Interest Rates on the Up

The process of weaning the New Zealand economy off super-low interest rates has begun. Alan Bollard pushed the official cash rate (OCR) up to 2.75% (from 2.50%) at the start of June, the first of an expected series of increases aimed at restoring the OCR to a more normal 5% over the next 18 months.

• What are these interest rate adjustments really about?
• Why are we raising rates when global markets are still flat?
• What does an increasing OCR mean for Kiwi investors?

What are these interest rate adjustments really about?

The tweaking of interest rates, and the timing of these tweaks, is the Reserve Bank’s way of responding to and influencing inflation. Think of the economy as a car, the Reserve Bank as the driver, and interest rates as the accelerating and braking system. If the car is cruising along at 50km/hr, all’s well and the driver can sit back and enjoy the trip. If the car slows down, the driver accelerates (lowers interest rates) to get back up to 50. If it speeds up to 60, the driver brakes (increases interest rates) to get it back to 50. Dialing the OCR up and down is a balancing act to keep the economy chugging along within a series of acceptable limits.

What are signs that the economy is cruising at 50kph?

• inflation staying between 1-3% per annum
• unemployment around 5%
• OCR at about 5%

Pre-recession, New Zealand had unemployment of 3.5%, inflation running at 3.4%, and the OCR at 8.25%. The recession had the effect of raising unemployment to 7.1%, inflation fell as low as 1.7% and OCR fell to 2.5%, all in a 24-month period.

At the moment, unemployment is falling again, and at 6% is only barely above the normal range.  Inflation expectations remain stubbornly elevated near the top of the Reserve Bank’s 1-3% range of tolerance, and the (GST and ETS-related) inflation surge coming up this year won’t help matters. Interest rates are rising, but until the OCR gets to the region of 5%, the Reserve Bank will still be accelerating the economy, albeit by a diminishing amount. 

 Why are we raising rates when global markets are still flat?

Increasing the OCR now is an indication that the governor of the Reserve Bank thinks that the economy no longer needs very cheap interest rates to keep growing in the zone consistent with 1-3% inflation.

With the New Zealand economy some 15 months into an expansion after a severe recession, no one could accuse the good doctor of being overly hasty. Australia began to increase its interest rates in October 2009, and even Canada beat us to the punch – just.

Timing aside though, that the central banks of all three countries have started increasing interest rates after lowering them dramatically  over 2008, indicates they’re all seeing light at the end of the tunnel.

A look at what we commonly think of as the world economy (USA, Europe, Japan) doesn’t give us the same picture. There is a stark difference between New Zealand’s and the US or European situation of unemployment rates near 10% and deflation and double dip recessions still a concern. Interest rates in these economies are going nowhere anytime soon.  

Why are New Zealand, Australia and Canada trending differently to the world economy?

The simple answer is that all three countries rely on commodity exports (dairy, grain, wood, metals etc.), so they’re are positioned to benefit from the fast-growing and resource-hungry developing world (eg. China and India). We are not as reliant as we used to be on exporting to the lumbering and broke giants of the developed world (USA, Europe, Japan). The performance of the developed world economy is simply less relevant to New Zealand, Australia and Canada these days.

What does an increasing OCR mean for Kiwi investors?

Homeowners and property investors with floating mortgages can expect to see their interest rates rise in lock-step with the OCR.  Fixed rates, however, have most of the expected interest rate increases already factored in, and won’t rise much from here unless the Alan Bollard ramps up the inflation-fighting significantly.

The flip-side is that bond-holders shouldn’t expect much increase in yield; term deposits over 6 – 12 months should rise along with the OCR.

The other big question is whether rising interest rates will spark renewed interest in the New Zealand dollar from off-shore.  The original push to US80c in 2008 came in part because the out-of-sync New Zealand economy offered much higher interest rates than the rest of the world. A repeat performance is in the making with the Kiwi economy riding along on the back of the Chinese dragon.