Autralia’s Retail Loan Rate Changes Essay Example

Act of 1959 when it took over the central banking responsibilities from the Commonwealth Bank.

RBA is responsible for formulating and implementing monetary policy.

Monetary Policy Instruments

Open market operations has to offer higher than the bond market rulings price to get a successful bid of the security, in case to ease monetary conditions and it consequently buys bonds from banks. By offsetting the liquidity requirements of the money market, RBA neutralizes the effects which the often erratic, fluctuations in funds may otherwise have on short-term interest rates, in particular the money market dealers pay on market cash rate (Bell, 2004) (see Appendix 2).

Indicators of Monetary Policy

RBA sets an operating target for the overnight cash rate, which is the interest rate on overnight loans made between institutions in the money market. The RBA Broad specifies the required target for the cash rate, which influences other interest rates in the economy (Kriesler, 1999).Figure1 shows that there is a strong relationship between most interest rates, especially among shorter maturity. Changes in the cash rate indicate changes in the stance of the monetary policy, with the rises in the cash rate being tightening of the monetary policy, and falls in the cash rate being easing.

The interest rate is relevant to borrowers and lenders in the real interest rate (cash rate minus inflation). High interest rate reflects tight monetary policy, and vice versa (Kriesler, 1999). In figure1, interest rate was starting to increase in recent 6 years. Changes in monetary policy mean a change in the operating target for the cash rate, and hence a shift in the interest rate structure prevailing in the financial system (RBA, 2008).Figure 1Figure 2The cash rate

is determined in the money market as a result of the interaction of demand for and supply of overnight funds.

The Reserve Bank's ability to pursue successfully a target for the cash rate stems from its control over the supply of funds which banks use to settle transactions among themselves.If the Reserve Bank supplies more exchange settlement funds than the commercial banks wish to hold, the banks will try to shed funds by lending more in the cash market, resulting in a tendency for the cash rate to fall and vice versa (Lewis, 1998).Figure 3Source: Bloomberg (as at 24 June 2008 )Figure 4Another indicator is the yield curve, the graph of interest rates of different maturities. When short-term interest rates (cash rate) are below long term interest rate (e.g. 10 year bonds), the yield curve is upward sloping. A downward sloping yield curve reflects the belief that interest rate and inflation will fall in the future, and is an indicator that monetary policy is tight. In figure 3, the downward sloping curve, indicating the tight monetary policy.

Goals of monetary policy

Bank charter is implemented in section 10(2) of the Act, which states the main concerns: the rate of inflation, the rate of unemployment, and the level and growth of national income (Appendix1) (Kriesler, 1999).The monetary policy aims to achieve the medium term and to encourage strong and sustainable growth in the economy.

In the long run, this is the principal way in which monetary policy can help to form a sound basis for long-term growth in the economy (RBA, 2008). Higher rate of income growth usually creates higher employment growth. If the RBA stimulates economic growth, the outcome

will be too high rate of inflation. If the RBA causes interest rates to be set too low inflation will eventually rise, while if interest rate are set too high economic growth will be stifled (Kriesler, 1999).

The Transmission of Monetary Policy to the Economy

The linkage from instruments to indicators and goals is known as the transmission mechanism of monetary policy (Lewis, 1998). The cash rates and announcements of the RBA's intentions are used to influence other market interest rates. These affect aggregate demand and thus output, employment, and prices (Kriesler, 1999).

The higher interest rate depresses aggregate demand, which leads to a reduction in output thus to a reduction in demand for labour by firms, then it is expected to effect on price increases, thus slow the inflation rate.A loosening in monetary policy involves a reduction in the cash rate, which should feed through to other interest rates, it should result in an outflow capital from Australia to countries where interest rates are higher. Resulting a reduction in the demand for Australian dollars on foreign exchange markets. These factors lead to a rise in Australian spending and production and a rise in the price level (Kriesler, 1999).

A negative association incurred between interest rates and both demand growth and inflation (Figure 5). Recent years, cash rate and the inflation occur increasing, but otherwise the growth is declining. Responding to cyclical developments and inflationary pressures, monetary policy has thus had a powerful influence on aggregate demand and inflation in the economy.Figure 53. Analysis of Changing Retail Loan Rates and The ImpactsThe increase in wholesale funding costs due to the US sub-prime crisis has affected banks around the world,

as well as Australian banks, forcing increases in interest rates on retail loans (Bankers, 2008).The spread of bank bills swap rates and cash, revealing that Australian banks had become as eager to increase their liquidity and as reluctant to part with it as banks in the US, Europe and the UK.

Australia's major banks were not as dependent on the Residential Mortgage Backed Securities (RMBS) market as many offshore institutions, but securitization had become very much more important in recent years (Businessspectator, 2008). The smaller players in the home mortgage market depended on securitisation as relatively cheap source of funds in the absence of a retail deposit base. When that market closed, it left a considerable hole in the funding of Australian household demand for mortgages.Australian banks raise most of their liabilities onshore, but there is an important role for offshore borrowing as well.FigureFigureIn the early months of the crisis, the global market has been declining due to lenders were uncertain about the extent of losses in all banks, and were meanwhile seeing the value of their existing portfolios of term bank paper decline. While Australian banks willing to pay a higher spread for short term funding, they were reluctant to pay what to them were unusually high spreads to borrow term until they were convinced the higher term spreads were enduring.

The response of the RBA and financial institutions

Though Australian banks have large offshore liabilities, they routinely swap their foreign exchange exposure into Australian dollars. Through the second half of last year the banks were able to close existing foreign exchange swaps with the RBA and others to meet foreign currency obligations at a time offshore

borrowing was temporarily difficult.While the RBA was active in supporting bank funding in the early months of the crisis, the banks themselves also responded quickly to the change in the funding pattern. This was most immediately evidently in the increased competition for new retail deposits, which have usually contributed about half of bank funding in Australia.

After declining for some time as a share of bank liabilities, deposits bounced back towards the end of last year.By the end of 2007 and the beginning of this year the banks had evidently decided that higher rates would prevail for some time to come. Because major global banks were twist back asset growth and were more interested in supporting their capital base than their lending, demand in offshore funding markets had retreated. In the first quarter of this year the Australian banks borrowed more offshore than in any quarter on record.Through a combination of prompt RBA support and the banks own programs to increase their retail deposits and seize opportunities to borrow offshore, the immediate pressure on bank funding began to fade towards the end of the first quarter of this year.

Australia's points of vulnerability

Australian financial markets are less stressed than they were at the beginning of the year, that major Australian financial institutions have got through without significant damage, and that the prospective impact of the financial crisis on output growth has not been sufficient, in the judgment of the RBA, to discourage it from tightening four times since the crisis became apparent at the beginning of August (The Australian Financial Review, 2008).Share prices measured by the ASX 200 index have doubled in the last three years, even

taking recent falls into account. House prices have increased 30 per cent over the last three years, and roughly doubled since the beginning of the decade (The Australian Financial Review, 2008).In constructing measures of vulnerability to financial crisis researchers often cite a current account deficit, a rapid increase in credit growth, extensive offshore borrowing, high household debt, a period of rapidly rising asset prices, and rising inflation as indicators of risk.

The strengths of the regulatory arrangements, the financial system and the economy.It is evident that despite the apparent vulnerability of the Australian financial system to precisely the kind of crisis which began in August, and despite the fact that many of its manifestations were apparent in Australian markets as soon as they become apparent in the US.There were major cyclical differences between Australia and other comparable economies. The big Australian boom in house prices and sales of established houses, which was quite as formidable as the boom in the US and the UK, ended in 2003. Mortgage loan growth through 2006 and into 2007 was not much less than half the rate evident during the boom.

House price growth had only just resumed, after several years of sluggish movement in median house prices. After a period of sharp decline associated with the housing boom, household savings as a share of GDP were rising through 2006 and into 2007. The credit crisis hit Australia after a period of household balance sheet consolidation. Much the same is true of the home construction industry. House construction was also quite weak through 2006 and into 2007, with the beginnings of a recovery only becoming evident after a sharp downturn in

2004 and 2005. By the middle of 2007 there was no Australian housing boom to leak.

One of the causes of the housing slowdown was the gradual tightening of the Australian cash rate since 2002. By the middle of 2007 the variable mortgage lending rate was 200 basis points higher than it has been in 2002. Australian mortgages are typically variable rate, the predominance of variable rates and the persistent upward trend in the cash rate, together with the evident slow growth in national median house prices, meant that by 2007 borrowers had already been discouraged from taking on loans they would not over time be able to service (Edwards, 2008).The durability of the investment upswing was underpinned by the unusual incidence of the credit crisis. It began in the US rather than in a less developed economy.

Driven by its own industrialisation, a capital exporter rather than importer, and with a sheltered financial system, China's growth was unaffected. So too, therefore, were the prospects for higher prices for Australian metals minerals and energy exports.Because of strength and durability of output growth, employment growth was quite strong and the unemployment rate had reached and then fallen under a 30 year low. Household incomes were rising quite firmly.5. Assessing the economic impactThe primary channel of influence of a financial shock on the real economy is often the exchange rate, but in this instance the exchange rate against the US dollar has continued the upward trend apparent well before July of last year.

Due to credit crisis much of this Australian dollar strength has reflected US dollar weakness, but even against Euro the Australian dollar remained fairly stable (Edwards, 2008).The

credit crisis has certainly exerted influence through the interest rate channel, though it needs to be borne in mind that the RBA has been increasing the cash rate through the episode, now by a total of 100 basis points. Since the most recent RBA increase was at the beginning of March this year, we must assume that it did not assess the impact of the credit crisis on market interest rates to that point as sufficient to achieve the slowdown it sought. The increase in market rates are significant, but not nearly as significant as the increase in the policy rate controlled by the RBA. From the beginning of the episode to now the yield on AAA 1 to 5 year notes has increased by around 120 basis points and the spread over government bonds by a similar amount (Ford, 2005). The standard variable home loan rate has increased 150 basis points, so two thirds of the increase was anyway explicitly sought by policy.

There may well be some channel of influence through business and consumer confidence, both of which have fallen since July last year. Turbulent market conditions and the collapse of the low-end US mortgage market have affected the value of some CDOs."When CDO products were offered, it was an attractive investment security with a stable and attractive return and an independent AAA rating, however, the US subprime crisis and the global credit crunch has resulted in many CDOs being downgraded and caused substantial write-downs for many global financial institutions and investors." (The Age, 2008)Declining consumer confidence corresponds to the weakness of retail spending volumes in the first quarter of this year, and perhaps

the decline in demand for housing lending and the slowdown in established house price growth in the March quarter (The Australian Financial Review, 2008).

Conclusion

In conclusion, if the housing price continues to decline, many more banks and companies will face bankruptcies. Prices of stocks will continue to decline, as people will not invest their money in high-risk financial market. Economic growth will also slow down due to credit crunch, thus many of the world's central bank will cut off interest rate in an attempt to counter the credit squeeze. Banks will increase rules and regulations in lending requirement, thus making it hard for prime borrowers to make a loan.

Banks in order to lessen the default risks faced when providing loans will impose higher interest rate loan to borrowers. As Australia is not greatly exposed to the effect of the sub-prime crisis, the economic growth will not be much affected.