Economics and Business: Why rate rises won't work

8 March 2007

There is a general expectation that Allan Bollard, the Governor of the Reserve Bank will act today by raising the Official Cash Rate (OCR) in order to slow the economy. In particular he is expected to want to slow the booming housing market. Whilst the economics of the situation might be obvious, what many have ignored is the business imperative that almost entirely negates Bollard’s control of the housing market. In other words, the official cash rate is largely de-coupled from the housing market. As you probably know I am not an economist, so let me explain the business issue here.

The Reserve Bank acts to control inflation by controlling the Official Cash Rate. This has resulted in interest rates in new Zealand that are significantly higher that many other countries. E.g. Right now, the offical cash rates from Interest.co.nz are:

Country Rate
NZ 7.25%
AUS 6.25%
USA 5.25%
UK 5.25%
Canada 4.25%
Norway 3.75%
Japan 0.50%

There is quiet a spread, and the big the spread the more opportunity for arbitrage. And business, is all about arbitrage; buying in one market and selling in another. So, the bigger the gap, the bigger the business opportunity.

In my mind, what is happening is that the banks are borrowing in low interest rate countries and using that money to lend to Kiwi homeowners, making somewhere between 1%–7% on the deal. It’s easy money.

Of course there is exchange risk, but that can, and is being managed. Consequently, the big banks don’t really need to work about the OCR when it comes to mortgages. Indeed, I predicate that it is possible and likely that the OCR could actually be higher than mortgage rate— just look how slim the margins are between the OCR and the typical fixed rate mortgage. It can be less than 1% and if the OCR goes up today, it will be less than 0.5% for some lenders.

But that doesn’t matter. As I said, the banks can still make money from the deal because they are borrowing overseas. So, whilst they can still make money out of the deal, they will.

No doubt some will argue that the OCR can be used to change consumer sentiment, and that is true. But, is it working in the housing market—apparently not.

So, what is Allan Bollard to do. Well, the proposed levy on mortgages could be effective, but such a move is likely to guarantee that whichever government supported it be voted out at the next election.

This all means that Allan Bollard is in a now win situation when it comes to mortgage rates…