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What interest rates might really be telling us

The Reserve Bank is set to deliver its decision on interest rates tomorrow.

The most recent move, back on November 10, 2016, saw the overnight rate lowered to 1.75 percent. While a Reuters survey of economists indicates no expectation of another move before mid-2019, some market-watchers are questioning the potential conflicting signals given by the Reserve Bank - simultaneously reporting that our economy is running well, while holding interest rates at levels that are normally associated with a crisis.

At their core, interest rates are prices - and prices contain information. With current interest rates, the danger could be that if the “prices” we’re seeing are mispricing real risks, investment decisions made as a result could be askew and (subsequently) costly.

As an example, while many may view the current low rates as a green light to increase borrowing - they could in fact reflect an underlying weakness in the economy, and be understating the inflation building in the system - meaning borrowers could be taking on large obligations into economic weakness and/or much higher rates over time.

With the current unemployment rate at 4.5 percent, the Reserve Bank has already met its employment target. Inflation, on the other hand, still lags their target of two percent per year – a fact they’re citing as one of the reasons for their decision not to move on rates.

A core component of that inflation reading is the contentious Consumer Price Index (CPI). One could argue that many have forgotten what the CPI was designed to do in the first place – measure the rate at which wages should be increased “to maintain the same quality of life, year on year”. According to RBNZ reports, the current rate of inflation has dropped to 1.1 percent per year, well below the 2.7 percent average we’ve seen since 2000 - but for a number of consumers, the reports don’t match reality.

We can look to the Boskin Commission findings by the Clinton Administration in 1996, as the point where the measurement of US inflation took a further turn – leading to wider implementation of substitution, geometric weighting and hedonic adjustments in the calculation of the rate of inflation.

An example of substitution would be replacing salmon for hoki in a consumer’s shopping basket – the argument being that people will choose a cheaper option when the original becomes unaffordable. If we want to maintain our lifestyles, however, it follows that CPI should reflect that – not the cost of survival on substitutes.

Geometric weighting is often applied to markets where prices are rising too fast, such as housing. The Reserve Bank currently underweights the cost of housing relative to real household expenses, whether owning or renting. Some households are paying 40 percent to 50 percent of their incomes on housing.

The current measure of consumer inflation also fails to account for rising taxations, fines and other costs that fall outside their measured baskets, and we may start to see inflation push through as the New Zealand Dollar drifts lower while oil trends higher.

The point is that central bank models may not always get it right - and we have seen spectacular booms and busts as a result.

In his recent book The End of Alchemy, Mervyn King, former Governor of the Bank of England, said the current monetary policies enacted by most central banks are unsustainable and questioned the efficacy of maintaining current measures. This message was echoed by head economist of the Bank for International Settlements, Claudio Borio, in a December 2016 white paper.

The message seems to have been received loud and clear by the major central banks and as a result, we’re seeing the US Federal Reserve once again take the lead, embarking on a cycle of rate hikes since.

The change in tact by the big central banks stands in sharp contrast to their actions in the midst of the financial crisis a decade ago. Loose monetary policies have inflated asset prices and we can expect a correction of asset prices to align with the new, tighter financial conditions ahead. The question is whether the central banks will be able to unwind these loose policies without causing too much volatility and disruption during the adjustments ahead - and some are fearful of the possibility of a recession in the US next year.

What the Reserve Bank does may be of lesser effect, as most banks borrow offshore and these costs have been increasing. We have seen LIBOR and other international bank lending benchmarks rally over recent months. Our Australian parent banks, already under pressure in Australia, will likely look to pass these costs on to New Zealand customers. Thus, the RBNZ’s hand may be forced by external factors down the track, or lending rates by banks could increase despite the RBNZ remaining on hold.

For the time being, regional stock markets are still strong. The NZX closed at an all-time high on Friday, and the ASX at a 10-year high. House prices have levelled off somewhat, and may also lend support to the RBNZ staying on hold over the next few meetings. The changing interest rate environment in which the New Zealand Dollar no longer provides its traditional yield that made it attractive for overseas investors may also prevent advances over the near term, and the outlook from most banks are for a weaker New Zealand Dollar by year end.

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