Monday, September 10, 2007

Tuesday column: The RBA loses control

The Reserve Bank has lost control of interest rates. As a result everything you’ve ever heard about the Bank “setting”, “tightening” or “adjusting” rates no longer applies. For the moment, it can’t do any of those things.

They idea that it could was always a fiction, perpetuated knowingly by the likes of myself and other financial journalists because it would usually be close to the truth and because the more we said it, the closer it became to the truth.

The Reserve Bank can’t set interest rates any more than a punter on a horse (or an election date) can set odds.

The Bank can influence rates because it is big and not easily trifled with, but it can no more guarantee a rate than can any big borrower or lender...

Some years ago the Bank of England declared that it could set the British exchange rate. It announced a rate of 2.95 Deutsche Marks to the pound and kept buying pounds in an attempt to keep it there.

The billionaire speculator George Soros didn’t agree that that should be the rate and relentlessly sold pounds and borrowed pounds in order to sell them until, ten billion pounds later, the Bank of England gave up and let the exchange rate plummet. Soros made a one billion pound profit.

Australia’s Reserve Bank has no more say over the price of money - the interest rate - than a big buyer or seller does over the price of apples at the fruit market.

It can try, and assert that it is in control (as I and others have assisted it to do for years) but it can’t issue a decree. Interest rates are prices. Australia lacks price controls.

When the Bank began announcing its efforts to adjust rates early in 1990 it spoke modestly about attempting to achieve a target. It now speaks more grandly about “decisions”.

Its latest announcement on August 8 said that it had “decided to increase the cash rate to 6.5 per cent”.

Two days later international financial markets went into free-fall and it lost control. Money market interest rates haven’t been near 6.5 per cent since.

When lenders worldwide discovered that the many of the US mortgage financiers through which they had lent money misled them about whether it could be paid back, many stopped lending – to anyone.

With money in much shorter supply, just as with apples in shorter supply in the fruit market – the price went up. In Australia the 90-day bank bill rate, which normally hugs the Reserve Bank’s target rate and is used to price other rates, climbed above 7.0 per cent – two entire rate hikes above than the Bank’s target.
Late yesterday the bill rate hit 7.07 per cent – entirely new territory for a cash rate target that’s supposed to be 6.5 per cent.

The usual way for the Bank to get the bill rate back down is to advance financial institutions money in return for collateral – a bit like unloading several more trailer-loads of apples at the fruit market. The Bank’s been unloading and furiously. Last week it announced that it would broaden the range of securities it would accept as collateral.

But as fast as it has pumped truck-loads of cash into the hands of Australia’s financial institutions they have sat on it. They’ve kept it away from the market, preventing the price (the interest rate) from falling.

Why are our financial intuitions and others all around the world sitting on money rather than on-lending it for profit?

Because they know they are about to need it themselves, big time.

All of our lenders on-sell some of their loans overseas. They bundle up at least some of their mortgages and sell the right to repayments to foreigners.

Non-bank lenders such as Rams, Wizard, Resi and the like do little else. Even the big banks bundle up a fair proportion of their loans to on-sell because they no longer have enough money on deposit to fund all of their loans. We’ve lost interest in parking our savings in low-interest savings accounts.

With lenders overseas suddenly (and hopefully temporarily) reluctant to part with their money Australia’s big banks have to lend out their own funds instead. In financial language they are eating into their capital. It is making their loans more expensive.

For non-bank lenders things are far worse. They don’t have deposits to fall back on. It is entirely possible that one or more of them will fall over.

The Rams share price has fallen 60 per cent in the last month.

When non-bank lenders do disappear, or when they are forced to charge prices so severe they are no longer competitive, Australia’s big banks will push up their rates too, regardless of what the Reserve Bank does.

For two reasons. One is that, to varying degrees, they too will be paying more for the money they lend. The other is - because they can.

When Rams, Aussie and the like began stealing business from the big banks in the mid-1990’s first the Commonwealth Bank, then the ANZ Bank, then all of the big banks sliced their margins and cut their rates to meet the competition without waiting for a move by the Reserve.

At the time the Treasurer Peter Costello hailed the working of the market declaring that competition was the best interest-rates policeman.

When that competition vanishes the banks will push their margins back out to about where they were before. That’s also the working of the market.

The market has taken over from the Reserve in setting interest rates. The Bank appears unable to get that control back without cutting – yes, cutting – its official cash rate target in the months ahead.

As recently as one month ago - before everything changed - no-one would have thought it possible.