SMELLIE SNIFFS THE BREEZE: When tight is loose

SMELLIE SNIFFS THE BREEZE: When tight is still loose

By Pattrick Smellie

Aug. 18 (BusinessDesk) – One of our mortgages came up for roll-over in the past couple weeks and, after a squizz round www.mortgagerates.co.nz, and a general vague feeling that interest rates are only going to rise from here, we fixed for three years at a bit over 7%.

Who knows if that was the right thing to do? Picking where interest rates will go with any precision has never been a strong suit. In the early 1990’s, with big Budget deficits and inflation above the target band for the foreseeable future – or so I thought – we locked in at around 14%, a rate almost unimaginable to today’s generation of home borrowers.

What I didn’t anticipate was Ruth Richardson’s 1991 “Mother of All Budgets”, which knocked the stuffing out of the economy for an extra couple of years and dropped borrowing rates to below 10% for just about the first time since 1984, when Labour ripped out Muldoon’s regulated interest rates.

Even with break fees, it was cheaper to move to those new rates than staying locked in at 14%-plus.

Over the past couple of years, it’s been an easy choice as a borrower simply to follow floating mortgage rates down to historic lows that, at their best, came close to 5.5%.

Since about May, however, the talk has all been about when, how and at what speed should New Zealand interest rates return to something like “normal”.

Westpac economists Brendon O’Donovan, Michael Gordon and Dominick Stephens have been having a stab at that in recent days, releasing two thought-provoking commentaries on the future path of interest rates, assuming the global financial crisis really is “over”, or at least as over as it’s ever going to be.

By their calculations, the “effective mortgage interest rate” averaged over the last 20 years, since inflation was tamed, has historically sat at around 7.7%. For the EMR – a mythical construct created from various guesses about national mortgage trends - to return to that average level over, say, the next couple of years, the Reserve Bank of New Zealand’s Official Cash Rate would need to rise from 3% today to about double that – around 5.75% or 6%, which is what Westpac reckons was the widely assumed “neutral” rate for the OCR prior to the global financial crisis.

Westpac doesn’t expect that increase to happen any more quickly than this slow-paced recovery allows, so there’s no need to panic yet.

However, it does point to a substantial increase in borrowing rates over the next, say, two-to-five years.

More significantly, Westpac is sceptical that such a rates rise would take New Zealand back to “normal” interest rates at all, since there is plenty of evidence that monetary policy settings were far from normal before the global financial crisis hit.

“It is not at all clear to us that the neutral rate in the… pre-GFC period was circa 6%,” the economists say. Instead, the period before the world went phut was characterised in New Zealand by “excessive risk taking, dizzying credit growth, and rampant asset price appreciation.”

Inflation was at the top of the 1%-to-3% target range and the current account deficit was blowing out, compensated only by a seriously over-valued New Zealand dollar. On that analysis, monetary policy was arguably loose then, even if it did produce some of the highest real interest rates in the developed world.

“A cash rate of 6.6% clearly did not deliver sustainable or equilibrium outcomes and it could easily be argued (with the benefit of hindsight) that it should have been closer to 7.5%.”

Uncomfortable conclusions follow. The first is that, far from moving too early, the two OCR increases since May have been no better than Clayton’s moves – the monetary policy tightening you do when you’re not really tightening monetary policy.

Meanwhile, Westpac reckons the EMR continued to fall until very recently, as low fixed-rate mortgages softened the initial impact of a higher OCR on floating borrowing costs.

“We have been in the peculiar position that monetary policy stimulus for many has been increasing, even as the OCR was being raised, Westpac says. “It will take at least another OCR hike (and the interest rate curve pricing in prospects of more to come) just to stabilise the EMR,” which is currently about 6.5%, having peaked before the global crisis at 8.8%.

Confused? Perhaps you should be.

And the Westpac guys are certainly not claiming a mortgage on future knowledge, owing to that classic out-clause of any forecaster, the problem of “many moving parts”.

However, if current market pricing suggests an OCR at 4.25%, then the EMR is heading over the next couple of years towards, say, 7.25%, still well below the average of the last two decades. If, as Westpac suspects, the return to normality means a return to an EMR at the historical average of 7.7%, then the OCR is heading back to 5.75% in that time.

In all that rather gloomy analysis, there is at least one ray of hope, unless you’re a bank shareholder: the one thing likely to keep falling, says Westpac, is banks’ lending margins.

Every cloud, eh?

(BusinessDesk)

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