Opinion: Why Bollard may be forced to review 'low till 2010' stance

By Roger J Kerr Most commentators are in agreement that the accompany statement to last week's OCR reduction was an unprecedented move by the Governor of the Reserve Bank. To understand how monetary policy is now being managed in New Zealand (and thus put some metrics around future interest rate risk) we need to make an attempt to comprehend Alan Bollard's motivation and objectives in stating that short-term interest rates must stay down at 2.5% or below for the next 18 months. Standing back from the rhetoric and daily market noise, it appears that the RBNZ now no longer trusts in the interest rate market to price the future; the RBNZ have decreed that they know better about where interest rates will be priced. Off course they do determine the short-term rates, but beyond four and five year swaps the lack of response by the markets to Bollard's command, underlines the reality that end-investors and end-borrowers are the ones who actually determine the pricing of longer term interest rates.

If that pricing turns out to be accurate and the RBNZ are wrong with their decreed pricing, one can expect a massive and violent upward movement in short-term rates at some point over the next 12 months. In my view the RBNZ have again added to the volatility in interest rates (and potentially the NZD exchange rate) instead of addressing inflation risks without undue volatility in financial markets as they are required to do under their mandate/contract (PTA) with the Minister of Finance. So, what drove Alan Bollard to make the statement he made about future interest rate levels last Thursday:-

• Concern about the economic recovery being de-railed by market interest rates and the NZ dollar increasing prematurely? However, there had to be good reason why the markets were pricing swap interest rates higher during March and April i.e. borrowers and investors acting in accordance with their strongly held view that the NZ economy will recover to positive growth sooner than others and super-loose monetary policy will no longer be commensurate with the related inflation risks in 12 to 18 months time.
• A genuine belief that deflation will pervade the NZ economy and the annual inflation rate will move below 0% in 2010. This is off course not consistent with the RBNZ's published GDP growth and inflation forecasts for 2010 as stated in their March MPS.
• He was spooked by the NZIER Quarterly Survey of Business Opinion ("QSBO") results a few weeks ago with employment and investment intentions falling to record and depressingly low levels. Unfortunately this QSBO survey excludes our largest industry, agriculture, where incomes and confidence are much higher than the retail and property parts of the domestic economy. The more representative National Bank monthly business confidence survey had agriculture at +15% positive on the economic outlook last week, whilst retail was -25% negative. One hopes that the RBNZ are not overly reliant on the QSBO as a lead indicator for the economy, which would be a mistake.
• Concern that household mortgage borrowers are not getting the full benefit of lower market interest rates due to banks not passing through reductions and/or being locked into historical fixed rate mortgages. A more cynical view (discussed below) is that the RBNZ want more mortgage borrowers to stay variable rate so that monetary policy can be more effective in changing spending/saving behaviour.
• The RBNZ want to play a role in restoring NZ bank profitability by forcing a steep upwardly sloping yield curve that allows the banks to take limited interest rates risk in borrowing short (and cheaper) to fund higher yielding term loans and assets. This is what the US Fed Reserve (Paul Volcker) did in the 1980's to work out of the savings and loans banking crisis at that time.
• It is all about the NZ dollar exchange rate and the RBNZ do not want to see overseas investment/speculative flows coming into the NZD that would upset an export-led recovery. This attitude presumes that our exporters are not sophisticated enough to hedge forward their currency risk. They would be wrong on that presumption as well.

If the economic data that comes out over coming months starts to evidence no further deterioration in the domestic recession and growing signs of strength in the big export industries, there will be growing pressure on the RBNZ to review their extraordinary stance taken last week. "”"”"”"”"”- * Roger J Kerr runs Asia Pacific Risk Management. He specialises in fixed interest securities and is a commentator on economics and markets. More commentary and useful information on fixed interest investing can be found at rogeradvice.com