Official rates will fall - retail rates may not

The Commonwealth Bank of Australia (CBA) is under fire from all quarters over its decision to raise its standard variable rate (SVR) loans by 10 basis points. Of the four big banks, CBA had the lowest SVR and even after this increase its SVR is still equal lowest. Prior to this, other banks had been quietly making adjustments to fixed rate loans. But this most recent increase has brought forth howls of gouging leading a federal senator to suggest a committee to investigate the incidence of bank gouging. However, what appears to be going on is just some good old fashioned speculation and supply and demand issues.

The speculation comes from the recent run of stronger than expected economic figures, including the 0.5 per cent GDP growth in the March quarter and last week's strong employment report. This has led financial markets to start trading on the basis that the Reserve Bank (RBA) will keep interest rates at 3 per cent this year before raising them to 4 per cent early in 2010. As a result, the cost of three-year funding for the major banks has increased by nearly 150 basis points, from 3.5 per cent to almost 5 per cent, over the past three months. Economists argue that it is this trading pressure that is forcing the CBA and other banks to raise their mortgage rates. In these circumstances the banks can either reprice the cost of lending to reflect their costs and continue to lend or they can leave prices where they are and restrict the amount they lend.

Now the government is within its rights to become indignant about all this. After all it wants to encourage spending and having the cost of borrowing as cheap as possible assists in this outcome. Also a little bank bashing goes down well with the electorate in any circumstances. But there are real implications for monetary policy if funding costs continue to rise. This will only be exacerbated as governments around the world continue to raise debt to fund deficits as part of their attempts to stimulate economies.

In the current economic conditions these pressures on the cost of retail lending rates are certain to push the RBA's hand. According to Macquarie Bank "[as] key lending rates [continue to rise] while unemployment is trending higher, pressure will build on the RBA to cut its policy rate below 3 per cent." How much they might cut and how much will be passed on by the banks remains to be seen.

In the short term a cut of 25 points seems most likely and we believe most or all of this will be retained by the banks to ease current funding pressure. The government will make noise about passing on these cuts to customers but what is more important is that credit remains as widely available as is prudently possible. The cost of borrowing to retail customers is at an all time low. Trying to make money cheaper now wont help the economy as much as ensuring (or even increasing) its supply.

In the medium-term rates are likely to stay low. A large part of the current specualtion about rising rates is mostly based on resurgent inflation. The minutes of the last RBA meeting indicate that concern about inflation in some markets to be unfounded at present stating, ''the outlook is for a fairly gradual expansion getting under way later in the year, with spare capacity tending to increase and inflation tending to decline''. Spare capacity means supply will outstrip demand so price pressure (inflation) will fall.

What concerns the board more is the continuing collapse in business invesment and its implications for unemployment. In its statement the RBA said:

''Business credit had fallen in the past few months, though other sources of funding had been stronger ... Many businesses were facing higher risk margins when loan facilities were rolled over or renegotiated, and many had experienced a significant tightening in the terms under which credit was available.''

Overall we believe the statement to indicate a contiuing bias towards easing monetary policy largely in support of business investment and its implications for employment. Though the cash rate is likely to fall, variable retail rates may not and fixed term rates may see modest increases. Although changes to official rates might provide an opportunity in fixed rate pricing for some banks to attempt to attract increased volumes. As always, we'll keep you posted.

(source: Sydney Morning Herald; News Ltd)