Reserve Bank interest rate hammer hits hardest since global financial crisis

Thursday, 13 April 2023

The Reserve Bank is working hard to stamp out inflation.

Reserve Bank action to beat inflation is the central bank’s toughest crackdown since its attempts to cool the economy in the run-up to the global financial crisis, ASB economists say.

Households’ spending power is being crushed by inflation at levels not seen since the 1990s, and home loan rates that have tracked up as the Reserve Bank cranked the official cash rate (OCR) up from 0.25% in August 2021 to 5.25% today.

But ASB economists say the true force of the Reserve Bank’s OCR hammer can only be measured when compared to the “neutral OCR” which is the notional level of OCR which would neither stimulate the economy, nor slow it down.

ASB estimates the current neutral OCR is about 3%, and that the Reserve Bank’s current rate will exert a dampening effect “equivalent to what was in place leading up to the GFC”, the ASB economics team headed by Nick Tuffley said.

* Here's what the Reserve Bank doesn't want you to know about its OCR decision this week

The path back to low inflation - Reserve Bank of New Zealand chief economist Paul Conway. (First published March 23, 2023)

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At that time the OCR peaked at 8.25%, ASB’s economists said.

ASB expects the OCR to peak at 5.5% in the current OCR cycle, and then ease to around 3%, during the next two years.

A falling OCR should feed through into falling mortgage rates, but the timing of the OCR coming down remains uncertain, ASB says, as inflation here and overseas has proven harder to shake than originally envisioned.

“We remain extremely wary about the inflation outlook,” ASB’s economists said.

The International Monetary Fund issued a global economics report this week suggesting that interest rates in the world’s 34 advanced economies, of which New Zealand is one, would return to pre-Covid levels sometime in 2024, or 2025, depending on conditions locally.

Freelance economist Tony Alexander said immediately before Covid-19 made an appearance in the country, New Zealand interest rates were unusually low as the Reserve Bank was worried about deflation.

Sharon Zollner says prices are too high but that doesn’t mean they can’t rise.

In August 2019, the Reserve Bank cut the OCR to 1% from 1.5%.

The first case of Covid-19 was confirmed on February 28, 2020 by the Ministry of Health in a person in their 60s who had recently returned to New Zealand from Iran.

On March 16 that year, the Reserve Bank took the OCR down from 1% to 0.25%.

ANZ chief economist Sharon Zollner said nobody knew for certain what the neutral OCR was, including the Reserve Bank.

“The range of possible estimates they published in November was 2.7% to 5.4%,” she said.

“If you think about that it means everything from the foot is on the accelerator, to our heads are about to hit the windscreen,” she said.

Not since the GFC has the Reserve Bank taken such powerful steps to dampen the economy, ASB says.

“They only know in hindsight 18 months from now when they see how the economy responds to what they're doing,” she said.

“That's a pretty important source of uncertainty around how high the OCR needs to go,” Zollner said.

The IMF recognised a high level of uncertainty around its interest rate forecasts.

“Overall, the analysis suggests that once the current inflationary episode has passed, interest rates are likely to revert toward pre-pandemic levels in advanced economies,” it said.

“How close interest rates get to those levels will depend on whether alternative scenarios involving persistently higher government debt and deficit or financial fragmentation materialize.”

After the GFC struck, ASB’s economists said the Reserve Bank cut the OCR to stimulate the economy dropping the OCR about 250 basis points below what was the estimated neutral OCR.

“Achieving the same degree of interest rate support this time around would see the OCR fall close to zero,” ASB said.

But, the bank did not expect that to happen.

“Arguably the shocks facing the NZ economy, whilst severe, are not of the same magnitude as the GFC. Inflation is also miles above target and the risk of outright deflation is remote. Even with 500 basis points of OCR hikes so far this cycle, real interest rates are still low historically,” ASB’s economists said.

“However, never say never.”