Monetary policy — its all about new loans

by

The Big4 banks’ refusal to fully pass on the RBA’s 25 basis point (bp) cut on Tuesday “has blunted the effectiveness of monetary policy” , according to Wayne Swan.  I don’t think the Treasurer’s statement is correct.   

Through its monetary policy a central bank controls the interest rates, and volume of money in circulation, in an economy, with the objective of stabilising prices and/or economic growth.   The conversion of liquidity into credit by commercial banks is the main mechanism of monetary policy.  In Australia the banking mortgage channel is a large part of overall credit creation by banks.  Ok, that is very standard.  But the point I think the Treasurer misses is that monetary policy acts mostly through the creation of new loans, rather than changing the interest rate on existing loans. 

Interest rates are the exchange rates between the present and the future.  Reducing interest rates makes present consumption more attractive relative to delayed consumption (saving), so consumption spending rises.  Moreover, as the cost of debt and equity capital declines with interest rates, investment projects become more valuable (future cashflows get discounted less heavily) and investment spending rises.   Increased consumption and investment occurs through new loans, and therefore monetary policy acts through new loans rather than existing loans. 

Consider the effect of the banks not cutting rates on existing mortgages.  By not passing on the full 25 bp, the banks are holding on to about $800 million per year ($500 billion of variable rate mortgages times 16 bp held across the four banks).   That is, households pay $800 million per annum to the banks that they would otherwise hold onto.  That is bad for the households, but why does it blunt monetary policy?  The households would spend or save the money.  But, the banks will simply lend it on, creating more credit in the economy, or pay it out as dividends.  The repricing of existing loans is fairly neutral in monetary policy terms. 

New loans are a different story.  Lower housing interest rates stimulate demand for credit to buy and build houses.  So long as that credit can be supplied (and as money volumes expand with lower rates credit should expand), then lower rates will stimulate economic activity. 

The effect of monetary policy in the mortgage market is principally through new loans not existing loans.  Existing loan rates are set by bank fiat, but the rates on new loans are negotiated with banks.  Households shop for mortgages, and the acheivable discount on a new loan is determined by competition between the banks. 

The banks’ pronouncements about passing on the RBA cut, are statements about rates on existing mortgages and therefore not closely connected to monetary policy.  Those pronouncements are not statements about the rates on new mortgages because those rates are determined by competition.

4 Responses to "Monetary policy — its all about new loans"
  1. I wonder why there is no comment on this post. I think it is a unique way of thinking to distinguish between rates of new and existing mortgages and the difference in there impact on the monetary policy and hence the economy. If what you are saying  is correct (it does sound very logical!) then it is a great post.

  2. can anyone answer how an expansionary monetary policy affects the credit creation process of commercial banks??

%d bloggers like this:
PageLines