about The Risk Environment and the Property Sector. His comments on the domestic scene are important, because he highlights not only risks in the hosing property sector, but also in the commercial sector, where a lot could also go wrong.

Our analysis has for some time focused on the buoyancy in parts of the property market and the leverage associated with that. Much of the focus has been on residential property, and I will start with that before turning to the commercial sector, where risks have also been growing. While the housing market has not been universally strong around the country, we have been seeing significant strength in the Sydney and Melbourne markets in recent times, with investors playing a large role. To summarise a few key facts:

Housing prices in Sydney have increased by 31 per cent over the past two years, and reached an annual rate of increase of almost 20 per cent earlier this year.

Melbourne prices were up by 16 per cent over the year to September this year.

The value of loan approvals to investors in New South Wales approximately doubled over the two years to mid-2015.

As a result of these developments, the household debt ratio has started to edge up again from a level that was already high, at around 1½ times annual income (Graph 3).

Graph 3

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It is against this background that the Reserve Bank has highlighted the need for prudence, and has supported APRA and ASIC in the measures that they have taken to strengthen lending standards.

As a general proposition, mortgage lending standards in the post-crisis period have been relatively tight, at least more so than before the crisis. Low-doc loans are rare, genuine savings are required to fund at least part of the deposit, and the application of interest rate buffers in serviceability assessments has become common. Nonetheless, investigations by APRA and ASIC have shown that there was some slipping in lending standards and that they were inadequate in some important respects to the current risk environment. Specifically, APRA found that, in some instances, lenders’ serviceability assessments were based on over-optimistic judgments about the reliability of borrowers’ incomes, or inadequate estimates of borrowers’ living expenses, or that they failed to take into account the possible effect of future interest rate movements on a borrower’s existing commitments. ASIC’s review of interest-only lending practices made similar findings, and also noted instances where the lender did not make reasonable inquiries as to whether the loan product was suitable to the borrowers’ circumstances.

Further to those findings, as a result of the additional scrutiny over the past year and substantial data revisions made by the banks, we now know that the level of investor activity in the housing market was in fact higher than previously thought.

As you know, APRA announced a number of supervisory measures in December last year to strengthen mortgage lending standards. These measures included expectations that:

banks should not be increasing their share of higher risk lending

growth in investor lending should not be materially above 10 per cent

appropriate interest rate floors and buffers should be applied in serviceability assessments.

It will take time for the full impact of these measures, and of the more recently announced increases in bank lending rates, to become apparent. Nonetheless, the indications to date are that the supervisory measures are having a beneficial effect on lending standards and are assisting in restraining new investor finance. There is also some tentative evidence that sentiment may now be turning in the housing markets in the two largest cities. But it is much too early to be definitive about that. What we can say is that the risks in that sector are now being more prudently managed than they were a year or so ago.

The second main area of risk focus domestically is in commercial property. Historically this has been a common source of financial instability both here and abroad. During the height of the GFC, Australian banks remained in comparatively good shape but they did suffer a noticeable deterioration in asset performance, with the aggregate non-performance rate rising to just under 2 per cent of loans. A significant part of that deterioration was in commercial property lending; impaired commercial property exposures accounted for around 30 per cent of Australian banks’ non-performing domestic assets at that time.

After the post-crisis downturn, the commercial property sector is again experiencing strong investor demand, and bank lending to the sector is increasing. However there are a number of signs of increasing risk. Trends in commercial property prices and rents have been diverging over the past few years, with prices continuing to rise while rents have been flat to down (Graph 4). As a result, yields have declined. At the same time, vacancy rates have been increasing.

Graph 4

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As in the housing market, conditions have not been uniform across the country, and they have been noticeably firmer in Sydney and Melbourne than in other centres. But in aggregate, the major categories of commercial property have all seen downward pressure on yields over recent years. Strong demand from foreign buyers has contributed to this, reflecting the global environment of low interest rates and ‘search for yield’ (Graph 5). The risks appear manageable at this stage, but they underscore the need for sound lending practices and for appropriate prudence by investors.

Graph 5

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RBA Statement on Monetary Policy – Do Words and Figures Differ?

In the latest statement, the bank says the outlook will be for low household income growth, slowing business investment, and lower productivity. Yet, GDP, inflation and employment should all improve. If not a disconnect, there is at least significant uncertainty. We think recent trends point more to the downside.

Central banks’ policies
For some time there has been uncertainty around the path for monetary policy in major economies and their net effect on financial markets, particularly exchange rates. Many observers expect the European Central Bank and the Bank of Japan to announce further steps to make their monetary policy more accommodative and there is considerable uncertainty about when the US Federal Reserve will start to normalise its policy rates. Many Federal Open Markets Committee members have indicated that they believe it will be appropriate to raise rates this year, but other members have expressed somewhat different views, and financial markets have not fully priced in a rate rise until the first quarter of 2016. Although it is hard to say how financial markets will react when policy normalisation begins in the United States, it is likely that the Australian dollar could depreciate.

Business investment
Total business investment is expected to fall over the next two years as mining investment continues to decline sharply and non-mining investment is forecast to recover only gradually and with some delay. Given the size of the falls in mining investment already factored into the forecasts, the most recent decline in commodity prices is not expected to lead to a significant additional fall in mining investment. However, there continues to be uncertainty around the size of the fall and the impact of the declines in commodity prices. The strength and timing of the recovery in non-mining business investment remains uncertain. Indicators of investment intentions provide little, if any, evidence of a material pick-up in the near term. Indeed, the ABS capital expenditure survey implies that non-mining investment could be lower than forecast in 2015/16. However, some of the preconditions for a stronger recovery in non-mining business investment are in place: borrowing rates for businesses are currently low and have tended to fall; survey measures of business conditions are at an above-average level; and the Australian dollar has depreciated significantly over the past couple of years. Indeed, demand for domestically produced services is expected to continue to pick up and could accelerate should the Australian dollar depreciate further. The services sector, however, is generally relatively labour-intensive. Hence, the additional capital expenditure required to meet a given increase in demand is likely to be less than if other, more capital-intensive, sectors were to play a larger role in the recovery. Nonetheless, given the significant uncertainty around the expected pick-up in non-mining business investment growth, the risks to these forecasts are assessed to be roughly balanced.

Household sector
There is still considerable uncertainty about the resilience of consumption to a period of below average income growth. Consumption is forecast to grow at a rate that is slightly above average from 2016, consistent with a further gradual decline in the household saving ratio. Whether this materialises will depend, in part, on the extent to which households perceive the low income growth to be temporary. This would be consistent with households judging the low wage growth of late to be associated with the rebalancing of the economy in response to the unwinding of the terms of trade and mining investment boom. If, however, households come to view lower income growth as being more persistent, consumption growth could be somewhat lower, and the saving ratio higher, than forecast. The extent of the pick-up in consumption growth will also depend on the strength of housing price growth and its associated wealth effects. Supply constraints, particularly in Sydney, may limit the extent to which new dwelling investment can satisfy growing demand. This raises the possibility that housing prices grow more quickly than forecast. At the same time, some market segments, particularly apartments in the inner-city areas of Melbourne and Brisbane, appear to be reaching a point of oversupply. It is also unclear how households will respond to changes in housing prices. In recent years, fewer households appear to have been using the increase in the value of their dwellings to trade up or increase their leverage for the purposes of consumption or alterations and additions to housing, which may have muted the effect of wealth increases on consumption.

Spare capacity in the economy
The elevated rate of unemployment, together with the low growth in wages and broader domestic cost pressures, suggests that the economy is currently operating with spare capacity. However, there remains considerable uncertainty about the degree of spare capacity in the economy and how it is likely to evolve over time. Recent changes in the sectoral composition of activity are one source of uncertainty around the productive capacity of the economy and the degree of spare capacity. The change in the sectoral composition of employment has involved a shift away from mining-related jobs that have very high output per hour worked (high labour productivity), towards jobs in the services sector that tend to have lower measured output per hour worked. This switch to activity in the services sector may reduce the economy’s measured potential output growth, unless it is offset by productivity improvements within industries. Compositional change could also produce a mismatch between jobs and the skills of available workers, reducing the effective amount of spare capacity in the labour market. However, there is little evidence of this to date. In particular, the relationship between the unemployment and job vacancy rates does not appear to have shifted from its historical pattern.

In the economic outlook, though, GDP is expected to pickup in 2016/2017, and inflation to rise, later. However, underlying inflation is expect to sit between 1.5 and 2.5% in June 2016, suggesting cuts to the cash rate are on the cards.

The unemployment rate may fall a little, later. Wage growth expectations are falling.

With regards to housing, the RBA says:

that the low level of interest rates is expected to continue to support housing market activity. Forward-looking indicators of housing activity, though somewhat mixed, generally point to further growth in dwelling investment, albeit at a moderating rate. Auction clearance rates and housing price growth in Sydney and Melbourne have declined over recent months.

Lending standards have been tightened in response to changes in APRA’s supervisory measures and, more recently, many lenders have announced increases in mortgage rates for both investors and owner occupiers. Housing credit growth has increased a little over recent months, with growth in lending to investors easing slightly while that for owner occupiers appears to be picking up. Supervisory measures are helping to contain risks that may arise from the housing market.

Over 2015, a number of financial institutions have made substantial revisions to the data that the RBA uses to compile housing, business and personal credit. While small revisions to historical data are not unusual, recent revisions have been large, especially in terms of the classification of investor and owner occupier housing credit. Overall, the share of housing credit extended to investors has been revised from 35 per cent of the total to 40 per cent. As the borrowers updating their personal details and by lenders reviewing the owner-occupier status of loans. This is boosting the level of owner-occupier housing credit and lowering investor credit. The net value of loan purpose switching is estimated to be $13.3 billion over the September quarter. The effect of loan purpose switching has been removed from the RBA’s measures of owner-occupier and investor credit growth so that these measures better reflect growth in net new lending. Putting the measurement issues aside, the differential pricing appears to be contributing to a pick-up in owner occupier credit growth, while investor credit growth has eased.

Mortgage Data Quality Issues Hit Home

Given the recent changes in the mortgage data set between owner occupied and investor loans, some would suggest the regulators have been flying blind. I discussed this with Ross Greenwood on 2GB tonight. Whilst that may be an overstatement, the reasons for the recent changes are beginning to become clearer. In a speech today RBA Deputy Governor Philip Lowe addressed this head on. More importantly, he highlights that the apparently dramatic switch away from investment loans may be overstated.

The basis of good analysis is good data. Improvements over time in the quality and comprehensiveness of the data on housing prices have, for example, helped improve the general understanding of housing market developments. In contrast, unfortunately, recent problems with the data relating to banks’ owner-occupier and investor housing loans have worked in the other direction, complicating our understanding of what is going on in the housing market.

These data problems have emerged as lenders have taken a closer look at their housing loans following increased supervisory scrutiny. As lenders have looked more closely, what they have found has surprised and, to some extent, concerned us.

There are two issues that are worth drawing your attention to.

The first is that over the past six months there have been very large upward revisions to the value of investor loans outstanding, with offsetting downward revisions to owner-occupier loans. Material revisions have been made by more than 10 institutions, including two of the largest lenders. The scale of these revisions can be seen in Graph 1, which shows the stock of investor credit outstanding as reported in each of May, June and September this year. The cumulative effect of the upward revisions has been to increase the stock of investor credit outstanding by around $50 billion, or 10 per cent. According to these new data, investor loans now account for 40 per cent of total housing loans outstanding, not the 35 per cent reported earlier in the year.

Graph 1

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While the reasons for some of these earlier errors have been identified, in other cases the reasons are unclear and lenders have not been able to provide comprehensive back data. As a result, when calculating growth rates for investor and owner-occupier credit, the RBA has had to make adjustments for what are effectively breaks in the series.

The second data issue has emerged over the past couple of months and has worked in the other direction, with lenders reporting that some loans that were previously recorded as investor loans were really loans to owner-occupiers. This is partly because, when faced with the higher interest rate on investor loans, some borrowers have indicated to their bank that they are not an investor, but rather an owner-occupier, and so should not have to pay the higher rate. Our liaison with lenders suggests that further reclassifications of this nature could be expected over coming months.

The effect of these recent reclassifications on measured growth rates can be seen in Graph 2. Taken at face value, the data suggest a very sharp slowing in growth in investor credit and a sharp pick-up in owner-occupier credit (shown as the dotted lines). However, if we make adjustments for these reclassifications then the changes in growth rates are much less pronounced (the solid lines).

Graph 2

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These various data problems have reinforced our view that the supervisory focus on investor lending has been entirely appropriate. And it is disappointing that some lenders’ internal systems have not been up to the task of reporting accurate data on the split between investor and owner-occupied housing loans.

This issue was discussed at the most recent meeting of the Council of Financial Regulators, with Council members considering what steps could be taken to improve the quality of data. Among other things, it has been decided that APRA, the RBA and the Australian Bureau of Statistics will, next year, undertake a thorough review of the data collected from authorised deposit-taking institutions regarding their domestic books.

However, what incentives are there for lenders to provide the right data to the regulators? And what penalties should be imposed when they fail to provide adequate data? Without good data, we are all flying blind.

RBA leaves cash rate unchanged at record low 2%: experts respond

From The Conversation.

The Reserve Bank of Australia has decided to leave the official cash rate unchanged at a record low of 2%, but said there was scope for a rate cut down the line.

In a statement on the RBA website, governor Glenn Stevens said:

At today’s meeting the Board judged that the prospects for an improvement in economic conditions had firmed a little over recent months and that leaving the cash rate unchanged was appropriate at this meeting. Members also observed that the outlook for inflation may afford scope for further easing of policy, should that be appropriate to lend support to demand.

The US Federal Reserve is expected to start increasing its policy rate in the period ahead, the statement said.

Recent attention has focused on the widening gap between the official cash rate and the mortgage rates set by the major lenders.

All of the big four banks have raised their variable home loan rates, after the introduction of tougher new capital requirements designed to act as a buffer in case of financial crisis. The new prudential regulations followed the Murray report into the financial system.

Australia’s estimated seasonally adjusted unemployment rate for September 2015 sits at 6.2%. The RBA said today that there had been “stronger growth in employment and a steady rate of unemployment.”

The RBA said inflation is low and should remain so, forecasting it to be “consistent with the target over the next one to two years, but a little lower than earlier expected.”

We asked experts to respond to the RBA decision.

Timo Henckel, Research Associate, Centre for Applied Macroeconomic Analysis, Australian National University:

This is the right decision. There are signs of weakness in the economy and financial conditions have changed, with the four big banks raising their home loan rates and global financial markets remaining nervous, but there’s not enough there to lower rates further. They are already very low by historical standards.

Inflation is low, that’s true – but a number of the CAMA Shadow Board members are still concerned about easy money and the danger of fuelling asset prices bubbles. I think several Shadow board members would not be unhappy about the banks recently increasing the mortgage rate.

Moreover, this year has witnessed a dramatic fall in energy prices, which would have exerted downward pressure on prices, albeit only temporarily. At this stage it is not clear to what extent lower inflation is supply-side or demand-side driven.

Monetary policy has been expansionary for a long time and this is helping to rebalance the Australian economy, away from the resource sector to manufacturing and the service sector. Whatever slack is left in the system is probably best left to other policy measures, like fiscal and micro-economic policy.

Today’s decision will probably not affect the gap between the official cash rate and the big four rates. When the banks lifted their mortgage rates, they presumably did not do this in anticipation of the RBA changing policy. It would have been interesting had the RBA dropped rates – would the banks have reversed their recent rate increase? Probably not. I cannot judge whether the additional regulatory measures imposed on the banks exactly justify the increase in their home loan rates. No doubt these measures were also a welcome excuse for the banks to squeeze a little but of extra profit margin for their shareholders.

Recent events have confirmed that the RBA is not the only institution assigned with macroprudential objectives. There’s been a vigorous debate, both in policy and academic circles, about whether central banks should be concerned with asset price inflation and excessive credit growth and whether they should use interest rates to prevent asset price price bubbles from becoming too large. It is reassuring to see the Australian Prudential Regulation Authority taking its role seriously and assuming responsibility.

Guay Lim, Professorial Fellow, University of Melbourne

I support and agree with the no-change, wait-and-see decision. I have concerns that further cuts will fuel asset prices with little effect on real spending.

In coming weeks, we will probably better understand what’s happening with fiscal policy and what’s happening with the US rate.

Richard Holden, Professor of Economics, UNSW Australia

The RBA’s announcement following their decision to keep the cash rate on hold at 2% had a fair bit of hedging language including:

Members also observed that the outlook for inflation may afford scope for further easing of policy, should that be appropriate to lend support to demand.

So, basically, the RBA will cut rates down the track if it decides to cut rates down the track. Got it!

The big four banks are unlikely to further change mortgage rates in response, having already hiked recently in response to heightened capital requirements, but a cut in the months ahead by the RBA still looks like a definite possibility.

RBA Cash Rate Unchanged

At its meeting today, the Board decided to leave the cash rate unchanged at 2.0 per cent.

The global economy is expanding at a moderate pace, with some further softening in conditions in the Asian region, continuing US growth and a recovery in Europe. Key commodity prices are much lower than a year ago, in part reflecting increased supply, including from Australia. Australia’s terms of trade are falling.

The Federal Reserve is expected to start increasing its policy rate over the period ahead, but some other major central banks are continuing to ease monetary policy. Volatility in financial markets has abated somewhat for the moment. While credit costs for some emerging market countries remain higher than a year ago, global financial conditions overall remain very accommodative.

In Australia, the available information suggests that moderate expansion in the economy continues. While GDP growth has been somewhat below longer-term averages for some time, business surveys suggest a gradual improvement in conditions over the past year. This has been accompanied by somewhat stronger growth in employment and a steady rate of unemployment.

Inflation is low and should remain so, with the economy likely to have a degree of spare capacity for some time yet. Inflation is forecast to be consistent with the target over the next one to two years, but a little lower than earlier expected.

In such circumstances, monetary policy needs to be accommodative. Low interest rates are acting to support borrowing and spending. While the recent changes to some lending rates for housing will reduce this support slightly, overall conditions are still quite accommodative. Credit growth has increased a little over recent months, with growth in lending to investors in the housing market easing slightly while that for owner-occupiers appears to be picking up. Dwelling prices continue to rise in Melbourne and Sydney, though the pace of growth has moderated of late. Growth in dwelling prices has remained mostly subdued in other cities. Supervisory measures are helping to contain risks that may arise from the housing market.

In other asset markets, prices for commercial property have been supported by lower long-term interest rates, while equity prices have moved in parallel with developments in global markets. The Australian dollar is adjusting to the significant declines in key commodity prices.

At today’s meeting the Board judged that the prospects for an improvement in economic conditions had firmed a little over recent months and that leaving the cash rate unchanged was appropriate at this meeting. Members also observed that the outlook for inflation may afford scope for further easing of policy, should that be appropriate to lend support to demand. The Board will continue to assess the outlook, and hence whether the current stance of policy will most effectively foster sustainable growth and inflation consistent with the target.

Payments In Australia, The Evolving Landscape

Tony Richards, Head of Payments Policy, RBA, spoke at the APCA Australian Payments 2015 Conference today. He gave an update on current payment initiatives in Australia, including NPP, payments coordination, and the interchange regime. He also mentioned the outcomes from the FSI.

The first is the initiatives that came out of the 2012 conclusions of the Reserve Bank’s Strategic Review of Innovation in the Payments System. The background to the Review was a growing amount of evidence that the services provided to end-users of the Australian payments system were falling behind the services available to end-users in some other countries.

The most prominent outcome of the Review was that the Bank asked the payments industry to consider ways of filling the gaps in the payments system that had been identified in the Review. As you know, the industry – coordinated by APCA – proposed a project, which has been developed over the past three years, to build some new industry infrastructure which will be called the New Payments Platform (NPP). The NPP will deliver real-time, data-rich payments to end-users on a 24/7 basis. It will also be a platform for all sorts of other innovative services, many of which we cannot yet imagine.

The Bank has been heavily involved in this project. It is one of the 12 financial institutions that have agreed to fund the build of the NPP and to connect to it when it goes live. The Bank is also developing a new service, the Fast Settlement Service (FSS), which will provide real-time settlement of NPP transactions. My colleagues in Payments Settlements Department are making good progress on the FSS.

Paul Lahiff, the Chair of NPP Australia Ltd, will be speaking to you in more detail about the status of the NPP, but I can tell you that the Payments System Board (the Board), having encouraged this project, has been taking a close interest in it and has been pleased by the excellent collaboration in the industry.

Another initiative coming out of the Strategic Review of Innovation was that the Bank called for the establishment of an enhanced industry coordination body. The intention was that this should take a more strategic view than existing industry governance bodies and have membership from a wider range of institutions than had traditionally been the case for APCA. It was also to have high-level representation, with individuals who are more able to commit their organisations to courses of action agreed by the group.

The rationale for this focus on industry governance was that the identified gaps in the services offered to end-users partly reflected difficulties in getting the industry to work together to develop the cooperative elements of payment systems. The development of common rules, standards, communications networks and other infrastructure sometimes requires collaborative innovation, where institutions have to work together. There was a concern that this had previously proved difficult in Australia.

I’m happy to say that there has been good progress here. The Australian Payments Council held its first meeting in late 2014 and – as you will have heard in the first session today – has recently been consulting on an Australian Payments Plan, seeking views on long-term trends, systemic challenges and desirable characteristics for the payments system.

The first meeting between the Board and the Council occurred in August. The Board is looking forward to seeing the progress that the Council makes on its payments plan. The Council may be a useful vehicle for the payments industry, including the Bank, to think about some of our legacy payment systems, in particular the future of the cheque system.

Fraud, digital identity and cyber security are other areas where there could be real benefits to industry collaboration. Of course, they are not just issues for the payments system. Cyber security and digital identity were referred to in the Government’s response to the Financial System Inquiry (FSI) Report and are issues that touch the entire financial system and, indeed, the broader economy.

The second issue I would like to cover is the Bank’s ongoing Review of Card Payments Regulation.

In its March 2014 submission to the FSI, the Bank indicated that it would be reviewing some aspects of the regulatory framework for card payments. The Final Report of the FSI, which was released in December 2014, endorsed the broad nature of the Bank’s reforms over the past decade or more but noted a few areas where the Inquiry believed the existing framework could be improved. The Bank released an Issues Paper in March 2015, inviting submissions on a broad range of issues in card payments regulation, including those raised in the FSI Report. I will touch on four of these issues.

The first is the growing lack of transparency of payment costs to many merchants. While interchange fees on credit and debit cards are currently subject to benchmarks that must be observed every three years, there has been a tendency for the two large international four-party schemes to promote new, high-interchange, high-rewards cards. At the same time, they have introduced lower interchange rates for ‘strategic’ or other preferred merchants. These merchants get the same low interchange rate – for credit cards, as low as 20 basis points – on all their transactions, even if a super-premium, high-rewards card is presented. But smaller merchants and others who do not benefit from strategic rates pay interchange rates of up to 200 basis points on their transactions. Furthermore, when presented with a card, such merchants may have no way of knowing if it is a card with a 30 basis point interchange rate or a 200 basis point rate. So the issues that we have raised are the growing lack of transparency of payment costs for many merchants and the growing wedge in average payment costs between preferred and nonpreferred merchants.

Second, the Bank is consulting on whether it would be desirable to lower the interchange benchmarks or to make other changes to the system, such as to have more frequent compliance. One issue here is that the behaviour of schemes and issuers under the current three-yearly compliance system is seeing average interchange rates rising significantly above the benchmark in between compliance dates.

The third issue is whether it would be desirable to extend the coverage of the regulatory framework for interchange payments. This is especially relevant in the case of companion cards – in particular, bank-issued American Express cards, which have issuer fees and other payments that are equivalent in many respects to interchange payments.

The final major issue for the Review is concerns over excessive surcharging in some industries. There is a balance to be struck here between ensuring that merchants have the right to surcharge for expensive payment methods, including some cards, and ensuring that they do not surcharge excessively. Excessive surcharging is not a widespread problem, but I think we can all point to a few cases where there are genuine concerns. The Board is keen to take action here.

The Board discussed the Review in its August meeting and will be discussing it again at its November meeting. In preparation for discussions about possible changes in the regulatory framework, the Board has recently taken a decision to designate five payment systems: the American Express companion card system, the Debit MasterCard system and the eftpos, MasterCard and Visa prepaid card systems. Designation does not impose regulation nor does it commit the Bank to a regulatory course of action; rather it is the first of a number of steps the Bank must take to exercise any of its regulatory powers.

Any proposals to apply regulation to designated systems through standards or access regimes are subject to requirements for detailed consultation. Designation of these five systems will allow a more holistic consideration of the issues – including issues such as the regulatory treatment of companion cards and prepaid cards – as the Bank continues with review of the regulatory framework and considers the case for changes to the framework.

As you know, there has been a lot of discussion of the issues that the Review is focusing on. Banks, payment schemes, consumer organisations and merchants have been able to express views in four different contexts: the original FSI call for submissions, submissions on the FSI’s interim report, the Government’s call for comments on the FSI Final Report, and responses to the Bank’s Issues Paper. And in turn, the industry will have seen the Bank’s views in at least three different vehicles: the Bank’s two submissions to the FSI in 2014 and its Issues Paper from March this year.

We have received over 40 submissions in response to the Issues Paper, with all non-confidential submissions published on our website. The Bank also hosted an industry roundtable in June and has held around 40 meetings with stakeholders.

Overall, there appear to be some areas where there is common ground across most stakeholders. For example, there is fairly wide acceptance that the widening of the international schemes’ interchange fee schedules has created issues in terms of the rising cost of card payments to nonpreferred merchants and the declining transparency of the cost of card payments to them. There is also general agreement that it would be good to deal with instances of excessive surcharging.

However, there are other areas where there are real differences in the views expressed by different stakeholders. These include issues such as whether companion card arrangements should be subject to regulation and whether there might be a case for a reduction in the interchange fee benchmarks.

It will be up to the Board to weigh up the arguments on some of these contentious issues, balancing the interests of consumers, businesses, financial institutions and card schemes. As always, its consideration will be based on its mandate to promote competition and efficiency in the payments system. And let me stress again that if the Board decides to propose changes to the regulatory framework, the Bank will, as usual, undertake a thorough consultation process on any draft standards.

Finally, as you will know, the Government released its response to the FSI yesterday. Its response referred to the Bank’s review and noted that it was looking forward to the Board completing its work on the issues of interchange fees and surcharging. The Government also indicated that it will ban excessive surcharging and give the ACCC enforcement power in this area. I would expect that once the Board has provided greater clarity on what constitutes excessive surcharging, we will work closely with Treasury and the ACCC on legislation. I expect that we will end up with a framework where the Board has decided on a narrower definition of costs of acceptance and allowable surcharges and where the Bank will be able to count on help from the ACCC in the enforcement of the new framework.

RBA Minutes For October

The minutes released today included comments on the housing sector.

Dwelling investment had increased strongly over the year to June, despite recording a decline in the June quarter. Building approvals had declined a little from their recent peak, but remained at levels that implied further growth in dwelling investment, albeit at a gradually declining rate. Loan approvals for construction of new dwellings had also fallen over the past year. Growth in housing prices in Sydney appeared to have eased slightly in recent months and auction clearance rates in Sydney and Melbourne had declined a little from their recent peaks. However, it was too early to be confident that these signs of slowing in housing price inflation would be sustained.

In relation to lending for housing, members noted that the data on the split of lending to owner-occupiers and investors were of questionable quality at present. The available data suggested that there had been a modest decline in the growth of credit extended to investors in housing of late, which was consistent with the tightening in banks’ lending standards in response to actions of the Australian Prudential Regulation Authority (APRA). With housing credit growth overall remaining steady over the past year, there had reportedly been a slight pick-up in the growth of housing credit to owner-occupiers.

Comments on financial stability risks, highlight risks in the residential AND commercial property sector.

Global financial stability risks had been shifting from advanced country banking systems to China and other emerging market economies. Partly in reaction to this, financial market volatility had picked up following a lengthy period of low volatility and compressed risk premia. Members noted the possibility of a sharp repricing in markets where investors for years had been ‘searching for yield’.

Members noted that domestic sources of risk to financial stability in Australia continued to revolve mainly around developments in local property markets. In the context of recent developments in the housing market and household credit, members discussed the findings from the enhanced scrutiny of housing lending practices undertaken by APRA and the Australian Securities and Investments Commission since the end of 2014. This scrutiny and related work had shown that investor activity was considerably higher – and lending standards in some parts of the market weaker – than had originally been thought.

Members further observed that the risks in commercial property and the property development sector were rising. Building approvals for new apartments remained very strong over 2015, even though rental markets appeared soft in some areas. The divergence between commercial property valuations and rents had widened further, with strong domestic and foreign investor interest for new and existing office buildings in particular, even though vacancy rates were quite high. At the same time, falling commodity prices were weighing on the profitability of many resource-related companies. The rest of the business sector seemed to be in relatively good shape, in contrast, with both gearing and failure rates at relatively low levels.

Members were also briefed on the risks in the New Zealand housing market and dairy sector, given the sizeable exposures of Australian banks through their New Zealand subsidiaries.

While Australian banks continued to perform well, they were taking steps to enhance their resilience. Banks’ asset performance continued to improve, profitability remained high, and the large banks had raised substantial amounts of capital in advance of forthcoming prudential requirements. Most banks had strengthened the serviceability metrics used in their mortgage lending and taken steps to slow the pace of growth in investor lending towards the prudential regulator’s expectations. Banks were also reportedly becoming increasingly wary of lending to property developers in markets that were thought to be at risk of becoming oversupplied. Nonetheless, competition among lenders had intensified in the owner-occupied segment of the housing market and had continued to do so in parts of the business lending market. Members observed that a key challenge would be to ensure that lending standards at both Australian and foreign-owned banks did not weaken from this point.

So, no change to rates:

Members noted that reductions in the cash rate earlier in the year continued to provide support to aggregate demand, particularly dwelling investment and household consumption. Members also noted that conditions in the labour market had strengthened further over recent months and were somewhat better than had been expected earlier in the year. Nevertheless, spare capacity remained in the economy, domestic cost pressures were very low and inflation was expected to remain consistent with the target over the next one to two years.

The key domestic sources of risk to financial stability, and stability of the Australian economy more broadly, revolved around developments in local property markets. Members noted that growth in lending for housing had been steady over recent months and that there were some signs of an easing in the strong rate of increase in dwelling prices in Sydney, in particular, although trends had been more varied in a number of other cities. At the same time, members judged that there were signs that the response of the banks to supervisory measures implemented by APRA were helping to manage risks in the housing market. Credit growth overall had been moderate.

Given these considerations, the Board judged that it was appropriate to leave the cash rate unchanged at this meeting. Information about economic and financial developments, both domestically and abroad, would continue to inform the Board’s assessment of the outlook and whether the current stance of policy remained appropriate to foster sustainable growth and inflation consistent with the target.

Financial Stability Review Says Housing Risks Higher Than Thought

The RBA released their latest Financial Stability Review today. It is worth reading through the 66 pages, because there are a number of important themes, relating to housing. Underlying this though is a beat which could be interpreted as the RBA admitting they have misread the housing sector.

In summary, they recognise that underwriting standards were not as good as initially thought, the investment loan and interest only loan sectors carry potentially higher risks, and the changes to capital and regulatory standards will have a mitigating impact, over the medium term. That said, households remain well placed (despite the highest ever debt at lowest ever interest rates).

They are however concerned about the impact of the current residential construction boom.

They also highlight risks from lending by banks to the commercial property sector, and the ongoing use of SMSF’s to invest in property.

There is also a section of the capital ratios for the banks, both under then IRB and standard approaches to capital ratios. Of particular note is for banks using the standard approach, they show how the presence of Lender Mortgage Insurance (LMI) and different LVR’s impact the capital weights. Despite the upcoming move from 17 to 25 basis points for banks under the advanced IRB approach, banks with the standard approach remain at a competitive disadvantage.