By Andrew Coleman The recent kerfuffle over flexible mortgage rate margins has distracted attention from a more serious policy issue: the slow speed at which the Reserve Bank's monetary policy stance is transmitted to the household sector. The symptoms of the problem have been the frustrated complaints emanating from the Reserve Bank that average mortgage rates neither rise much when monetary policy is tightened (two years ago) nor fall much when monetary policy is eased (now). And while the direct cause of the problem is New Zealanders' preference to use short term fixed rate mortgages, the underlying problem seems to have been the inability of the Reserve Bank to control inflation without an extraordinarily long period of high short term interest rates. First things first. In the middle of 2008, 85 percent of residential housing mortgages were fixed rate rather than flexible rate, a fraction that had increased from 60 percent in 2002. Because only 3-5 percent of fixed rate mortgages are reset each month, it takes a long time for changes in short term wholesale rates to filter through to retail markets.
Indeed, this is one of the reasons why many households prefer fixed rate mortgages: they provide them some certainty that rates will not suddenly change. But certainty for individuals means average mortgage rates only change slowly when the central bank changes interest rates. Between June 2008, when the Reserve Bank of New Zealand started aggressively cutting interest rates, and May 2009, average mortgage rates only declined by 1.25 percent, even though flexible mortgage rates declined by 4.5 percent, and new 3 year fixed term mortgage rates declined by 2.25 percent. The contrast with Australia, where 90 percent of mortgages have flexible rates, is instructive. Even though flexible mortgage rates have fallen less in Australia than New Zealand since June 2008, average mortgage rates have dropped by nearly three times as much, providing much needed support to their economy. It is probably no coincidence that New Zealand is now experiencing its fifth quarter of recession, while output in Australia has scarcely declined. The accompanying table shows how interest rates in Australia and New Zealand changed between June 2008 and May 2009. In New Zealand, both the official cash rate and 90 day wholesale rates declined by 5.8 percentage points, from over 8 percent to under 3 percent. During this period, flexible mortgage rates declined 4.5 percent, implying the margin between wholesale rates and retail lending rates widened by approximately 1.4 percent. This is a large increase, and deserves explanation. But a similar expansion in margins also took place in Australia, where flexible mortgage rates only declined 3.7 percent. The main difference between the countries concerns average mortgage rates. In New Zealand, average mortgage rates have declined by 1.26 percent, because most New Zealand mortgage borrowers had fixed term mortgages in June 2008, and these have not yet been rolled over. In Australia, average mortgage rates have declined by 3.28 percent. The difference between the two countries was even more pronounced last December, by which time Australians were enjoying a 2.3 percent decline in mortgage rates, compared to a paltry 0.3 percent in New Zealand. Do average interest rates matter? In many countries they do not, because for every borrower there is a lender and the borrower's gain is the lender's (and the tax collector's) loss. But in New Zealand and Australia, average rates are important because both countries are net debtors, borrowing from overseas. New Zealanders borrow approximately $170 billion in net terms, or 100 percent of GDP. If average rates had declined here by as much as in Australia, the economy would have already had a cash boost of $3.4 billion, or nearly $300 million per month. This boost will come "“ when the old mortgages are rolled over. But, unlike the situation in Australia, it didn't come when it was most needed, when the Reserve Bank started desperately cutting interest rates in the middle of last year. The deeper question concerns why most New Zealanders have chosen fixed term mortgages while most Australians have chosen flexible term mortgages. One reason reflects differences in short term and long term interest rates in the two countries. In New Zealand, flexible mortgage rates have normally been higher than fixed rate mortgages rates, and statistical evidence shows that whenever the flexible mortgage rate is higher than the fixed rate, the fraction of fixed rate mortgages increases. Between 1993 and 2009, flexible mortgage rates exceeded three year mortgage rates by an average of 0.55 percent, and for 40 percent of this period, including 70 percent of the last five years, they were at least one percent higher. In Australia, flexible rates were at least one percent higher than fixed rates only three percent of the time. Given these rate differentials, it is hardly surprising that most New Zealanders have fixed rate mortgages, whereas most Australians don't. So why are flexible rate mortgages so high in New Zealand? The answer lies in the way monetary policy has been conducted in New Zealand. While most countries increase short term interest rates above long term interest rates from time to time to control inflation, New Zealand is extremely unusual in the extent to which the central bank has found it necessary to keep short term interest rates high. One measure of the tightness of monetary policy is the extent to which wholesale 90 day interest rates exceed five year government bond rates. Since 1993, New Zealand 90 day interest rates have been at least one percent higher than five year interest rates some 37 percent of the time "“ and in the last five years a staggering 70 percent of the time. Other central banks seem fortunate enough to control inflation without needing to do this. Since 1993, Australian 90 day bank bill rates have been one percent higher than five year government bond rates only 5 percent of the time, and such a margin is scarcely ever seen in the United States. It is unclear why such high short term rates have been necessary to counter inflation in New Zealand for such a long period of time, for inflation outcomes have not been noticeably different to those experienced in other developed countries. It is possible that inflation is easier to control in other countries because the tax systems are different, or because their economies have different wage-price dynamics. Further research on these topics is urgently needed to better understand why New Zealanders face some of the highest interest rates in the world. But it would be an unfortunate irony if the high interest rate policy used to counter inflation so reduced the fraction of people borrowing at flexible rates that monetary policy ultimately became a relatively ineffective tool for stabilising the economy. ____________ * Andrew Coleman is a Senior Fellow at Motu Economic and Public Policy Research. All of Motu's research can be found here.