Brian Fallow: Bollard may be left with blanks

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Another jumbo-sized official cash rate cut from governor Alan Bollard today will no doubt be greeted with a kind of grim satisfaction by borrowers.

But not, perhaps, by another numerous group - depositors.

There is a lot of speculation these days about how low the OCR will eventually go, with expectations clustered in the 2.5 to 3 per cent range.

The better question is how low can it go before it loses traction and becomes largely irrelevant to interest rates out here in the world.

Even after today's cut, the OCR will be high by international standards, leaving Bollard with more bullets in his bandolier than his international peers.

But some will be blanks, and none of them is silver.

Putting their money in the bank remains New Zealanders' preferred savings option, according to ASB's quarterly survey of investor sentiment.

But deposit interest rates have fallen sharply over the past six months, like everything else. Reserve Bank data show rates for six-month deposits fell from 8.5 per cent last June to 4.8 per cent by the end of the year.

They also show base lending rates, offered to new business borrowers, hardly budged over the same period. Funny that.

At current levels for many savers, real after-tax returns from deposits are now negative.

It is fortunate for the banks, because deposits remain their biggest source of funding, that these are risk-averse times and alternative asset classes are in a woeful state.

ASB's chief economist Nick Tuffley says that while there is nothing to stop the Reserve Bank from cutting the OCR all the way to zero, as the US Federal Reserve and Bank of Japan have done, there will come a point where OCR cuts lose their potency in driving down effective interest rates.

"For example, deposit rates will need to remain competitive with risk-adjusted returns available from alternative investment vehicles."

If the OCR gets very low it will just mean a wider gap between it and the rates banks need to pay for retail deposits if they are to keep on attracting them.

And as far as banks' wholesale funding sources are concerned, the OCR, or rather expectations for the future track of the OCR, are only one influence on wholesale interest rates. A risk premium is added to that, influenced by global market conditions and New Zealand-specific factors.

It is not just that there is a global credit crunch going on. Our interest rates are systematically higher than other developed countries' if only because our net international debt stands at the conspicuous level of around 90 per cent of GDP.

Spreads in the overseas credit markets upon which we have come to rely may have narrowed from the scary, market-freezing heights they reached in September and October last year but they remain high.

The Treasury has just hacked 50 basis points off the fee it charges the banks for a Government guarantee of longer-term debt issues.

At the rates it set when the guarantee was introduced in November, there have been no takers. The banks have preferred either to borrow for short terms without invoking the guarantee or to use the Reserve Bank's version of a pawnbroker's window.

Treasury secretary John Whitehead said the cost of raising longer-term funds faced by banks in other countries, operating under their own guarantees, had proven much higher than anyone had expected.

While New Zealand policymakers can control the price of the insurance service they provide, they cannot influence that underlying cost.

So there are limits to the extent OCR can influence the banks' retail and wholesale funding costs, and thereby the rates they charge.

The major central banks have all slashed their policy rates and, for those where it is arithmetically possible, more cuts are expected.

ANZ National Bank chief economist Cameron Bagrie notes that during the last two recessions, in the early 1990s and 1998, the gap between short-term interest rates in New Zealand and its major trading partners shrank markedly.

But he offers several reasons that could count against further aggressive easing from here.

Clearly, the more Bollard front-loads his easing, the less ammunition he has in reserve if things get uglier.

The recession will be long, Bagrie says, and monetary policy will have to be seen to continue acting. "If the unemployment rate is moving up aggressively over the entire 2009, the Reserve Bank will find it tough to sit on its hands."

In addition we have an enormous current account deficit to fund, in a global environment when investors are displaying a lot of home bias - witness the strange strength of the US dollar - and there is increasing competition for debt capital.

Safety rather than yield may be at the forefront of investors' minds at the moment. But New Zealand is hardly a major economy and will still need to offer a decent yield to attract the capital it needs, Bagrie argues.

The swaps market expects the OCR to be a bit below 3 per cent in a year, possibly touching 2.5 per cent en route.

That would be a whopping 200 basis points below the trough implied in the Reserve Bank's December monetary policy statement.

Westpac's chief economist, Brendan O'Donovan, argues that the dismal news since then, on world growth prospects, commodity prices and New Zealand firms' intentions, would be worth 200 basis points of rate cuts under the Reserve Bank's economic model. He is picking a 2.50 per cent bottom for the OCR cycle.

But others expect Bollard today to start trying to haul upward market expectations about the depth and duration of the OCR cycle's trough.

Policy rates are not the only tool central banks have, however.

They can also influence interest rates by buying interest-bearing securities issued by corporates and governments.

The Federal Reserve has been doing this sort of thing for some time and its chairman Ben Bernanke has been at pains to stress that the Fed is not out of ammunition just because the Fed funds rate is effectively zero.

But doubts linger about this "quantitative easing" approach. Sceptics worry about the longer-term implications of the expanding size and deteriorating quality of central banks' balance sheets.

Will they be able to "sterilise" this expansion in their assets by borrowing more themselves? If not, they could be fuelling inflation down the track.

How do they know how much is enough? And what is the exit strategy? How do they unwind these positions?

It is a sign of the perilous times that the questions outnumber the answers.

Today's Reserve Bank announcement - OCR cut to 3.5pc

- NZ Herald

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