Blog: ‘Bad old days’ of credit regulation might be better than rate rises – The Australian Financial Review

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

But higher interest rates were not thought to be a major influence on consumer spending. After all, every dollar borrowed by someone is a dollar lent by someone else, such that higher interest payments by some are matched by higher interest receipts by another (or perhaps higher bank profits if the flow through is less than complete!) Only if the sensitivity of spending of lenders and borrowers to interest rate changes was different might there be some predictable effect.

Not always the case

It was not the usual case to expect a major channel of monetary policy to be conducted through the reduction in free cash flows and spending ability of households with outstanding mortgages who are now facing higher loan repayments. Of course, that might be very effective. For recent borrowers in particular, interest (rather than principal) payments are a very large part of the total meaning that large increases in payments result from interest rate increases.

For those with already high debt service (repayment/income) ratios, scope to reduce living expenses can be limited. The “wagyu and shiraz” example of making less luxurious dining choices hardly applies for lower income borrowers.

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

The recent RBA cash rate rises have already eaten up most of the 2.5 percentage point buffer. The recent unexpected rise in the price of many essentials suggests that the buffers may not have been sufficient (or inappropriately calculated) to prevent many cases of hardship.

If this is so – undoubtedly so in some cases, although a media “beat-up” may overstate the case – it should be asked whether there are other ways the authorities could act to rein in demand. That is particularly the case if banks do not, or are unable to, extend the term of mortgage loans for those facing hardship such that current cash flow repayments are left unchanged or only marginally increased.

The “wagyu and shiraz” example of making less luxurious dining choices hardly applies for lower income borrowers.

One option would be to take actions which reduce bank lending – thus focusing more directly on investment type expenditures financed in this way. One such approach would be direct controls on the quantity of bank lending, although many would see this as a return to the “bad old days”. (Even though APRA has recently used loan/valuation 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 thus it warrants questioning whether relying on a blunt weapon such as interest rate increases to achieve policy goals, which may adversely affect a significant number of households, is appropriate and desirable.

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