2015-04: The Mortgage Interest Rates and Cash Rate Cycle Relationship and International Funding Cost: Evidence in the Context of Australia (Working paper)

Australia is a nation of home-loan borrowers. Hence, the movement of mortgage rates is closely watched in the country. Borrowers expect mortgage rates to synchronise with the cash rate, particularly when the cash rate decreases. More recently, however, the media has reported a weakening of this link. This has been accompanied by complaints from the public and politicians that banks no longer automatically pass on full reductions in the cash rate to mortgage holders. Banks claim that this is due to the effect of international funding costs. We test this claim in this paper. We investigate the relationship between mortgage rates and the cash rate, taking into account international funding costs in the context of Australia. Using a battery of econometric tests, we analyse data pertaining to all 20 Australian banks during the period 1996 to 2012. We find that international funding costs significantly affect mortgage rates, but the cash rate still continues to drive mortgage rates in Australia. However, the linkage between the cash rate and mortgage rates has indeed weakened since 2006. Our findings, therefore, confirm the divergence of mortgage rates from the cash rate cycle and provide support for the claim by banks that this is due to the effect of international funding costs. The innovation of this paper is that it is the first to test the effect of international funding costs in the context of the cash rate cycle and mortgage interest rate relationship in Australia.