Mixed reactions mean bank probably got it roughly right

By Peter V O'Brien

Friday 7th May 2004

The noisy mixture of approval and disapproval that always accompanies the setting of the Reserve Bank's official cash rate (OCR) suggests the monetary authority probably gets things roughly right.

Last week's disagreement among economists about inflationary trends and the likely direction of the currency as the OCR was lifted from 5.25% to 5.5% maintained the historical pattern.

Reaction to the rise from 5% to 5.25% in January was a front-page story in The National Business Review on January 30. Exporters were incensed at the increase, saying it would add to their problems with the then value of the currency, which was expected to go through the 70US¢ level.

The New Zealand dollar was worth 67.39US¢ on January 30, went to US70.10¢ on February 13 and stayed above 70US¢ for only five days.

It was at 62.03US¢ on April 30, a fall of 7.9% from January 30 and 12.2% below the year's high of 70.65US¢ reached on February 17 and 18.

Juggling the OCR in relation to the exchange rate and internal influences on inflation is a contentious issue and will remain so as long as economic forecasting lacks certainty.

The rise to 5.5% can be compared with January's setting of 5.25%, 5% in October, 5.25% in July last year and 5.5% in the previous April.

That meant the OCR was where it was a year ago and current interest rates in other areas showed similar movements.

Yields on 90-day bank bills and on July 2009 and April 2013 government stock at the end of each quarter since March last year, and on the day after the latest OCR increase, are in the table.

In view of the for and against arguments about last week's rise in the OCR, it was interesting to see yields on 90-day bank bills go from 5.58% to 5.67% in the five working days before Reserve Bank governor Alan Bollard's announcement.

Someone reckoned the OCR would go up, irrespective of the merits of each side of the debate.

There was a jump to 5.78% on the day of the announcement but such movements are normal when the market gets confirmation of a change.

Forecasters, market dealers, the business community and the public had to assess the effects of the OCR change on other economic indicators and general costs.

Its relationships to the currency and inflation were important parts of any equation.

Dr Bollard and the bank apparently considered the currency would continue to weaken against the US dollar. A comparison with the situation last April supported that view.

The New Zealand dollar was worth 56US¢ on April 30, 2003 (and causing difficulty) when the OCR was cut from 5.75% to 5.5%.

It continued to rise, justifying official rate cuts which were logical when the currency appreciated, other things being equal (they rarely are equal).

The reverse applied when the currency depreciated, again presuming there was no pressure from other elements in the mix.

Time will show whether proponents of continuing currency weakness or people favouring more appreciation are correct. Dr Bollard could have another go in July, or earlier, if adjustments to the OCR were necessary.

The usual publicity was given to a rise in house mortgage rates resulting from the latest OCR and to the level of New Zealand's interest rates relative to those of other countries.

Overseas investors in New Zealand debt securities, or those of any country, would be foolish to ignore potential exchange rate movements.

A falling New Zealand dollar could lead to a higher OCR, increases in other yields, consequent capital erosion of the security and fewer units of the overseas currency after realisation and exchange conversion assuming an initial unhedged position in our dollars. A two-way loss.

An increase in the New Zealand currency, accompanying a lower OCR, interest yields and the security's capital appreciation would produce a double winner.

Emphasis on the cost of house mortgages was understandable, given the impact on people's disposable incomes but this overlooked the point that what went up in April 2004 had gone down last year in line with OCR reductions and declining yields on 90-day bank bills, the latter a contributing factor in house mortgage rates.

The latest OCR and adjustment to yields should benefit the many people who deposit money with registered banks and other sound financial institutions.

Deposit rates rises as yields on alternative securities go up, subject to each institution's demand for funds and the maturity mix of their borrowing and lending portfolios.

The decisions of Dr Bollard and the Reserve Bank lack (so far) the massive worldwide impact of those emanating from US Federal Reserve chairman Alan Greenspan and his colleagues. The former's effects on the smaller-scale New Zealand economy are just as intricate, although in miniature.

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