Signals confusing consumers

By BRIAN FALLOW

Borrowers are getting mixed messages about interest rates these days.

Reserve Bank Governor Alan Bollard is all but certain to raise the official cash rate (OCR) on Thursday, for the sixth time this year, and with it floating mortgage rates.

But, at the same time, the banks, led by the Bank of New Zealand, are cutting fixed mortgage rates, particularly for two-year terms.

That is the last thing the RB needs, as it confronts an inflation pressure gauge in the red zone and moves to slow the economy down.

With floating mortgage rates set to hit 8.75 per cent, but two-year fixed loans as low as 7.15 per cent, the RB's axe seems to have lost its edge.

The main way the bank can cool an overheated economy down is to push up short-term interest rates, which drives up floating or variable mortgage rates, leaving borrowers with less to spend. This also raises the cost of short-term credit to business.

But only 28 per cent of all mortgage debt is at a floating rate (against 33 per cent at the start of the year).

The gap between floating and fixed rates has widened to the point where almost all new borrowing, including the resetting of fixed loans as they mature, is at fixed rates.

There are two reasons for this. One is a fight for market share by the banks, leading to a squeeze on the margin between their borrowing and lending rates.

The other is that the financial markets believe the economy is set to slow down and that, before long, the RB will be cutting interest rates. The market is picking rates will fall by the middle of next year.

In a world in which interest rates are generally low and rising, New Zealand is one of the few places to offer the prospect of falling interest rates and, therefore, rising bond prices and a capital gain for investors who pile in now.

Westpac chief economist Brendan O'Donovan said two of the Reserve Bank's five tightening moves this year had effectively been undone by lower fixed mortgage rates.

He said the forecasts the bank released last month had two further rate increases built into them but still showed inflation to be a problem - at or above the top of its 1 per cent to 3 per cent target range until the middle of 2006.

Since the September monetary policy statement, growth and inflation figures had come in stronger than the Reserve Bank expected.

Also the Institute of Economic Research's quarterly survey of business opinion found the economy running effectively at full capacity in terms of physical plant and labour, a signal of strong inflationary pressure.

On the other hand, the exchange rate is climbing. On a trade-weighed basis, it is 3.75 per cent higher than the Reserve Bank's assumed level for the second half of 2004.

By reducing export incomes, a higher dollar does some of the growth-retarding work interest rates would otherwise have to do.

O'Donovan said this put the Reserve Bank in a bind. It wanted to push the official cash rate up, to put the squeeze on fixed-term mortgage rates so that an effective tightening occurred.

But a continued OCR increase would underpin an already high New Zealand dollar, hurting exporters and increasing the risk of a hard landing for the economy.

O'Donovan believed the bank was placing less reliance than it had in the exchange rate doing its work for it, because of the volatility.

So he is among the minority of economic forecasters - four out of 14 in the latest Reuters' poll - who expect the Reserve Bank to raise rates again in December.

"We would rate the chance of another tightening in December as around 60 per cent, even though we think it would be unnecessary.

"We expect interest rates cuts around mid-2005 as it becomes increasingly clear the monetary policy brakes have been applied too hard."

Despite the strength of recent economic data, the portents of a slowdown are clear.

House price inflation peaked in December last year and turnover is well down on year-ago levels.

A cooling of the housing market feeds through to consumption with the main effect felt 15 months to 18 months later, Westpac modelling suggests.

Meanwhile, exporters have been shielded from the rising dollar by a combination of record world commodity prices and currency hedging.

O'Donovan said that as commodity prices began to fall and currency hedges ran out, exporters' incomes would fall, slowing economic growth in the first quarter of next year.