RBA – Page 82 – Digital Finance Analytics (DFA) Blog

RBA – Willing To Lower Rates Further, But May Not Be That Effective

Glenn Stevens speech, The World Economy and Australia given to The American Australian Association luncheon in New York, included comments on both the world economy, and conditions in Australia. It contained a clear signal the RBA is willing to lower rates further, and the expectation the dollar has further to fall. But it also refers to the limits of monetary policy when household debt is so high. Overall a balanced set of comments. Here is the transcript:

The World Economy

There are about as many indicators of the world economy as there are people studying it. My remarks will be fairly high-level, and since we have just had the IMF meetings, it seems appropriate to begin with the picture they present. The Fund’s latest publication estimates that output in the world economy grew by 3.4 per cent in 2014 (Graph 1). This is a bit shy of the long-run average of 3.7 per cent, and actually fractionally above the previous estimate in October. The projections are for a slight pick-up in 2015 and around average growth in 2016. These figures are broadly in line with the private sector consensus.

Most of the recent growth has come from the emerging world. As a group, the emerging world grew by 4½ per cent in 2014. China grew by about 7½ per cent, more or less as the authorities intended. It will probably grow by a little less in 2015; the IMF is saying below 7 per cent. But given its size now, China growing at 6–7 per cent would still be a major contributor to global growth. Indeed, the current projections have China contributing about the same growth in global output in 2015 and 2016 as it did in recent years. Meanwhile, growth looks to have picked up in India but softened in some other emerging markets.

Graph 1

In the major advanced economies, in contrast, growth has generally been below previous averages for quite a number of years. It has taken longer to recover than we had all hoped. There are, happily, some signs of improvement at present. Growth is slowly recovering in the euro area and has resumed in Japan. In the United States, notwithstanding some recent softer numbers, the economy looks to have pretty reasonable momentum. So it would appear that we are heading in the right direction.

Unfortunately, that doesn’t mean the legacy of the 2008 crisis is yet behind us. From the vantage point of most central banks, the world could hardly, in some respects, look more unusual. Policy rates in the major advanced jurisdictions have been near zero for six years now. In fact, official deposit rates in the euro area and some other European countries are now negative. As it turns out, the ‘zero lower bound’ wasn’t actually at zero. Central bank balance sheets in the three large currency areas have expanded by a total of about US$5½ trillion since 2007, and the ECB and Bank of Japan will add, between them, about another US$2½ trillion to that over the next couple of years.

That central banks have had to take such extraordinary measures speaks both to the severity of the crisis that these countries faced and the limited capacity of other policies to support growth. History tells us that recovering from a financial crisis is an especially long and painful process, and more so if other countries are in the same boat.

The direct effect of this unprecedented monetary easing has been to lower whole yield curves to extraordinarily low levels, and that process is continuing. The most pronounced effects can be seen in Europe. If one were to invest in German government debt for any duration short of nine years, one would be paying the German government to take one’s money. The same can be said for Swiss government debt. Even some corporate debt in Europe has traded at negative yields. It seems likely that these European developments are also affecting long-term interest rates in the United States.

These ultra-easy monetary policies have helped along the process of balance sheet repair, bringing households and businesses closer to the point where they can start to spend and hire and invest again. And, it has to be observed, it has made fiscal constraints on governments much less binding than they would otherwise have been. Lower interest rates also increase the value of assets that can be used as collateral. Banks’ willingness to supply credit is affected by their balance sheet’s strength, of course, but it seems to be improving even in Europe at present. For larger businesses with access to capital markets, borrowing terms have probably never been more favourable.

Such policies are, then, working through the channels available to them to support demand. But these channels are financial in nature. They don’t directly create demand in the way that, for example, government fiscal actions do. They work on the incentives for private savers, borrowers and investors to alter their financial behaviour and, it is hoped in time, their spending behaviour.

A striking feature of the global economy, according to World Bank and OECD data, is the low rate of capital investment spending by businesses. In fact, the rate of investment to GDP seems to have had a downward trend for a long time.

One potential explanation is that there is a dearth of profitable investment opportunities. But another feature that catches one’s eye is that, post-crisis, the earnings yield on listed companies seems to have remained where it has historically been for a long time, even as the return on safe assets has collapsed to be close to zero (Graph 2). This seems to imply that the equity risk premium observed ex post has risen even as the risk-free rate has fallen and by about an offsetting amount. Perhaps this is partly explained by more sense of risk attached to future earnings, and/or a lower expected growth rate of future earnings.

Graph 2

Or it might be explained simply by stickiness in the sorts of ‘hurdle rates’ that decision makers expect investments to clear. I cannot speak about US corporates, but this would seem to be consistent with the observation that we tend to hear from Australian liaison contacts that the hurdle rates of return that boards of directors apply to investment propositions have not shifted, despite the exceptionally low returns available on low-risk assets.

The possibility that, de facto, the risk premium being required by those who make decisions about real capital investment has risen by the same amount that the riskless rates affected by central banks have fallen may help to explain why we observe a pick-up in financial risk-taking, but considerably less effect, so far, on ‘real economy’ risk-taking.

Potential Vulnerabilities

Whether this is best seen as a temporary increase in risk aversion, a genuine dearth of investment opportunities, evidence of monetary policy ‘pushing on a string’, a portent of secular stagnation, or just unusually long lags in the effects of policy, will probably be debated for some time yet. I don’t pretend to know what that debate may conclude.

In the meantime, we have to think about some of the vulnerabilities that may be associated with the build-up of financial risk-taking. This is one of the responsibilities of the Financial Stability Board, particularly (though not only) through its Standing Committee on Assessment of Vulnerabilities. Two factors stand out at present as potentially combining to heighten fragility at some point. The first arises from the sheer extent and longevity of the search for yield.

As I have noted, compensation in financial instruments for various risks is very skinny indeed. Investors in the long-term debt of most sovereigns in the major countries are receiving very little – if any – compensation for inflation and only minimal compensation for term. Some model-based decompositions of bond yields suggest that term premia on US long-term debt and some sovereign debt in the euro area are actually negative. Compensation for credit risk is also narrow in many debt markets.

Moreover, because the search for yield is a global phenomenon, considerable amounts of capital have flowed across borders. There is some evidence to suggest that as emerging country bond markets have developed, particularly in Asia, more issuers have been able to raise funds in their local currencies. This leaves the foreign exchange risk associated with the capital flows more with the investor rather than a local bank or corporate, which is a good development. Nonetheless, we don’t have full visibility of those risks and there has been a notable build-up of debt overall in some emerging markets.

The other factor of importance is a set of structural changes in capital markets, where there are two key features worth noting. One is the expanding role of asset managers. The search for yield, and the general tendency since the crisis for some intermediation activity to migrate to the non-bank sector, has resulted in large inflows to asset managers since the crisis.

Yet liquidity – the ability to shift significant quantities of assets in a short period without large price movements – has probably declined, which is the second of the structural changes worth noting. Certainly the willingness of banks and others to act as market-makers in the way they did in the past will have diminished considerably. Now, of course, to some extent this is a result of the changes to financial regulation which have aimed to improve the robustness of the financial system. We should be clear that it was intended that the cost of liquidity provision in markets be more fully borne by investors. Liquidity was under-priced prior to the crisis.

Nonetheless, the question is whether end-investors truly appreciate that the availability of liquidity in the system has declined. Good asset managers have sufficient liquidity holdings to meet redemptions that may occur over any short time period and will also offer appropriate redemption terms and so pose only limited risks to the broader financial system. But the cost of holding the most liquid assets in a world of very low returns overall may pressure some asset managers to hold less genuine liquidity than they might otherwise. Meanwhile, the amount of client funds being managed is much larger than it was and we don’t know how all those investors will behave in a more stressed environment, should one eventuate. A key concern the official sector has is that investors may be assuming a degree of liquidity that will not actually be available in a more stressed situation.

Putting all that together, we find a world where the banking system is much safer, but in capital markets some valuations are stretched, credit spreads are compressed, there has been significant cross-border capital flow and liquidity may be less available than investors are assuming. That raises the risk that a sell-off, were it to occur, could be abrupt.

What might trigger such an event?

The usual trigger people have in mind is a rise in US interest rates. The US economy now looks strong enough for the Federal Reserve to consider increasing its policy rate later in the year. In itself, this should be welcomed. And it will have been very well telegraphed. Understandably, the Fed is proceeding with the utmost caution. But it will also have been over nine years since the Fed previously raised interest rates. Some market participants won’t have lived through a Fed tightening cycle before. Hence, it would not be surprising to see some bumps along this road.

A second trigger could come from slower growth in emerging markets. Growth has already weakened in some economies, several of which have been bruised by falling commodity prices. Capital that flowed into emerging markets could flow out again, perhaps when interest rates begin to rise in the United States. That would probably occur alongside an appreciating US dollar. So the distribution of credit risk and foreign currency risk will be of considerable importance. One can easily see why investors could become less forgiving of borrowers on a shaky footing, be they corporates or sovereigns.

A complicating factor here is that the rise in US interest rates looks set to occur while the central banks of Japan and Europe are continuing an aggressive easing of monetary policy via balance sheet measures. The combined Japanese and European ‘QE’ will be very substantial. The extent to which such funds will flow across borders will depend on which sorts of investors are ‘displaced’ from their sovereign debt holdings and what their risk appetites are. To the extent that funds do flow across borders, the proportions in which they flow to emerging markets, as opposed to the United States, will also be important.

So there is a fair bit that we don’t know, but need to learn, about this environment. It will be important for the officials thinking about these and other risks to continue an effective dialogue with private market participants over the period ahead.

Australia

These major global trends have certainly affected financial and economic conditions in Australia. We see the effects of the search for yield all around us. Short and long-term interest rates are at record lows, but are still attractive to some international investors. Foreign capital has been attracted not just to debt instruments but to physical assets. The demand for commercial property has been particularly strong and meant that prices have risen even as rental income has softened and the outlook for construction seems reasonably subdued. That raises some risks, which we discussed in our recent Financial Stability Review.[¹]

We also noted the attention being given by APRA (Australian Prudential Regulation Authority) and ASIC (Australian Securities and Investments Commission) to risks in the housing market. APRA has announced benchmarks for a few aspects of banks’ housing lending standards and both APRA and the Reserve Bank will be monitoring the effects of these measures carefully; at this stage, it is still too early to judge them. We can only say that over the past few months, the rate of growth of credit for housing has not picked up further.

Overall, we think the Australian financial system is resilient to a range of potential shocks, be they from home or abroad. Banks’ capital positions are sound and are being strengthened over time. They have little exposure to those economies that are under acute stress at present. Measures of asset quality – admittedly backward-looking ones – have been improving.

But it is developments in the ‘real’ sector of the economy that, right at the minute, seem more in focus. The economy is continuing to adjust to the largest terms of trade episode it has faced in 150 years. As part of that adjustment, there has been a major expansion in the capital stock employed in the resources and energy sector, accomplished by exceptionally high rates of investment. These are now falling back quickly, exerting a major dampening effect on demand. There has been a major cycle in the exchange rate, which is still under way. There has been considerable change to the structure of the economy. This all happened as the major economies encountered the biggest financial crisis in several generations, with its very long-lasting after effects, and which also had an impact on Australian attitudes to spending and leverage. To say there have been some pretty powerful, and disparate, forces at work is something of an understatement, even for a central banker.

At present, while growth in Australia’s group of trading partners is about average, and is higher than the rate of growth for the world economy as a whole, the nature of that growth is shifting. The growth in Chinese demand for iron ore, for example, has weakened at the same time that supply has been greatly increased, much of it from Australia. Iron ore prices are therefore falling and contributing to a fall in Australia’s terms of trade.

As the terms of trade fall, and national income grows more slowly than it would have otherwise, adjustment is occurring in several ways:

Incomes of those directly exposed to the resources sector, be it as employees, owners or service providers, are reduced.

Nominal wages generally are lower than otherwise.

The Australian dollar has declined and will very likely fall further yet, over time. This is one of the main ways that the lower national income is ‘transmitted’ to the population: purchasing power over foreign goods and services is reduced. At the same time, Australians receive some price incentives to substitute towards domestically produced goods and services. And the purchasing power of foreigners over the value added by Australian labour and capital is higher than otherwise.

Saving by households, which rose when the terms of trade rose, is tending to decline as the terms of trade fall. This is a natural response to lower income growth and is being reinforced by easier monetary policy, which has reduced the return on safe financial assets. That said, the fact that many households already carry a considerable debt burden means that the extent to which they will be prepared to reduce saving to fund consumption may be less than it once was. More on this in a moment.

As part of the same adjustment, government saving is increasing more slowly (more accurately, government dis-saving is lessening more slowly) than otherwise. This is more or less automatic to the extent that lower commodity prices directly reduce state and federal government revenues. More generally, the more reluctant households are to lower their saving and increase their spending the harder the government may find it to increase its saving.

Macroeconomic policy is supporting the adjustment. On the fiscal front, the government has little choice but to accept the slower path of deficit reduction over the near term. But over the longer term, hard thinking still needs to occur about the persistent gap we are likely to see (under current policy settings) between the government’s permanent income via taxes and its permanent spending on the provision of good and services.

In the case of monetary policy, the Reserve Bank has been offering support to demand, consistent with its mandate as expressed by the medium-term inflation target. Relevant considerations of late include the fact that output is below conventional estimates of ‘potential’, aggregate demand still seems on the soft side as resources investment falls sharply, and unemployment is elevated and above most estimates of ‘natural rates’ or ‘NAIRUs’. And inflation is forecast to be consistent with the 2–3 per cent target. So interest rates should be quite accommodative and the question of whether they should be reduced further has to be on the table.

What complicates the situation is that these are not the only pertinent facts. A good deal of the effect of easier monetary policy comes via the housing sector – through higher prices, which increase perceived wealth and encourage higher construction, through higher spending on durables associated with new dwellings, and so on. These are not the only channels but, according to research, together they account for quite a bit of the direct effects of easier monetary policy. And they do appear to be working, thus far. Housing starts will reach high levels this year and wealth effects do appear to be helping consumption, which is rising faster than income.

But household leverage starts from a high level, having risen a great deal in the 1990s and early 2000s. The extent to which further increases in leverage should be encouraged is not easily answered, but nor can it be conveniently side-stepped. Even if we chose to ignore it, monetary policy’s ability to support demand by inducing households to bring forward spending that would otherwise be done in future might well turn out to be weaker than it used to be. For a start, households already did a lot of that in the past and, in any event, future income growth itself looks lower than it did a few years ago.

Then there are dwelling prices, which, at a national level, have already risen considerably from their previous lows, at a time when income growth has been slowing. Popular commentary is, in my opinion, too focused on Sydney prices and pays too little attention to the more disparate trends among the other 80 per cent of Australia. That said, it is hard to escape the conclusion that Sydney prices – up by a third since 2012 – look rather exuberant. Credit conditions are only one of several factors at work here. But credit conditions are very easy. So while the conduct of monetary policy can’t allow these financial considerations to dominate the ‘real economy’ ones completely, nor can it simply ignore them. A balance has to be found.

To this point, the balance that the Reserve Bank Board has struck has seen the policy rate held at what would once have been seen as extraordinarily low levels for quite a while now. The Board has, moreover, clearly signalled a willingness to lower it even further, should that be helpful in securing sustainable economic growth. The Board has been proceeding with a degree of caution that is appropriate in the circumstances. It also has, I would say, a realistic assessment of how much monetary policy can be expected to achieve in supporting the adjustment the economy needs to make.

Any help in boosting sustainable growth from other policies would, of course, be welcome. In particular, things that could credibly be seen as lifting prospects for future income, and increasing confidence in those prospects, would give easy monetary policy a good deal more traction.

In fact, that point generalises to the rest of the world. Across much of the world, too much weight is being put on monetary policy to try to achieve what it can’t: a durable and sustainable increase in growth, in an environment where private leverage is already rather high or even too high. Monetary policy alone won’t deliver that.

This is probably a moment to recall the commitments we all made in the G20 meetings in Australia last year, as we agreed on the goal of an additional rise in global GDP of 2 per cent over five years.

Those commitments were not actually about monetary policy; they were about other policies. It will be important this year, after one of the five years has passed, to see whether we are all making good on our various promises. More generally, actions which promote entrepreneurship, innovation, adaptation and skill-building, that reward ‘real’ risk-taking, while providing a stable macroeconomic environment and a well-functioning financial system, will best support our future wellbeing.

Bilateral Local Currency Swap Agreement with the People’s Bank of China

The Reserve Bank of Australia has signed a new bilateral local currency swap agreement with the People’s Bank of China (PBC). The agreement, which can be activated by either party, allows for the exchange of local currencies between the two central banks of up to A$40 billion or CNY 200 billion. It follows the initial swap agreement between the two central banks signed in 2012 and is for a further period of three years.

As with the initial agreement in 2012, the main purposes of this agreement are to support trade and investment between Australia and China, particularly in local-currency terms, and to strengthen bilateral financial cooperation. The agreement reflects the increasing opportunities available to settle trade between the two countries in Chinese renminbi (RMB) and to make RMB-denominated investments. Other recent initiatives between the two countries include the establishment of an official RMB clearing bank and the granting of a quota as part of the RMB Qualified Foreign Institutional Investor program in November 2014.

No Rate Change Today – RBA

At its meeting today, the Board decided to leave the cash rate unchanged at 2.25 per cent.

Moderate growth in the global economy is expected in 2015, with the US economy continuing to strengthen, even as China’s growth slows a little from last year’s outcome.

Commodity prices have declined over the past year, in some cases sharply. The price of oil in particular is much lower than it was a year ago. These trends appear to reflect a combination of lower growth in demand and, more importantly, significant increases in supply. The much lower levels of energy prices will act to strengthen global output and temporarily to lower CPI inflation rates. Prices for key Australian exports have also been falling and therefore Australia’s terms of trade are continuing to decline.

Financial conditions are very accommodative globally, with long-term borrowing rates for several major sovereigns at all-time lows. Financing costs for creditworthy borrowers remain remarkably low.

In Australia the available information suggests that growth is continuing at a below-trend pace, with overall domestic demand growth quite weak as business capital expenditure falls. As a result, the unemployment rate has gradually moved higher over the past year. The economy is likely to be operating with a degree of spare capacity for some time yet. With growth in labour costs subdued, it appears likely that inflation will remain consistent with the target over the next one to two years, even with a lower exchange rate.

Credit is recording moderate growth overall. Growth in lending to investors in housing assets is stronger than to owner-occupiers, though neither appears to be picking up further at present. Lending to businesses, on the other hand, has been strengthening recently. Dwelling prices continue to rise strongly in Sydney, though trends have been more varied in a number of other cities. The Bank is working with other regulators to assess and contain risks that may arise from the housing market. In other asset markets, prices for equities and commercial property have risen, in part as a result of declining long-term interest rates.

The Australian dollar has declined noticeably against a rising US dollar over the past year, though less so against a basket of currencies. Further depreciation seems likely, particularly given the significant declines in key commodity prices. A lower exchange rate is likely to be needed to achieve balanced growth in the economy.

At today’s meeting the Board judged that it was appropriate to hold interest rates steady for the time being. Further easing of policy may be appropriate over the period ahead, in order to foster sustainable growth in demand and inflation consistent with the target. The Board will continue to assess the case for such action at forthcoming meetings.

Paying For Cards

The RBA published a paper on “The Value of Payment Instruments: Estimating Willingness to Pay and Consumer Surplus” by Tai Lam and Crystal Ossolinski. This paper draws on a survey of consumers’ willingness to pay surcharges to use debit cards and credit cards, rather than cash. Just as the price a consumer is willing to pay for a good or service is indicative of the value he/she places on that item, the willingness to pay a surcharge to use a payment method reflects that method’s value to that consumer, relative to any alternatives.

They find a wide dispersion in the willingness to pay for the use of cards. Around 60 per cent of consumers are unwilling to pay a 0.1 per cent surcharge, which suggests that for these individuals, the net benefits of cards are very small or that cash is actually preferred. At the other end of the distribution, some individuals (around 5 per cent) are willing to pay more than a 4 per cent surcharge, indicating they place a substantial value on paying using cards.

On average, consumers have a higher willingness to pay for the use of credit cards than debit cards. This difference can be viewed as the additional value placed on the non-payment functions – rewards and the interest-free period – of credit cards. They estimate that on average credit card holders place a value of 0.6 basis points on every 1 basis point of effective rewards rebate.

Based on the survey data and information on the costs to merchants of accepting payment methods, they predict the mix of cash, debit card and credit card payments chosen by consumers under different levels of surcharging and explore the implications for the efficiency of the payments system. In particular, the consumer surplus in a scenario where merchants do not surcharge and the costs of all payment methods are built into retail prices can be compared with that where merchants surcharge based on payment costs and retail prices are correspondingly lower. Their findings suggest that cost-based surcharging leads to some consumers switching to less costly payment methods, resulting in greater efficiency of the payment system and an increase in consumer surplus of 13 basis points per transaction.

RBA On Household Risks

In the financial stability report today, the RBA comments:

“Household sector risks continue to revolve largely around the housing and mortgage markets. At this stage, competitive pressures have not induced a material easing in non-price housing lending standards. The composition of new mortgage finance remains skewed to investors, however, particularly in the largest cities. Ongoing strong speculative demand would tend to amplify the run-up in housing prices and increase the risk that prices in at least some regions might fall significantly later on. In the first instance, the consequences of such a downturn in prices are more likely to be macroeconomic in nature because of the effects on household wealth and spending would be spread more broadly than just on the recent property purchasers. However, the further housing prices fall in that scenario, the greater the chance that lenders would incur losses on their housing loans.

At the margin, the recent decline in mortgage interest rates can be expected to boost demand for housing further, although it will also make it easier for existing borrowers to service their debts. Indicators of household stress are currently at low levels, but could start to increase if labour market conditions weakened further than currently envisaged”.

They go on to discuss the APRA and ASIC measures and say it is too soon to assesses their effectiveness. Not, to worry though, as they are “monitoring an array of information”. Too little too late in my view. Actually households are currently more in debt than ever, so levels of stress are in relative terms higher. If rates were to rise, or if house prices fell, the impact would be severe and immediate (in Ireland it took just nine months to wreck household budgets in 2007).

RBA Data On Bank Funding

In the latest RBA Bulletin for the March quarter, there is an interesting article on bank funding “Developments in Banks’ Funding Costs and Lending Rates”. It demonstrates mix of forces in play, including competitive dynamics, relative product pricing, and the impact of the global financial system on the banks. The main finding is that the spread between the major banks’ outstanding funding costs and the cash rate narrowed a little over 2014. This was due to slightly lower costs of deposits combined with a more favourable mix of deposit funding. The contribution of wholesale funding to the narrowing was marginal as more favourable conditions in long-term debt markets were mostly offset by a rise in the cost of short-term debt. Lending rates declined a little more than funding costs, reflecting competitive pressures.

The spread of banks’ funding costs to the cash rate is estimated to have narrowed by about 9 basis points in 2014. With the cash rate unchanged over the past year, the slight narrowing in the spread was entirely due to changes in the absolute cost and mix of funding liabilities. In particular, the narrowing was driven by a lower cost of deposit funding and changes in the composition of deposits. Changes in the costs and composition of wholesale funding (i.e. bonds and bills) contributed only marginally to the fall in funding costs. Nonetheless, funding costs relative to the cash rate remain significantly higher than they were before the global financial crisis in 2008.

Interest rates offered on some types of deposits declined over the year. The cost of outstanding term deposits is estimated to have fallen by about 40 basis points as deposits issued at higher rates matured and were replaced by new deposits at lower rates. Similarly, the major banks’ advertised ‘specials’ on new term deposits fell by about 40 basis points over the past year.

During 2014, the estimated average interest rate on outstanding variable-rate housing loans continued to drift lower relative to the cash rate. The overall outstanding rate declined as new or refinanced loans were written at lower rates than existing and maturing loans. This reflected a sizeable reduction in fixed rates over the year and an increase in the level and availability of discounting below advertised rates. The interest rates on around two-thirds of business
loans are typically set at a margin over the bank bill swap rate rather than the cash rate. While these spreads remain wider, reflecting the reassessment
of risk since the global financial crisis, they have generally trended down over the past two years. Much of the narrowing of spreads over 2014 was due to average business lending rates declining by over 20 basis points, with outstanding rates for small business decreasing by more than rates for large businesses.

RBA Leaves Door Open For More Rate Cuts

The RBA released their Minutes of the Monetary Policy Meeting of the Reserve Bank Board from 3 March 2015. Clearly housing is the potential brake on further cuts, but that said further falls are possible.

In assessing the appropriate stance for monetary policy in Australia, members noted that the outlook for global economic growth had not changed, with Australia’s major trading partners forecast to grow by around the average of recent years in 2015. Lower oil prices were expected to boost growth in major trading partners and reduce inflation temporarily. More generally, although the decline in many commodity prices over the past year had largely been in response to expansions in global supply, members observed that demand-side factors, including the weakness in Chinese property markets, had also played a role. Although the Australian dollar had depreciated, particularly against the US dollar, it remained above most estimates of its fundamental value, particularly given the significant declines in key commodity prices. Conditions in global financial markets remained very accommodative. Changes to the stance of monetary policy by the major central banks were likely to be important influences on financial markets over the coming year.

Data available at the time of the meeting suggested that the Australian economy had continued to grow at a below-trend pace in the December quarter and that domestic demand growth had remained weak overall. There had been some evidence suggesting that growth of dwelling investment and consumption had picked up in the December quarter, but there had also been indications that business investment could remain subdued for longer than had been previously expected. On balance, the evidence suggested that labour market conditions were likely to remain subdued and the economy would continue to operate with a degree of spare capacity for some time. As a result, wage pressures were expected to remain contained and inflation was forecast to remain consistent with the target over the next year or so, even with a lower exchange rate.

At the same time, activity in the housing market had remained strong. Housing prices had continued to increase strongly in Sydney and at a solid pace in Melbourne. In other capital cities, trends had been more mixed and annual increases in capital city housing prices (excluding Sydney and Melbourne) had averaged about 3 per cent. Growth of dwelling investment was estimated to have picked up in the December quarter and was expected to remain at a high level in the near term. While credit had continued to grow a little faster than incomes, household leverage had not increased significantly and the Bank would continue to work with other regulators to assess and contain risks that might arise from the housing market.

Members noted that the current setting of monetary policy had been accommodative for some time and that the recent reduction in the cash rate would provide some further support to the economy. They also acknowledged that a lower exchange rate would help achieve balanced growth in the economy. Nonetheless, on the basis of the current forecasts for growth and inflation, members were of the view that a case to ease monetary policy further might emerge.

In considering whether or not to reduce the cash rate further at this meeting, members saw benefit in allowing some time for the structure of interest rates and the economy to adjust to the earlier change. They also saw advantages in receiving more data to indicate whether or not the economy was on the previously forecast path. Further, they noted the greater degree of uncertainty about the behaviour of borrowers and savers in a world of very low interest rates. Taking account of all these factors, members judged it appropriate to hold the cash rate steady for the time being, while recognising that further easing over the period ahead may be appropriate to foster sustainable growth in demand while maintaining inflation consistent with the target.

Regulatory Changes And The Fixed Income Market

Guy Debelle, Assistant Governor (Financial Markets) gave a speech on “Global And Domestic Influences on the Australian Bond Market.” He covered some of the important up coming regulatory changes.

One global development that has garnered a large amount of comment of late is the effect of reduced market-making capacity in fixed income. The Bank for International Settlements (BIS) Committee on the Global Financial System (CGFS), issued a report on this topic late last year. That report documents the intended effect of regulation in bringing about this reduction. There is a debate as to whether the reduction has gone too far, but the fact that market-making activity is lower than it was pre-crisis is a desirable outcome given liquidity risk was under-priced pre-crisis.

Rather than describing it as a reduction in market-making, I think it is more useful to think of it as a reduction in the risk-absorption capacity of intermediaries. Their ability to warehouse portfolio adjustments of asset managers is curtailed. In the past, asset managers were dealing bilaterally with individual trading desks that each had their own limit. Now these limits are applied holistically across the trading desks so that selling one part of a portfolio to one desk will reduce the capacity to sell another part of the portfolio to another desk in the same institution. Asset managers need to take account of these changes in market dynamics in thinking about how they adjust their portfolios. Transactions costs are higher and, in particular, liquidity costs are higher. I am not sure that all market participants have fully appreciated this yet and are fully cognisant of the impact of the post-crisis changes.

The second development to note is in the asset-backed security space. As many of you know, as of 30 June this year, the Bank will introduce mandatory reporting requirements for repo-eligible asset-backed securities (ABS). The Bank continues to work with the industry to ensure the timely implementation of these requirements. The required information, which must also be made available to permitted users, will promote greater transparency in the market, supporting investor confidence in these assets. These requirements will also provide the Bank with standardised and detailed data on ABS, which are a major part of the collateral eligible to be used under the CLF.

In preparation for the introduction of these reporting requirements and to facilitate industry readiness, the reporting system for securitisations was made available for industry testing in November 2014, with voluntary reporting accepted from 31 December 2014. The Bank is currently working with a number of institutions undertaking test submissions, with some institutions expecting to commence regular reporting shortly. The industry is strongly encouraged to undertake testing early to ensure readiness for the commencement of mandatory reporting on 30 June 2015.

The third development is the proposed changes to the settlement convention to T+2 for over-the-counter (OTC) transactions in domestic fixed income securities. The Bank strongly encouraged this initiative. The current standard of T+3 settlement in the Australian market compares unfavourably with many other jurisdictions that have already progressed to shorter settlement cycles for OTC transactions in their domestic fixed income markets. A shorter settlement cycle will reduce the risks associated with settlement, in particular, counterparty risk. Market makers in OTC fixed income securities may particularly benefit from the reduced period of counterparty exposure, as any given trade will count towards internal credit limits for a shorter period of time. This could boost market turnover and trading capacity for participants. Further, moving to T+2 is likely to encourage straight-through processing, which could reduce the risk of an operational issue affecting the settlement of OTC fixed income securities. Ideally, this would be implemented by the end of 2015.

Stress Testing Households – RBA Paper

The RBA published a Research Discussion Paper “Stress Testing the Australian Household Sector Using the HILDA Survey”. They use data from the Household, Income and Labour Dynamics in Australia (HILDA) Survey to quantify the household sector’s financial resilience to macroeconomic shocks.

Given high household indebtedness, large mortgages and high house prices, estimating the potential impact of changes to interest rates and unemployment are important. Especially so when so much of banks lending is property related, and capital ratios are lower than pre-GFC. DFA of course models mortgage stress in our own surveys, so we have an interest in this work.

Their model suggests that through the 2000s the household sector remained resilient to scenarios involving asset price, interest rate and unemployment rate shocks, and the associated increases in household loan losses under these scenarios were limited. Indeed, the results suggest that, despite rising levels of household indebtedness in aggregate, the distribution of household debt has remained concentrated among households that are well placed to service it. In turn, this suggests that aggregate measures of household indebtedness may be misleading indicators of the household sector’s financial fragility. The results also highlight the potential for expansionary monetary policy to offset the effects of increases in unemployment and decreases in asset prices on household loan losses.

Our perspective is that the household analysis they are using is not granular enough to get at the differential stress across households, and how potential interest rate rises or unemployment will impact. In addition, interest rates are low today, so it is not possible to extrapolate from events in 2000’s. Given the larger loans, adverse interest rate movements will impact harder and faster, especially amongst households with high loan to income ratios. Therefore the results should not be used as justification for further easing of monetary policy.

Some additional points to note:

The stress-testing model uses data from the HILDA Survey, is a nationally representative household-based longitudinal study collected annually since 2001. The survey asks questions about household and individual characteristics, financial conditions, employment and wellbeing. Modules providing additional information on household wealth (‘wealth modules’) are available every four years (2002, 2006 and 2010). So some data elements are not that recent.

As they rely on information from the HILDA Survey’s wealth modules, they had to impute responses to minimise the number of missing responses and thus increase the sample size. The total sample size for each year is around 6 500 households. Individual respondent data were used to estimate probabilities of unemployment; this part of the model is based on a sample of around 9 000 individuals each year. DFA uses 26,000 households each year, our sample is larger.

How then do they estimate potential household stress? Their model uses the financial margin approach where each household is assigned a financial margin, usually the difference between each household’s income and estimated minimum expenses. This is different from a ‘threshold’ approach, where each household is assumed to default when a certain financial threshold is breached (for example, when total debt-servicing costs exceed 40 per cent of income). DFA captures data on the precursors of stress, and models the cash flow changes as unemployment and interest rates move. We also model the cumulative impact of stress which builds over time (typically households survive for 18-24 months, before having to take more drastic action).

Looking at the potential economic shocks, they examined how an increase in interest rates leads to an increase in debt-servicing costs for indebted households, by lowering their financial margins. Interest rate rises tend to increase the share of households with negative financial margins, and thus the share of households assumed to default. Interest rate shocks are assumed to pass through in equal measure to all household loans.

Falling asset prices have no effect on the share of households with negative financial margins. They assume that a given asset price shock applies equally to all households.

A rise in the unemployment rate causes the income of those individuals becoming unemployed to fall to an estimate of the unemployment benefits that they would qualify for, lowering the financial margins of the affected households. Their approach uses a logit model to estimate the probability of individuals becoming unemployed. This means that unemployment shocks in the model will tend to affect individuals with characteristics that have historically been associated with a greater likelihood of being unemployed.

In their most extreme example, households in the middle of the income distribution and renters are the most affected. Households with younger heads are also affected, while household with older heads are not especially affected in any year, suggesting that the increase in indebtedness among these households through the 2000s did not significantly expose the household sector to additional risks. Households with debt are more likely to be impacted by the scenario than those without debt. However, of those households with debt, the impact of the scenario is greatest on those with relatively little debt.

Their results from the hypothetical scenario suggest that the household sector would have remained fairly resilient to macroeconomic shocks during the 2000s, and that the households that held the bulk of debt tended to be well placed to service it, even during macroeconomic shocks. However, based on this scenario, the effect of macroeconomic shocks appears to have increased over the 2000s. This suggests that household vulnerability to shocks may have risen a little. This might be because some households were in a less sound financial position following the global financial crisis (for instance, because the labour market had weakened and the prices of some assets had declined). As a consequence, shocks of a magnitude that previously would have left these households with a positive financial margin and/or sufficient collateral so as not to generate loan losses for lenders may, following the crisis, have been large enough to push these households into having a negative financial margin and/or insufficient collateral.

The results imply that expected losses (under the scenario outlined) on banks’ household loans were equivalent to a little less than 10 per cent of total bank capital (on a licensed ADI basis), assuming that eligible collateral consists of housing assets only. This result assumes that banks have already provisioned for pre-stress losses, but this may not always be the case, as the deterioration in asset quality may surprise some institutions or may take place before objective evidence of impairment has been obtained. Assuming pre-stress losses are not provisioned for, potential losses as a share of total bank capital roughly double. It is important to reiterate that these estimates are simplistic and could differ to actual losses incurred in reality under this scenario by a large margin. For example, some of these loan losses may be absorbed by lenders mortgage insurance.