Interest rates

The ‘bad old days’ of credit regulation may be preferable to a sharp rate hike

Higher interest rates would also tend to cause the exchange rate to rise, making exports less competitive and imports cheaper. The latter might be expected to moderate inflation, while the economy would be slowed by the reduced competitiveness and, ultimately, lower production of local producers.

But higher interest rates were not considered to have a major influence on consumer spending. After all, every dollar borrowed by someone is a dollar lent by someone else, so higher interest payments by some are offset by higher interest receipts by another (or maybe (be higher bank profits if the flow is less than full!) Only if the sensitivity of lenders’ and borrowers’ spending to changes in interest rates were different if there could be a foreseeable effect.

Not always the case

It was not usual to expect a major monetary policy channel to be through the reduction in free cash flow and spending capacity of households with outstanding mortgages who are now facing higher loan repayments. Of course, this could be very effective. For recent borrowers in particular, interest (rather than principal) payments make up a very large portion of the total, meaning large increases in payments result from rising interest rates.

For those whose debt service (repayment/income) ratios are already high, the opportunity to reduce living expenses may be limited. The “wagyu and shiraz” example of making less luxurious dining choices hardly applies to low-income borrowers.

In theory, loan approvals by mortgage lenders should have (and are required by the Australian Prudential Regulation Authority) allowed for a sufficient ‘buffer’, so that the borrower could still make repayments at an interest rate higher. That buffer was 2.5 percentage points before October of last year and 3 percentage points since.

Recent RBA cash rate hikes have already absorbed most of the 2.5 percentage point buffer. The recent unexpected rise in the price of many basic necessities suggests that buffers may not have been sufficient (or miscalculated) to prevent many cases of hardship.

If this is the case – no doubt in some cases, although a media “coup de theater” may exaggerate the matter – it is worth considering whether there are other ways in which the authorities could act to curb Requirement. This is particularly the case if banks do not or cannot extend the terms of mortgages for people in difficulty, so that current cash payments remain unchanged or increase only slightly.

The “wagyu and shiraz” example of making less luxurious dining choices hardly applies to low-income borrowers.

One option would be to take measures that reduce bank lending – thus focusing more directly on investment-type spending financed in this way. One such approach would be to directly control the amount of bank lending, although many would see this as a throwback to the “bad old days”. (Even though APRA has recently used loan/assessment limits to restrict mortgage lending.) Of course, such actions may simply shift lending to non-bank institutions.

Another option would be to use changes in bank capital requirements, either by changing risk weights or required capital ratios, to inhibit new lending.

Current economic and financial conditions are unusual and therefore the question should be asked whether it is appropriate and desirable to rely on a blunt weapon such as rising interest rates to achieve policy objectives, which can harm a large number of households.