Brian Fallow: Central bank's Bollard in a fix over rates

The Reserve Bank's brakes have not failed but, in governor Alan Bollard's words, they're spongier than they've been.

And that, he told MPs last week, heightens the risks.

He had just delivered as stern and hawkish a monetary policy statement as he could, short of actually raising the official cash rate, only to have two banks cut their fixed mortgage rates.

This prompted headlines about the governor firing blanks, and the banks running his red light.

So the central bank is understandably keen to rebut the imputation of impotence and insist that monetary policy still works.

"True," says assistant governor Grant Spencer, "the links from our official cash rate, which largely determines the overnight rate at which banks lend among themselves, to the ultimate goal of price stability, are far from precise and can change over time. But there is no doubt the bank has the tools to achieve its mandated goal of medium-term price stability."

The bank's problem is that borrowers currently prefer, to an unprecedented degree, home loans at fixed rates, typically for one- and two-year terms. With floating rates at nine per cent and fixed rates at an average 7.2 per cent, the popularity of the latter is not hard to understand.

When most mortgages were at floating rates, monetary policy was a lot easier to do. As those loans were funded from short-term money, 90-day bank bills whose interest rates were essentially determined by the Reserve Bank, it could in effect reach straight into people's pockets and remove or restore spending power.

But with 75 per cent of mortgage debt now at fixed rates, the relevant cost of funds for the banks is determined further out the yield curve, where rates are influenced not only by domestic monetary policy but also by global, especially US, bond yields.

The Reserve Bank has hauled the short end of the curve up with seven rate hikes in the past 18 months so that New Zealand has the highest policy rates going among developed countries.

But, most unhelpfully from its point of view, the other end of the rope is being dragged down by a 10-year US Treasury bond, which recently fell below 4 per cent.

The relative importance of those two influences on the cost of two-year money varies over time.

With global rates so inexplicably low at present - even the mighty Federal Reserve chairman Alan Greenspan is scratching his head - their gravitational pull is extending to parts of the yield curve where traditionally local monetary policy would have been the predominant influence.

"There is no doubt changes in the OCR do influence fixed mortgage rates," Spencer says. "However, changes in global interest rates will affect the strength of this relationship, as they do in other countries, and as they have done since New Zealand opened its markets 20 years ago."

This means the Reserve Bank's interest rate policy is reinforced when New Zealand is in sync with the global economy but potentially weakened when we are out of sync.

When we are out of sync and our interest rates are (more than usually) higher than other countries', money is attracted here and the dollar climbs. In those circumstances, monetary policy tends to work more through the exchange rate than the mortgage rate, hammering exporters rather than people with mortgages. But the exchange rate channel isn't flowing as freely as it might, either.

Exporters in key pastoral industries - lamb, beef and dairy - have enjoyed world prices at or near record levels, which has dampened the impact of the high kiwi dollar.

Exporters in the manufacturing, forestry and fishing sectors, however, have not had that advantage and as the anaesthetic of foreign exchange hedging wears off, the painful level of the exchange rate is increasingly being felt.

The Reserve Bank argues that it is a similar story of "you can run, but you can't hide" when it comes to fixed mortgage rates.

As fixed-rate loans come up for resetting of their interest rates, borrowers face significant increases.

"As an illustration, existing borrowers refinancing two-year mortgages over the next six months or so will face interest rates up to 1.5 percentage points higher than those available in 2003," Spencer said. "Indeed, media coverage of this issue ensures most borrowers will already be aware of these increases and will be factoring them into spending plans."

The bank argues that it can get more bang for its buck in terms of OCR changes because household debt has doubled - relative to incomes - since the early 1990s.

"That degree of indebtedness should make people more responsive to any change in interest rates than they were previously, as real debt servicing costs consume a larger proportion of household income. If so, a smaller change in effective interest rates might be required to achieve the same economic impact as in years past."

The bank reckons the effective average mortgage rate - what people are actually paying - has risen 65 basis points from its lows in late 2003. It expects the effective average rate to rise another 30 or 40 basis points over coming months as loans are refinanced at rates similar to those now prevailing.

In other words, about a third of the tightening it has already done is still in the pipeline, yet to be felt by borrowers, but on its way.

Bollard told the finance and expenditure select committee last week that "without that pipeline effect, we would be concerned that monetary policy wasn't tight enough".

His problem is that every time a bank cuts its fixed mortgage rates because cheaper international money allows it to, that pipeline effect weakens.

Even if that does not eventuate, it is clear there is a longer than normal lag between what the Reserve Bank does to its official cash rate and the effective interest rates people with mortgages pay.

And there is a further lag between that impact on their discretionary spending power and inflation, which is what the bank is trying to control.

The elongation of the lag is one of the reasons the economy has stayed stronger for longer than expected, with more inflationary pressure building in the meantime.

The risk is that the bank will lose patience, tighten again, and increase the chances of a hard landing.

Another worry is that the low level of global bond yields is telling us something unpleasant but true.

A normal yield curve points upwards - it costs more to borrow money for long periods than short ones, because the lender is taking on more risk.

An inverted yield curve, where longer rates are higher than short ones, as they are in New Zealand now, generally heralds an economic downturn.

If the same thing is approaching in the US, we all have cause to worry.