Many weird and not exactly wonderful things have happened over the past 12 months.
One of the more curious developments, largely unnoticed, has been significant shrinking in importance of the Official Cash Rate (OCR).
Now, I know what you'll say. "What are you on about?" "Are we actually talking about anything else other than the OCR at the moment?" "How could the significance have reduced?" "Don't be ridiculous!"
Hear me out.
What's happened is that the importance of the actual, here and now, physical OCR has diminished considerably in favour of a spectral 'Future OCR'; that is, what the OCR might/could be - in the months and years ahead.
The physical level of the OCR in the here and now (for the record currently 2%) has taken a back seat in favour of this 'Future OCR' when it comes to pricing of wholesale and retail interest rates.
The 'market' is currently working in the mindset of an OCR of around 4% - not the actual 2% level the OCR is at now.
Without us really realising this was happening, this transformation began when the Reserve Bank (RBNZ) released its Monetary Policy Statement on May 26,2021. This MPS reinstated - for the first time since the start of the pandemic in early 2020 - the forward projection of the OCR usually contained at the back of the publication. Just some dates and numbers and the RBNZ's best guess at what the level of the cash rate might be in future.
The particularly interesting thing about the May 2021 MPS was that the commentary in it was not much changed from the sort of commentary seen since the outbreak of the pandemic - IE very cautious, uncertainty, slow recovery etc. But everybody was blown away when it came to reading the OCR projections.
Bear in mind, at the time the cash rate was still sitting on the 0.25% emergency level that it had been dropped to in March 2020. And also bear in mind it had been not many months before that the RBNZ had been pointing very strongly toward the prospect of NEGATIVE interest rates.
Yet, now, here it was in all its glory. A newly minted OCR rate track that showed INTEREST RATES GOING UP! And how. The RBNZ forecast that the cash rate was going to climb to, wait for it, 1.75% - by June 2024 (as opposed to the 'real' 2.0% we've got two whole years earlier!). But financial markets then were gobsmacked. And this kicked off sharp rises in wholesale interest rates, which were then further kicked on by global inflationary developments. Before very long mortgage rates started to move up. Strongly.
By the time the RBNZ actually lifted the OCR from 0.25% to 0.5% in October 2021, average one-year fixed mortgage rates had already climbed by 38 basis points compared with May 2021, while the two-year rates were up 61 basis points - this before the OCR had been touched.
This pattern has continued since. The OCR rate track, the spectral 'Future OCR' has become more important than the physical cash rate. Global developments have kicked in as well. Mortgage rates have soared at a far more rapid rate than surely anybody could have foreseen.
There's some irony in all this. What we are seeing is actually very back to the future. We're now seeing monetary conditions and retail interest rates set much more in 'the way they used to be' by the RBNZ.
You see, prior to introduction of the OCR in early 1999, the RBNZ used a number of 'raised eyebrow' methods and mechanisms to influence monetary conditions. According to the public announcement at the time in 1999, the rationale for introduction of the OCR was that "...by directly managing the market cash rate, we will be able to influence the level of other short-term interest rates and, hence, monetary conditions more generally..."
And so it was that from that point on if the RBNZ wanted to tighten or loosen monetary conditions it moved the OCR. So, this was the RBNZ effecting change in the markets with a physical, rather than signalled move.
So, no 'raised eyebrow' projections then?
Well, until 2016 the RBNZ did a sort of 'raised eyebrow' special in that it ran in its MPS documents projections of what it thought the 90-day bank bill rate might be in the months and years ahead. Now the 90-day bank bill rate is not the OCR of course, but its IS very heavily influenced by the level of the OCR. So the bill rate projection was a kind of proxy for the OCR. All the market observers needed to do was subtract say 20 or 30 basis points from the bill rate projections to get some idea of what the OCR could possibly be in future. All very oblique though.
But in 2016 the bullet was bitten and proper forecasts of the OCR commenced.
And now very clearly this forward cash rate track has been picked up by the RBNZ as the weapon of choice to use in the current environment and is the thing to be watched - more so than the actual movements of the OCR itself.
I will let you into a secret. When reporting on the latest Monetary Policy Statement for interest.co.nz on May 25, 2022 I had cheated and already pre-written my 'breaking headline' for the website ahead of the release of the MPS - so confident was I that a 50 basis point rise in the OCR would be announced.
When the statement emerged at 2pm, I glanced at the OCR figure, reflexively pushed the button to publish the pre-written 'breaking headline', and then immediately buried my nose in the OCR forward track projections, nearly falling off my chair when I saw what they were. The market reaction (IE falling off chairs) was fairly similar.
So, a 3.9% OCR by the middle of next year? Really?
I've seen it suggested that RBNZ Governor Adrian Orr is bluffing. And that he and the RBNZ Monetary Policy Committee won't lift the rate that high.
So is it a bluff?
No. Absolutely not.
Why bluff and say you will do something you don't intend to do when there's a reasonable chance that bluff will be called?
What we are seeing is the RBNZ basically saying that it wants its efforts to quash inflation to be taken seriously.
And if that means a 3.9% OCR is needed then that's what it will do.
If you make a strong statement of intent, you've always got to be prepared to go through with it. But it doesn't mean you can't change your mind if actual circumstances dictate.
So, by that token, WILL the OCR go to 3.9%?
Well, it entirely depends on inflation expectations.
Yes, that's right it doesn't depend on inflation - 'real' inflation.
It depends on 'inflation expectations' - what people think might happen with inflation.
What we've got here is a spectral Future OCR taking on a spectral Future Inflation. Which is all a bit weird really and possibly, just possibly, not that sensible.
The RBNZ places a lot of weight/emphasis on its own survey of expectations, through which a group of economists, forecasters and senior business types are surveyed for their views on future inflation.
For reasons that escape me quite a few economists sharply played down the results of the last survey. I really couldn't understand that. The survey participants were surveyed days after the RBNZ had hiked the OCR (the real one!) by 50 points. If that didn't tell those surveyed that the RBNZ was serious about cutting off inflation, what would? And yet, just days after this, the survey participants hiked their collective expectation of inflation in FIVE YEARS' TIME to 2.42% from 2.3% previously.
So, in other words the RBNZ had just thumped out a monster rise in interest rates - but informed market participants were still thinking, even after this, that inflation was not going to be properly under control in 60 months' time (bearing in mind the RBNZ explicitly targets inflation at 2%).
So, the participants were saying: "Is that all you got?"
Well, Orr has come right back at them and is now saying that there's plenty more where that came from - unless people behave. In other words, stop expecting inflation, you bad people.
The rhetoric from the RBNZ has been such that another 50 basis point rise in the OCR on July 13 (next review date) is a slam dunk. I've already written my breaking headline.
Of MUCH more interest is what happens when the next RBNZ survey of expectations is released on August 8. I'm betting that 'Future inflation' will back off. Which means I think all bets will be off for what happens next physically with the OCR. And potentially also that 'Future OCR'. (There's another OCR review and MPS issue on August 17.)
A further wrinkle in all this is that I'm still not sure the RBNZ is quite (yet) fully aware of just how much bang it is getting for its buck with the OCR hikes (real and projected).
According to RBNZ figures, as of April there was nearly $297 billion worth of fixed-rate mortgages around the country. Of this, $239 billion (just over 80%) was due to reset within two years. Well over half of the money ($160 billion) was due for a reset within 12 months.
These rate rises are carrying enormous firepower.
A quick example, using the trusty interest.co.nz calculator: Please don't feel picked on Kiwibank, but I will use your one-year 'special' rate for this example as it was raised this week to an (at time of writing) market leading (for specials) of 4.85%. At the end of May last year Kiwibank's one-year special was 2.35%.
In May last year the average-sized new mortgage (according to RBNZ figures) was $329,000. So, using the Kiwibank rate of 2.35% on a 30-year mortgage would have meant payments of $1274. If this imaginary customer were to today reset this mortgage for another year they will be paying $1736 a month. That's a rise in payments of 36%. On a weekly basis it would mean over $100 EXTRA a week.
The RBNZ has suggested that even the short-term fixed mortgages are heading for 6%. On that basis our mortgage customer would then be paying $1973 a month, a rise of 55% on what they were paying in May last year and on a weekly basis some $160 more.
I did an Auckland-esque example using a $900,000 Auckland-sized mortgage as well, but I've decided the results were too frightening to detail here. Suffice it to say my sympathies are with the people who will be in that boat.
But sooner or later the impact of these 'Future OCR'-fuelled interest rate rises will become all too obvious.
The economy is going to grind to halt. Don't doubt that. But will inflation, actual inflation, come down? Personally I fear that with the latest supply chain ructions out of China and the probably still to be fully-felt effects of the Ukraine invasion we may well see a second wave of inflation later this year.
At that point it becomes a matter of how committed the RBNZ really will be to killing inflation at all costs. The risks of killing everything else are very real.
So, an OCR of 3.9% next year? I wouldn't bet against it. But I wouldn't imagine it would be a hell of a lot of fun if we get there either.
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