Examining explosive growth in debt ratios

Central banks have lent freely, although not at penal rates, as the central bankers were too nervous to risk this classic response. The US central bank has cut cash rates 50 basis points, stimulating a large bounce in share prices.

Australia has been relatively immune from the effects of the sub-prime ripples. One or two banks have been the subject of rumours but the Reserve Bank has reportedly begun to mop up the excess liquidity.

The graph shows the official cash rate while the slightly higher line shows an average market-based bill rate. The gap is a measure of stress in cash markets. The normal gap is 10 to 15 points, but this blew out to more than 50 basis points during the crisis. Note the subsequent fall back, not all the way but signalling a clear relaxation of market stress.

Two very recent bits of economic data suggest the overall effect on the economy has been effectively unnoticeable. With the sub-prime crisis and the August rate hike, credit growth was expected to moderate. Instead it accelerated. Total credit grew 1.5 per cent for the month and 15.6 per cent for the year to August. Housing credit grew a "robust" 0.9 per cent for the month, while business credit grew a "staggering" 2.7 per cent for the month and 22.4 per cent for the year.

Job vacancies are growing strongly, by 2.9 per cent in the three months to August and 11.9 per cent over 12 months. Unemployment is set to fall below 4 per cent for the first time for a generation and may fall further.

The boom goes on and may be accelerating. Monthly data on inflation suggests outcomes close to the top of the target range of 2-3 per cent.

Battellino concludes by saying there are two issues that arise from the developments in household finances over the past decade or two.

"The first is that the rise in household debt has made the household sector more sensitive to changes in interest rates. This has meant that central banks have been able to achieve their monetary policy objectives with smaller interest rate adjustments."

This general point has made the Reserve Bank cautious - too cautious it will be judged if indeed the boom is accelerating.

"Second, the household sector is running a highly mismatched balance sheet, with assets consisting mainly of property and equities, and liabilities made up of debt. This balance sheet structure is very effective in generating wealth during good economic times, but households need to recognise that it leaves them exposed to economic or financial shocks that cause asset values to fall and/or interest rates to rise."

A third point, which was not made, is that the great credit bubble of the past 30 years has been caused in part by monetary policy that has been too easy. If this great boom is followed by a great bust, this will be the main point.

It was entirely appropriate that Battellino's talk was delivered in Melbourne, the focal point of Australia's great asset and credit bubble of the 1880s.

Could the deputy-governor in fact be more subtle than he seems?