RBNZ continues with a rapid pace of OCR increases

By Christina Leung, Principal Economist for the New Zealand Institute of Economic Research

The Reserve Bank of New Zealand (RBNZ) continued with tightening monetary policy at a quick pace with another 50 basis points increase in the Official Cash Rate (OCR) at its August meeting. The move brought the OCR to 3 percent – well above the record low of 0.25 percent a year ago.

Inflation pressures have surged over the past year, with the lift in annual CPI inflation to 7.3 percent for the year to June 2022, bringing it to the highest level since 1990. This strong outturn reflects both strong imported inflation and domestic capacity pressures in the New Zealand economy. The disruptions from the COVID-19 pandemic have created supply constraints in major economies worldwide, including New Zealand. On top of that, unprecedented stimulus from policymakers has boosted demand well beyond the constrained levels of supply, thus driving a surge in inflation. Central banks around the world are now hastily looking to unwind monetary policy stimulus by raising interest rates in order to dampen demand.

Growing fears of a recession in the major economies

The rapid pace of interest rate increases has increased fears of a recession in the major economies. Recent US data points to a mixed outlook for the economy, as economic activity contracted, but its labour market remained strong. Meanwhile, the ongoing war in Ukraine is dragging on activity in Europe, given the disruptions to the oil supply. Here in New Zealand, the latest retail trade data showing a further 2.3 percent decline in sales volumes in the June quarter increased speculation about the economy being in a technical recession (broadly defined as two consecutive quarters of declines in GDP).

Yield curve inversion as markets price in expectations of slowing economic activity

Expectations that the rapid pace of interest rate increases would slow economic activity to the point of recession has driven a decline in longer-term interest rates. With short-term interest rates rising alongside central banks’ increase in their policy rate, this has led to the inversion of yield curves in the major economies. In normal times, the yield curve tends to slope upwards as long-term interest rates are higher than short-term interest rates to compensate investors for the extra risk (of inflation or default) of having their money tied up for longer.

However, in the case of an inverted yield curve, long-term interest rates are lower than short-term interest rates. In the US, the negative spread between the 2-year and 10-year US Treasuries of over 30 basis points suggests market expectations of a significant slowing in economic activity ahead.

This could have implications for the efficacy of monetary policy in the future

The decline in long-term interest rates globally has influenced longer term interest rates here in New Zealand lower. For example, when looking at wholesale swap rates, the difference between the 2-year and 20-year of -11 basis points has implications for the mortgage rate curve. Major banks recently cut their 1-year fixed mortgage rates to below 5 percent – well below the floating mortgage rate of over 6.5 percent offered by most banks. Any further declines in long-term wholesale interest rates should reduce longer-term fixed mortgage rates.

This matters for the efficacy of monetary policy in the future because households tend to fix at the lowest mortgage rate at that point in time. The lower longer-term fixed mortgage rates are, the more likely households will choose to fix at the longer tenors. A shift in mortgages towards being fixed for longer periods would mean that any future moves in the OCR would have a more delayed effect, given the longer time for mortgages to come up for repricing.