My mate Pete is building a house. He is a talented builderand property developer, but the recent change in the market has left himneeding to complete and sell his current project this year. He works every hourthat the inclement Wellington weather allows, and practically sleeps with hisdrill clasped in his calloused hand. Pete dances a little jig every time AlanBollard drops interest rates. He has a floating mortgage, and every little fallgives him precious extra time or money to finish up the house and get it soldor rented.
After years of being synonymous with the Grim Reaper, DrBollard is enjoying a reincarnation as Santa Claus. Every time Dr Bollard is ontele now, mortgage rates fall. But Pete isn’t really sure why Dr Bollard hasgone from zero to hero. Why is he so busy lowering rates now, when they were sohigh before?
Alan Bollard runs the Reserve Bank, which is where bankssettle up their transactions each day. Like all central banks, the Reserve Bankacts as a ‘banker of bankers’, lending banks cash when they are short and overseeingthe financial industry. As a result of the problems caused by inflation in the1970’s, nowadays Reserve Banks tend to be independent from Government and focusedon controlling inflation. The method our Reserve Bank uses to control inflationhas varied since the 1980’s. Currently the Reserve Bank uses the Official CashRate (OCR) â€“ this is the short term interest rate they offer to banks for overnightloans and deposits.
Changes in the OCR should (in theory) flow through to bankfloating deposit and loan rates. Banks won’t offer on-call deposit rates higherthan the OCR because they can borrow cash from the Reserve Bank at around thatrate. Theoretically, banks could also offer floating rate loans at the OCR rateplus a margin to cover their costs and risks.
Lower short term interest rates have a knock-on effect rightthrough the economy, which is where Pete starts getting interested. Whenborrowing costs fall, it allows Pete to spend more on materials and labour. Italso becomes easier for people and businesses to borrow more to spend andinvest, although Pete, like many of us, is wary of borrowing more at the moment.Lower interest rates mean fewer overseas investors are interested in putting theirmoney here, and our exchange rate falls. Our dollar has fallen over the lastyear, which is great if you are exporting, but not so hot if you have apenchant for imported German power tools like Pete.
This is all a good kick-start for the New Zealand economy in tough times. When times are good – too good â€“ Dr Bollard putsinterest rates up with the opposite effect. These interest rate changes flowthrough the economy, stoking or cooling the pace of growth with the intentionof keeping prices reasonably stable.
This formula has served us pretty well for the past twodecades, providing reasonably stable, low inflation growth. But around theworld monetary policy isn’t working as well as it used to do. Since 1987 everytime that economic strife has struck, central banks have lowered interest rates,allowing consumers to take on more debt, enabling economies to spend their way outof the crisis. This has created what we economists call a moral hazard â€“borrowers and the financial industry got saved by low interest rates every timethey got in trouble, so they kept taking bigger risks. Now, very rightly, borrowersare unwilling to take on more debt, and lenders are wary of bad loans. Thereare only so many houses Pete can buy and do up at once, and he doesn’t want anymore debt right now. Debt levels are now so high and interest rates so low thatcentral banks can’t save the day. This is the problem the US and the UK face now, which is why they have turned to printing money.
But the problem isn’t simply the level of debt, it’s what we’veused the money for. We used cheap debt to bid up the prices of our own houses,which has proven to be a poor investment for NZ Inc. Partly this outcome is aresult of the tax benefits that housing enjoys. These incentives haveencouraged productive, energetic people like Pete to focus their skills onbuilding houses rather than doing other stuff, like creating something forexport. It just so happens he’s a pretty good web designer too.
Falling interest rates work for Pete right now. Hopefullythe low OCR will actually get passed on to floating mortgage rates, and buy himsome more time to finish his house. In the mean time let’s hope a capital gainstax (at least on second homes) is being seriously considered in the Beehive.This would dampen our housing obsession and focus the ingenuity of people likePete on more sustainable ways of growing our economy.
Enjoyed this article?
You might like to subscribe to our newsletter and receive the latest news from Infometrics in your inbox. It’s free and we won’t ever spam you.