David Hargreaves says the Reserve Bank will ultimately decide where interest rates go and at what speed. But what will it decide?

I have sympathy for anybody faced right now with the need to refix their mortgage. 

Trying to figure out exactly where interest rates are going is a bit of a head-exploder at the moment.

But look on the bright side - at least all the angst now is about how far rates will DROP rather than how far they will RISE.

So, relief is on the way. It's just how much relief can you get, and when? And, wow, that's a tricky one at the moment.

The situation is incredibly fluid. I'm mindful that whatever I say now could be quite out of date even by the end of a week that, amongst other things sees us getting the June quarter GDP figures and (most crucially) finding out if the US Federal Reserve is going to jump, and how far (IE will it cut, and will it cut by 25 basis points or more?)

The Fed decision will matter for a number of reasons, but not the least will be what it does for wholesale interest rate pricing and what expectations will be placed on our Reserve Bank (RBNZ).

As we know the RBNZ has just commenced what we presume will be an 'easing cycle', dropping the Official Cash Rate (OCR) from its cyclical peak of 5.50% to 5.25%. 

The RBNZ, which is charged with getting inflation back into a 1% to 3% range, with an explicit target of 2%, forecast in its August Monetary Policy Statement that annual inflation as per the Consumers Price Index (CPI) would drop from the June quarter figure of 3.3% to just 2.3% as per the end of the September quarter we are in. That figure, by the way, will be out on October 16, which rather inconveniently is a week after the RBNZ's next (October 9) OCR decision.

Early indications from Statistics NZ's monthly Selected Price Indexes data (covering around 45% of the CPI components) are that the headline annual inflation figure for the September quarter will indeed be well under 3%, for the first time since mid-2021.

But it's good news-bad news potentially because we are currently seeing things like weak petrol prices (well, comparatively!) - but such internationally priced items are beyond the control of the RBNZ and its monetary policy. What the RBNZ can control is the so-called non-tradeable inflation that is notionally generated domestically. And that's still 'sticky', with the annual rate being a still-elevated 5.4% as of the June quarter, while the RBNZ reckons it's only going to fall to 5.1% as of the end of the September quarter.

So, while the 'markets' might see a rapidly falling 'headline' inflation figure and may be looking at the US Fed starting to tuck into some serious rate cuts, our RBNZ is still being cautious. And if it stays cautious it might not cut as fast as people would expect or like - and maybe some of the current bank mortgage rate cuts are being overly presumptuous.

Skinny margins for the banks

On that, it is interesting to view what the differential, the gap, is between bank retail rates and the OCR. At the moment it is skinny. If we use the country's biggest bank ANZ as an example and look at its one-year and two-year 'special' fixed mortgage rates these are currently 6.35% and 5.79% respectively.

Well, that compares with an OCR of 5.25% right now, today, as opposed to what we think it might be, or would like it to be!  And that means the gap between the OCR and ANZ's two-year rate is just 54 basis points, which is real skinny historically. Here's a graph of the OCR since inception and another graph showing six-month, one-year and two-year market average fixed 'special' mortgage rates since 2017. (Click on the little magnifying glass for a bigger version).

What that shows us is there tends to be a gap between the OCR and popular mortgage rates of between two and three full percentage points - and sometimes a bit more. So for the gap in one instance (IE the ANZ two-year rate) to be currently only about half a percentage point is very unusual and tells you that the banks won't want to see such a gap for long.

At the moment of course the banks are short of new mortgage business because of the lack of activity in the housing market and there's keen competition for 'switching' of existing mortgages.

But be sure, our gallant banks will want to see their lower rate crusade followed in short order by an OCR that 'falls into line' - IE comes down plenty.

So, will the OCR come down by plenty?

In its August Monetary Policy Statement (MPS) the RBNZ - and I'm taking some liberties with this because of the imprecise way the forecasts are notated - indicated the OCR could be 4.75% by the end of this year.

Cutting till it bleeds

There's two OCR reviews left this year, on October 9 and November 27. Therefore a 25 basis point reduction in each of those reviews would see the OCR at 4.75% by year-end 2024.

However, at time of writing - and due warnings must again be given about volatility - the financial markets are fully pricing in an OCR of 4.50% by the end of the year, with a better than 50-50 chance that the OCR will actually be as low as 4.25% by the end of 2024.

No wonder then that the banks are firing on all cylinders with the mortgage rate reductions.

Throwing the timeframe out a bit, the RBNZ is essentially signalling an OCR of 3.75% by the end of 2025 and 3.00% by the end of 2026.

To summarise, this suggests the RBNZ right now sees a further 50 basis points of cuts this year, another 100 bps next year and 75 bps in 2026.

The markets say no. They say at least 75 bps more of cuts this year - and very possibly 100 bps. And they see the OCR being 2.75% by the end of 2025 - which is 100 whole basis points lower than the RBNZ is forecasting.

Somebody could end up being disappointed.

Of course, as the RBNZ has been quick to try to stress in the wake of its ill-starred 'hawkish shift' in May its OCR forecasts can tend to be over-analysed, and they are based on assumptions.

In other words the RBNZ can and it will change its mind. And it most certainly has done in the past and indeed very recently after the May 'hawk attack'. 

We can't be sure that the markets are 'wrong' therefore.

I was interested in a recent piece of, I think excellent, analysis from outside of New Zealand on the whole issue done by independent economic research firm Capital Economics.

They will cut more than we think

Having a look at what folk outside of the country can be a very good idea and gets you out of the 'NZ Inc Group Think'. And this was thought-provoking.

Abhijit Surya, Australia & New Zealand economist for Capital Economics, is predicting that the RBNZ will cut the OCR to 2.25% by the end of NEXT YEAR. Which would be a game changer if it happened.

"All told, we expect spare capacity in the economy to keep rising over the next couple of years," Surya said.

"As the incoming data make it clear that the risks to the RBNZ’s current inflation outlook are tilted to the downside, the Bank is likely to embrace a more aggressive approach to policy easing."

He also points out something else: "The Reserve Bank of New Zealand has always ended up cutting interest rates by more than it anticipated at the start of previous easing cycles. We think this time won’t be any different..."

He provides this evidence:

He also produces evidence to back up his suggestion that the RBNZ will cut faster than most other central banks, resulting in it getting the OCR to 2.25% by the end of next year.

"...The analyst consensus thinks rates will bottom out only towards end-2026, making the current easing cycle the longest one in modern history. What’s more, most analysts seem to be expecting the RBNZ to only move in 25bp increments. However, we doubt that the Bank will shy away from larger 50bp cuts, as evidenced by most of its previous easing cycles."

Now, that is just one opinion. But it is an international opinion and our rates of course will be affected by the international perceptions and trading patterns.

All of which doesn't make the job of trying to work out just how quickly rates will fall any easier.

I suspect the release of the inflation figures on October 16 is going to be pretty huge. If those figures do indeed show a 'headline' inflation figure well under 3%, but, more crucially a domestic inflation figure that is starting to drop meaningfully, then the lights are flashing bright green for aggressive rate cuts. 

At that point our stressed mortgage re-fixer might have a clearer idea of what really is a good term to fix for. At the moment - well, good luck.

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