Brian Fallow on the economy

Brian Fallow is the Herald's Economics Editor

Brian Fallow: Don't count on OCR fall as Bollard exits

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The markets are in a 'risk off' phase, reflecting heightened levels of concern about Europe's sovereign debt crisis. Photo / AP
The markets are in a 'risk off' phase, reflecting heightened levels of concern about Europe's sovereign debt crisis. Photo / AP

Money market pricing implies governor Alan Bollard will drop the official cash rate from 2.5 to 2 per cent before he leaves the Reserve Bank in September.

Don't count on it.

The hints he gave at the time of the March monetary policy statement about the possibility of cutting the OCR were in the context of frustration at a dollar that seemed stuck about US82c.

Since then it has fallen to US76c and by more than 4 per cent on a trade-weighted basis.

In addition, longer-term wholesale interest rates have dropped, allowing banks to lower fixed mortgage rates.

Five-year swap yields, for example, at 3 per cent are about a full percentage point lower than their previous trough in the global financial crisis and about half their long-term trend level.

Monetary conditions, in short, have eased significantly without the Reserve Bank having to do anything.

The markets are in one of their binary "risk off" phases, reflecting heightened levels of concern about Europe's sovereign debt crisis.

But the same consideration incentivises the Reserve Bank to keep its powder dry.

When the GFC hit, the bank was in the fortuitous position of being able to slash the OCR by 575 basis points.

That was very helpful.

Were we to face GFC II, the sequel, it is better placed than many central banks in still having 250 basis points of easing power before it runs into the dreaded "zero bound" and cannot cut the OCR any more.

Don't expect it to fritter that away.

ANZ's head of global markets research, David Croy, says that if the situation in Europe got significantly worse the Reserve Bank could be called upon to embark on a series of emergency OCR cuts.

Rather than regard current market pricing as a conviction that the central bank will cut by 50 basis points in the next few months, it should be seen as a hedge or insurance against the possibility of much deeper cuts.

"In some ways you could view the 50 basis points of cuts priced as representing a 20 per cent probability of the OCR being cut to zero in response to an Armageddon-style scenario playing out in Europe. We would ascribe [a] significantly lower probability to such an event," Croy says.

Or a one-in-three chance of a 150 basis point easing.

Westpac chief economist Dominick Stephens says: "In the event of a serious disruption to the European, and therefore the global, financial system we could be looking at an OCR of 1 per cent. But the main form of adjustment would be a sharply lower New Zealand dollar."

Local market economists do not discount the possibility of OCR cuts altogether - Stephens puts the odds at 25 per cent - but they expect the next move in the OCR to be up, though not until March next year.

Bank of New Zealand economist Craig Ebert attributes the stark difference of view between the markets and the economists as a preoccupation on the part of the former with a menacing global outlook, while the latter are conscious that local economic conditions, if not flash, are not falling over either.

"You could characterise it as a trader in New York thinking the world is about to end and how can New Zealand possibly avoid it versus people in New Zealand saying it is bad in Europe and could well get worse, but it is not going to be the death knell of the New Zealand economy."

Last week's Budget was predicated on a rather upbeat view of NZ's prospects and an expectation that Europe will muddle through.

The Budget is contractionary, significantly so in the year after next.

It reflects the Government's belief that the dangers in piling up debt at the current rate are great enough to justify shutting off the fiscal irrigation and hoping enough rain will fall to keep the economy verdant and growing.

But two of the three sources of stimulus behind what has been a fairly weak recovery so far have now veered from tailwind to headwind: fiscal policy and the terms of trade. The third, extremely loose monetary policy, may remain in place for a while yet, but it carries dangers of its own.

Mortgage rates are at multi-decade lows, a 47-year low in the case of floating rates.

Low interest rates are one of those good things - like debt and fiscal consolidation - that you can have too much of. An extended period of ultra-low interest rates could encourage people to think they are now the norm.

A couple who can afford a mortgage only at these rates probably can't afford a mortgage.

The risk is it begins to inflate another housing boom.

The glass-half-full view - espoused by the Reserve Bank - is that the legacy of the last boom in terms of households debt and lousy affordability metrics means that another one is unlikely.

The glass-half-empty view is that the fact house prices didn't crash after the last boom, combined with distortions in the tax system, could mean our immunity to another outbreak of virulent house price inflation is impaired.

"There is a serious risk that low mortgage rates drive house prices higher and that engineers a more buoyant mood among consumers which, combined with the Canterbury rebuild, could spur some inflationary pressure," Stephens says.

He suspects that internally the Reserve Bank is wary on that front too.

"However I think the bank's attitude is that the dangers to the downside are more acute than the danger to the upside, so why not signal low interest rates for a long time?

"And should the housing market really pick up it can always change its signal and move to a plan that involves more OCR hikes."

The Government's stock response to the charge that its Budget is too contractionary, too tough for this stage of the cycle, is to say never mind, it will just allow the Reserve Bank to keep interest rates lower for longer.

Interest rates are a very blunt instrument. Only a third of households have mortgages and so far many have opted not to go out and spend the extra money that low interest rates have left in their pockets, but rather to pay down debt while the going is good.

The risk is we set ourselves up for another ruinous bout of asset price inflation, but in the meantime do not get much of a spur to demand, in an economy still quite some way from being fully stretched.

- NZ Herald

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