How do reserve banks influence home-loan interest rates?

Question

On the First Tuesday of every month the board of the RBA (Reserve Bank of Australia) meets and sets the target for the cash rate.

I understand that they are trying to adjust the amount of money people have to spend by changing the amount of people's income that goes into paying their home loan.

The question is how does the RBA affect the interest rate of these home loans?

This isn't a legally-binding level on the banks: it's uncommon, but it does happen, that banks don't follow the RBA or they change their rates independently of the RBA.

Also, if interest rates are going up, why doesn't one off the bank decide not to move their home loan rate up with every body else, in order to offer a discount and gain more customers?

Answer 1

The Reserve Bank of Australia's role in monetary policy has three objectives: currency stability (primarily keeping inflation within a narrow band); full employment; and improved prosperity and welfare.

Its primary weapon in this, is its setting of a target for the cash rate - the overnight money-market interest rate charged between financial intermediaries. Short-term market rates closely track this cash rate target, because the Reserve Bank controls the supply of funds that banks use to settle the transactions that use the overnight money-market interest rates.

Australian capital markets are liquid, with many deposits / loans being on variable-rate or short-term rates; hence changes to the cash rate quickly propagate throughout the market. NB that the changes propagate, but not all interest rates are at the same level: the absolute values don't propagate. Different interest rates will reflect different loan periods, and different (perceptions of) risks.

Banks are profit-maximisers. So they won't loan at a lower rate to one borrower, if they can loan the same money to someone else at a higher interest rate (and the same or lower risk). And they won't lend money out, unless they can cover the cost of their own borrowing, plus overheads, plus a reward for the risk of the loan.

Hence the home loan rates of all banks will tend to move in the same direction, by broadly the same amount, at the same time.

Answer 2

Banks conduct "Transfer Pricing" reviews. In fact Home Loan interest rates are only really important to the media and opportunistic politicians. The standing joke used to be borrow at 'x', lend at 'y', and be on the 18th hole by 'z'. The rate set by the RBA is only loosely indicitive of the cost of funds.

Borrowing for capital expenditure (sheet metal presses, trucks, plant) is far more important to the economy. The RBA does not consider the plight of Joe Mortgagor to be terribly important.

In addition the amount of freely available cash in the consumer pocket is no longer as tightly coupled to home loan repayments.

Forty years ago we did not have families paying hundreds of dollars a month in tolls, nor in mobile phone and internet plans. School fees can be four times as much as the interest on the home loan. Tax is a lot higher (bracket creep), there is no child endowment.

There are of course other barriers to industry besides the cost of borrowing, red tape, environmental considerations, planning and approval, the nimby brigades etc.

Building industry jobs are "hamburger jobs", there is no particular reason to use the building industry to alleviate unemployment, especially if many of the created jobs go to low wage visa holders working here temporarily.