The next major challenge the Reserve Bank faces is convincing everyone that once interest rates hit peak highs they won't start falling rapidly again

We are all still busily talking and speculating about how high the Official Cash Rate (OCR) will go.

But what happens when it hits the top?

It seems to me that there's a forming assumption that interest rates only bite while the OCR is still rising.

And then once the OCR has reached its peak in the cycle, then interest rates will soon start to subside.

Well, that's not how the Reserve Bank sees things, I'm sure.

However, it may well be how the markets and the public view matters.

Which is where it could all get pretty interesting.

I am of course jumping the gun a bit at the moment talking like this, but I see a bit of conflict potentially ahead between what the RBNZ wants and what the marketplace delivers.

In short, we could see a situation developing a bit down the track where wholesale interest rates are falling and mortgage rates start to follow suit - and the RBNZ will not be pleased.

To give this all some context, at the moment the Official Cash Rate is sitting at 4.25% having been hiked in increasingly large (last one 75 points) increments all the way up from 0.25% as of October 2021.

The RBNZ has its first review of the OCR for the year (and first since November 2022) on February 22. At its last outing in November the RBNZ was extremely 'hawkish' and it raised the OCR by the aforementioned 75 points. The reason for the hawkish mood was that November's review followed closely on from September's inflation figures, which while showing a slight decline in the rate of annual inflation to 7.2% from 7.3% previously, were much hotter than expected - particularly the domestically generated inflation, which is what the RBNZ is targeting with the OCR.

The clear indication from the RBNZ was that it would again hike the OCR by 75 points in February, taking the OCR to 5% and with a likely peak of 5.5% to be hit by the middle of the year.

Sure enough, market pricing via the wholesale interest rates moved to pretty much 'price in' a 75 point rise. But three months is a long time between OCR reviews. In the meantime December quarter inflation figures came in lower than expected (7.2% again) and unemployment, at 3.4% was higher than expected. These things plus a few other signs that steam is coming out of the economy have seen market expectations move more toward a 50 point OCR rise this month, taking it to 4.75%.

Market expectations of where the OCR peak may be have now settled to about 5.25%, while some economists are suggesting 5% will do the trick.

What this all means is that we may now be getting toward the OCR peak and possibly sooner than expected. We might possibly hit it as soon as April, which is when the next review is after the February one.

So, maybe we will have 'peak OCR' in a little under two months' time. What then?

My answer to that is that once the perceived top of the rate hiking cycle has been reached, that's when it gets quite tough for the RBNZ.

Source: 123rf.com. Copyright: dilendom

It seems to me, rightly or wrongly, that there's a perception out in the populace that the OCR is only 'working its magic' when it is being hiked. So, once it has hit the top, down it starts to come again and we all go back to where we were before, 2% to 3% mortgages and 30% annual house price inflation. The good old days.

Except I don't think the RBNZ quite sees it like that.

It might seem to be stating the obvious, but an interest rate hike is not just having an impact at the point at which it is hiked. If your mortgage payments go up $500 next month, well they'll still be that $500 higher the following month as well. And the month after that etc. The financial pressure stays on, whether overall interest rates are still rising or not.

It is not necessary for the OCR to be continually hiked in order to have a restricting impact on spending and the economy.

The RBNZ and economists like to talk about the 'neutral' interest rate, an unobservable but rather crucial thing. The neutral rate is in Goldilocks terms neither too not nor too cold, it is the interest rate level that is neither stimulatory nor restrictive. 

Till recently the RBNZ has believed the 'neutral' rate to be about 2%, but indicated in mid-2022 that the rate was now likely higher. It hasn't yet come out with anything definitive on where it sees the level now - I'm rather hoping it might say something about the subject in its February Monetary Policy Statement - but the indications coming out of the bank late last year was that 'neutral' might now be equal to about 3%.

This may seem esoteric, but it is important. It all means that if the OCR is above 3% then the current monetary policy settings are restrictive. If it is below 3% then the settings are stimulatory. 

Now, regardless of whether we see the neutral rate being 2% or 3%, we can therefore all agree that when the OCR was sitting on 0.25% - as it was from March 2020 to October 2021 - this was as stimulatory as hell.

With a current OCR of 4.25% monetary policy settings are most definitely restrictive, in line of course with the efforts to slow things down and curb inflation.

So, if the OCR peaks somewhere around or above 5% it will be more restrictive still and it will continue to be restrictive whether it then goes any higher or not. The OCR will only get less restrictive once it's reduced from those levels. 

This needs bearing in mind. 

In its last Monetary Policy Statement issued with the OCR review in November 2022, the RBNZ forecast that, yes, the peak OCR would be reached mid-2023 - but our central bank was indicating that the OCR would STILL BE ABOVE 5% in March 2025 - more than two years from now.

That's right, the RBNZ sees interest rates going up a long way - and then staying there. It doesn't see them falling quickly. 

Now, I'm labouring that point because I'm not sure the markets and the public see things that way at the moment. I suspect there's a school of thought that says: "Get the peak OCR out of the way and then let's see interest rates sinking again."

Okay, you might argue that it's what happens with the OCR that's really important, not what the public and markets think. Well, yes...and...maybe no.

Ultimately the level of our mortgage rates will be set based on what the banks are having to pay for funding through the wholesale markets.

For example, mortgage rates were already well and truly on the rise by July 2021, well before the RBNZ officially began the rate hiking cycle in October of that year. The reason the mortgage rates had already risen was because the wholesale markets were rapidly rising in response to the inflation spike - and therefore the costs to the banks had already risen.

This could all happen in reverse. Quite soon. The markets love to second-guess. Once the anticipation is in the markets that peak OCR has been achieved then the speculation will immediately be about when rates are going to come down. This in turn may well lead to falling wholesale rates - and therefore the banks, for whom mortgage business is a bit quiet at the moment, will very likely start pushing mortgage rates down in competition with each other.

What we could therefore see is sometime in the not distant future - maybe the middle of the year - a situation in which the wholesale interest rate markets are effectively causing an easing of monetary conditions; before the RBNZ is good and ready for such an easing.

The problem for the RBNZ will then become: How does it convince the markets and public that it is deadly serious about keeping interest rates at high levels, if it is not actually increasing them? 

From the RBNZ perspective, the efforts to get inflation under control could be mucked up if there is a general easing of monetary conditions and homeowners are getting mortgage rate relief (and therefore more cash to spend to re-inflate the economy).

This is going to be an interesting one to watch as it plays out.

We are not there yet, but I'm convinced we will see this kind of scenario develop quite soon.

How the RBNZ reacts will be pivotal. I'm sure it will want to see restrictive monetary conditions continue for two years, regardless of whether interest rates actually go much higher or not from here. But the markets might have different ideas. Something would have to give.

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