Opinion: Why the RBNZ's monetary policy has lost its potency

By Roger J Kerr The failure of all of the big four trading banks to follow the "instructions" of the RBNZ to lower their mortgage lending rates when the RBNZ cut the OCR to 2.5% ten days ago tells us a lot about the "two-tier" interest rate market that has developed in recent months and also the now complete impotency of monetary policy. The facts are that the banks' cost of borrowing have not reduced at all over recent weeks, they are paying up to 4.00% (more in some cases) for retail deposit monies and more than that for offshore wholesale funding. The banks are not in a position to cut lending rates as this would erode into their net interest margin and overall profitability. Bank profitability requirements and targets are driven out of the Australian parent banks and there is nothing the NZ Government or RBNZ can do about that. The two-tier interest rate market has come about as the reality of the marketplace is that investors and borrowers (the banks) are meeting on price at a higher interest rate than what the RBNZ is lending to banks on the overnight market (OCR at 2.5%). It appears that the real interest rate market for cold hard cash is between 4% and 5% in New Zealand today. The swaps market may be pricing 1-year money at 3.00% and 2-year money at 3.60%, but supply is meeting demand for funds between investors and borrowers at rates considerably above these interbank swap rates.

It needs to be remembered that swap market is purely an "exchange" market of fixed for floating and floating for fixed. The principal amount is only a notional amount between the parties. It does not involve lending/borrowing the physical stuff and the interest rate being applied for the real cash is higher. The net result of the two-tier interest rate market is that the OCR does not work anymore and it seems to me that it does not make a scrap of difference to investors and borrowers whether the OCR is 2.00% or 2.50% or 3.00%. The RBNZ and monetary policy have become impotent and irrelevant amidst these conditions in my view. The NZD forex market is today sending a clear message with the jump up to 0.6100 as to what they think about current and future interest rate levels in NZ i.e. higher, not lower. The RBNZ will be scratching their heads pretty hard is to what to do from here. Greater forces have taken over NZ interest rates and the NZ dollar. In my opinion, the best course the RBNZ can take from here is to say and do nothing "“ just allow the market to take its own course. Over the past few months the statement and actions of the RBNZ have caused more confusion and market volatility than the desired clarity and stability. In early March, their MPS included a +4.00% GDP growth forecast for 2010. The RBNZ clearly received the message from all quarters that they were being too optimistic on the economic recovery with that forecast. In stating last week that he now wants short-term interest rates at 2.5% for the next 18 months, the Governor is signalling that they now see the economy weaker for longer with no inflation threats. It is this flip-flop on their outlook for the NZ economy that is causing the confusion and volatility. It is extremely difficult to forecast anything with confidence right now, but what has become very apparent is that the recession is turning out to be far shallower than most anticipated for 2009. The local FX and sharemarket gains are telling us this. Borrowers and exporters have had plenty of opportunity to hedge their risks against rising interest rates and a rising NZD currency value over the past six months. If they have not done so, the Boards and shareholders of these companies should be asking some serious questions about how they manage their risks and where they take their advice from. "”"”"”"”"”- * 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