Bollard's stern talk doesn't worry banks

Reserve Bank Governor Alan Bollard was as hawkish as he could be without actually raising interest rates yesterday - only to see two banks cut their mortgage rates.

Although as expected he left the official cash rate unchanged at 6.75 per cent, he left the door open to a further rate hike and said there was no scope for an easing in the foreseeable future.

But in a vivid illustration of the market conditions which have partially stymied his moves to cool the economy, the National Bank and Kiwibank promptly shaved 15 basis points off their two-year fixed mortgage rates, to 7.65 and 7.35 per cent respectively.

Although the Reserve Bank has raised its official cash rate seven times since early last year, 1.75 percentage points in all, it estimates that only about 65 basis points of that has flowed through to effective mortgage rates (the average rates people pay).

That reflects the fact that, as at the end of April, 75 per cent of all mortgage debt was on fixed-rate loans, mainly for one and two-year terms.

Bollard's problem is that what he does to overnight rates is not the only influence on the wholesale interest rates from which banks fund those mortgages. Long-term international bond yields also have an impact, and they are low and falling.

While floating rates are generally at 9 per cent, the weighted average rate being paid on existing fixed-term mortgages at the end of April was 7.16 per cent.

Assistant governor Grant Spencer told Parliament's finance and expenditure select committee that about 30 per cent of all mortgages would come up for resetting over the next few months. He said those borrowers would face increases of between 1 and 1.5 percentage points, enough to raise the effective average mortgage rate by another 0.3 or 0.4 percentage points.

As Bollard put it: "The brake is a bit spongier than a year ago. It still has an effect but it heightens the risks."

The Reserve Bank believes that the impact still to come of interest rate hikes it has already administered, together with the high dollar's impact on the export sector and a flattening of house prices, will be enough to keep inflation within its 1 to 3 per cent target band, but only just.

Any upside surprises on the inflation front would be likely to trigger a rate hike, but downside surprises would only keep rates on hold.

Its June monetary policy statement paints a picture of an economy whose growth has peaked but is declining more slowly than expected.

Economic growth, which was 4.8 per cent last year, is forecast to slow to 3 per cent this year and 2 per cent in 2006 and 2007.

But having averaged 4 per cent during the past four years, it has left the economy with little or no spare capacity and with inflationary bottlenecks that will persist for some time.

"The price cycle peaks later than the economic activity cycle and we are not there yet," Bollard said. "We don't see any loosening in the foreseeable future." He said yesterday's decision was a close call.

Deustche Bank chief economist Ulf Schoefisch said: "Given he didn't do anything, he tried to sound as tough as possible. I don't think he really wants to raise rates again, but he's determined to keep the [financial] market on its toes so that it doesn't price in an easing."

ANZ National Bank chief economist John McDermott said: "He probably did want to increase rates but the recent run of weak data made it impossible."

Westpac chief economist Brendan O'Donovan expects the Reserve Bank to keep the official cash rate on hold and to continue downplaying weak data and reacting strongly to anything that implies greater inflation pressures.

"Slower growth is not enough. Inflation has to look like it is firmly heading down before the bank will relax," he said.

"But it is going to have to contend with a market that disbelieves the rationale for being so hawkish and is inclined to discount the bank's message."

The big picture

Growth to slow to 2 per cent.
But unemployment rises only a little.
Inflation stays at or near 3 per cent for two years.
So there is no scope to cut interest rates.