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Has The Reserve Bank of NZ lost its effectiveness?

Written by: David Weusten

Article Overview: A review of the tool the Reserve Bank of New Zealand uses to manage inflation in New Zealand and the limited effectiveness this provides.

Has The Reserve Bank of NZ lost its effectiveness?

The Reserve Bank of NZ raised the Official Cash Rate (OCR) 25 basis points to 6 25 % on Thursday the 9th of September 2005.

That means in the last year, the OCR has risen 125 basis points and the economist are predicting more. But what impact has it really had on the NZ economy?

Is the Reserve Bank firing blanks or merely proving nuisance value?

I ask this because the RB chooses not to exercise control over the exchange rate and it has very little control over the mid to long term fixed interest rates (as these are effected by the international interest rate market) so all that is left is floating rates and the 6mths and one year fixed rates.

My borrowing clients merely fix for the best rates around the two years and wait for the Reserve Bank to reverse its heavy handedness as commented on by the ANZ economics departments publication dated 28th May 2004 commenting on the poor control exercised by the Reserve Bank of New Zealand.

“..the market is also wary of the undulating nature of the OCR since 1999. Up in 2000, down 2001, up 2002, down 2003, up 2004…bets anyone on 2005”

Background

From about 1986 to March 1999 the Reserve Bank used the Monetary Conditions Index (MCI) to control the economy. It required balancing the exchange rate against interest rates. If one went up the other had to go down. In fact, countering a falling currency with rising interest rates during the 1998 Asian crisis pushed New Zealand into a recession and led ultimately to the abandonment of the MCI as a control mechanism.

The MCI could be seen as New Zealand’s economic accelerator. A lower TWI meant cheaper New Zealand exports and rising demand for our products. This stimulated economic activity and so interest rates were increased to put brakes on the economy and keep inflation in check.

The OCR

The OCR replaced the failed MCI and the Reserve Bank hoped this would be a more effective control mechanism (maybe it would be if used effectively, as commented above). The market uses the OCR and it’s anticipated direction to price the 90-day bill rate (the interest rate that is charged on money borrowed or lent for 90 days) The market sets the 90-day bill rate and the market moves this rate in the direction it anticipates the OCR going. The rate at time of writing is 6.39 % so the market is anticipating future rate rises. With the banks wishing to maintain their margin of 2 % over their cost of funds, floating housing rates will probably rise to around 8.39 % or higher.

With Mortgage Brokers involved and the competition of non-bank lenders willing to accept smaller margins this will probably help to keep the floating rate generally a little below this.

Current options.

The floating rate currently sits around the 8 % mark and is likely to go to 8.5 % by the end of the year. Most economists believe it will peak there. So by just leaving your loan ‘floating’ this shouldn’t prove to hard on the budget. If you have lumpy income or are expecting significant surplus funds, then the flexibility of the floating option is valuable to you.

Of course if you are lucky enough to have a bank that is willing to discount for volume or offers a package, then you may save up to .5 % anyway.

Summary

While the New Zealand economy is humming along, (and it looks like this will continue for quite some time yet), the pressure on production capacity, skilled staff and other resources will translate into upward pressure on inflation (wages go up in order to secure the reducing amount of skilled labour). The Reserve Bank has a brief to keep inflation under 3 % so to date the Reserve Bank has not managed to control this very well.

If you can secure a 2 year fixed rate for around the 7.5 % mark then you would be fixing around the historical trend rate and pretty much hold the middle ground. I would caution anyone fixing for 5 years because to be locked into a bank for that length of time could prove quite claustrophobic and expensive should you wish to exit if rates fall again (which I believe has a high probability of happening).

If you are still not sure what to do in your circumstances, ask an NZMBA accredited mortgage broker, of which the writer is one.

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