Rodney Dickens says the effective OCR is well over double the 1.75% actual rate, and SMEs are paying that price for their working capital financing

By Rodney Dickens*

We still live in the shadow of the financial crisis. For example, high debt levels in the crisis countries mean international interest rates will remain much lower than "normal" for a protracted period still.

The effective level of the OCR is another example. While the actual level is 1.75%, the effective level that allows for the impact the financial crisis is still having on interest rates faced by borrowers is dramatically higher as explained in this Raving.

In addition to the 1.75% level of the OCR greatly overstating how low NZ interest rates are, three game changing factors are at work in the NZ economy that mean predictions of higher interest rates are likely to be misguided. This has parallels with the experience in 2010 when the economic forecasters similarly overlooked negative game-changing factors that were at play well before the Canterbury earthquakes struck. Just as I was alone in 2010 in correctly warning clients that interest rates could fall, I seem to be alone again in warning that interest rates are more likely to fall than increase because of the game changing factors the forecasters are largely overlooking, as discussed in our July economic report.

The financial crisis still casts a shadow over NZ interest rates

Prior to the financial crisis six-month term deposit rates offered by banks moved quite closely in line with the OCR while six-month mortgage rates offered by the major banks were at a reasonably stable premium to both (adjacent chart). Between January 1999 and June 2008 the OCR average to 6.25%, the six-month term deposit rate averaged 6.19% (i.e. 0.06% lower) and the six-month mortgage rate averaged 7.64% (i.e. 1.39% higher than the OCR and 1.45% higher than the six-month term deposit rate).

There was a dramatic change following the financial crisis because banks had to fund more from retail deposits relative to overseas funding. As a result, the six-month term deposit rate increased relative to the OCR (e.g. the term deposit rate is currently 1.56% above the OCR compared to it generally being marginally below the OCR prior to the financial crisis).

But the six-month mortgage rate has continued to largely move in line with the six-month term deposit rate although the gap has increased somewhat (e.g. the current gap is 1.83% versus the 1.45% average gap prior to the financial crisis).

The result is that the average six-month mortgage rate offered by the major banks is currently 3.39% above the OCR compared to the average of 1.39% prior to the crisis. In effect, this means the current level of six month mortgage rates is what you would expect prior to the crisis if the OCR was 2% higher (i.e. 3.75% versus the actual 1.75%). This is the lower bound of my estimate of the effective level of the OCR.

In terms of the overdraft rate faced by small and medium-sized businesses (i.e. SMEs) the adjacent chart suggests the effective OCR is dramatically higher. As was the case prior to the financial crisis, the 90 day bank bill yield, the benchmark short-term wholesale interest rate, continues to move largely in line with the OCR but averages slightly above the OCR.

Prior to the crisis the SME overdraft rate averaged 3.2% above the 90-day bank bill yield and 3.53% above the OCR. Now it is 7.41% above the 90-day bank bill yield and 7.61% above the OCR. The current SME overdraft rate is consistent with an effective OCR of 5.83%. This is the level the OCR would have to be now to generate the current 9.36% SME overdraft is the pre-crisis premium still existed (i.e. an OCR of 5.83% plus the pre-crisis premium of 3.53% = 9.36%). This is the upper bound.

Largely as a result of higher term deposit rates, all fixed mortgage rates remain dramatically higher relative to wholesale or swap rates than was the case before the crisis (adjacent chart).

Prior to the crisis mortgage rates were around 1% above swap rates but now the premiums range from 2.5% to almost 3.25%. This points to the effective level of the OCR being around 2% above the actual level for mortgage borrowers but for business borrowers the effective level of the OCR is higher.

While this implies that the effective level of the OCR is more than double the actual level of 1.75% it doesn't tell us what the current appropriate level should be. The consensus view of the 8 economic forecasters surveyed by NZIER last month was that the 90-day bank bill yield would increase to 3% over the next three years (blue line, left chart below), none forecast that the 90-day bank bill yield would fall (green line) and the most hawkish predicted an increase to almost 4% (red line).

The 90-day bank bill yield forecasts can be viewed as proxies for OCR forecasts. By contrast, swap rates have fallen since the peak level late last year (right chart). The money market is starting to backtrack in terms of expectations of OCR hikes which I see as being justified by the game-changing factors currently at work that have the potential to justify lower interest rates as discussed in the July economic report.

The lower swap rates haven't flowed through to lower fix mortgage rates yet.. However, as was the case in 2010 when there was a sufficient market-led fall in interest rates to result in lower interest rates faced by borrowers, the market is well ahead of the economic forecasters who were similarly predicting higher interest rates in 2010.

There are some differences between current prospects and what occurred in 2010 but the parallels are strong enough that they should be taken seriously as outlined in the July economic report.

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*Rodney Dickens is the managing director and chief research officer of Strategic Risk Analysis Limited.