At 2.30pm this afternoon, the Reserve Bank of Australia (RBA) will announce whether or not they will be changing the official cash rate. The bank began increasing the cash rate just over a year ago and since then it has risen by 1.25% to its current level of 4.25%. Most observers in the financial markets expect the RBA to lift the rate another 0.25% today, pointing to last week’s inflation figures as one of the key factors. One of the RBA’s stated objectives it to attempt to maintain “an inflation rate of 2–3 per cent, on average, over the cycle”. That phrase “over the cycle” gives the bank a fair amount of wriggle room, nevertheless it will certainly be concerned that the inflation rate for the March 2010 quarter was 0.9% (or 3.6% on an annualized basis). The RBA uses a number of smoother measures of inflation that aim to strip out some of the volatility in the headline inflation numbers. One of these, the “trimmed mean”, is widely considered to be one of the bank’s favourite smoothed measures and the March quarter reading has now nudged outside the 2-3% target band.
Australian Inflation (2003-2010)
However, the point of this post is not to speculate on the likelihood of another rate hike, but to respond to a query from a reader about the link between the RBA official cash rate and mortgage rates.
In Australia, most home owners have “variable rate” mortgages, so their interest rates can go up and down over the life of the mortgage. It is possible to lock in “fixed rates”, although typically the fixed rate periods only last from between 1 to 5 years. In contrast, the most common mortgage product in the United States is a 30 year fixed rate mortgage, which certainly takes away a significant element of risk for borrowers. An indication of just how significant this risk can be is evident in the fact that the US “sub-prime” mortgages at the heart of the global financial crisis were not fixed rate mortgages and big increases in interest rates tipped many borrowers into default.
The United States aside, variable rate mortgages are very common around the world. What is rather unique to Australia is the way in which rates can vary. In most countries, variable rates are set relative to a standard published benchmark. Since the point of a variable rate is to allow lenders to increase (or decrease) what they charge borrowers as their own short-term borrowing costs change, these benchmarks are typically short-term market rates such as surveyed inter-bank lending rates (typically a 1 month or 3 month rate) or perhaps the official central bank cash rate. These central bank rates apply to very short-term borrowings, typically applying for somewhere between one day and one week (for example, the RBA cash rate is an overnight rate), but have the advantage of not moving around too often. A mortgage-lender might then quote their mortgage rate as, say, 2% over the benchmark rate.
In Australia, things are a little different. The standard variable rate is a so-called “discretionary variable rate”. Put simply, this means that the rate can be whatever the lender wants it to be. Try explaining that to anyone from another country and they would be horrified (I can speak from experience here), but in Australia we seem to have become accustomed to giving all this discretion to our lenders. The usual justification for this approach is that competitive pressure would stop a bank abusing the power inherent in that word “discretionary” and in practice all the banks move their rates in line with the RBA cash rate anyway.
Of course, since the onset of the global financial crisis put pressure on funding costs for banks, this link between the official cash rate and mortgage rates has broken down. Back when the RBA was cutting rates, banks were cutting mortgage rates by less than the RBA cut and, on the way back up, they have been hiking in bigger increments than the RBA*. Some have even increased rates “out of cycle” (i.e. independently of the RBA cash rate movements). Once upon a time, the then Treasurer Peter Costello said that any bank not passing on an RBA cut in full was a “bastard”. Things are different now and if the RBA does indeed increase rates today and you have a mortgage, do not be too surprised if your mortgage rate goes up by even more. If you don’t have a mortgage, try not to gloat. It is unseemly.
* UPDATE: as noted in the comments below, the RBA has estimated that mortgage rates have increased by around 1.3-1.4% more than the official cash rate.