Setting interest rates: no need to change the system

Andrew Little has moved on from wanting to “stiff-arm” banks over dairy foreclosures, to talking of the possibility of legislating to force banks (and other lenders?) to pass on in full any OCR changes.

It isn’t the oddest idea in the world – and personally I find the new talk of a Universal Basic Income, much as it has also been propounded by some  on the right, including Milton Friedman, rather more consequential, and worrying.  Many quite sensible countries set fixed exchange rates.

For 15 years in New Zealand –  1984 to 1999 –  we didn’t have a government agency setting interest rates at all.  For much of that time, many of us at the Reserve Bank thought that was only right and proper.  And when we first proposed an OCR-like system, many of the leading economics commentators and bank economists were pretty dismissive.  But in 1999 we simply concluded that –  like most of the rest of the advanced world –  it made more sense to set, or manage directly, an official interest rate.  And now that model is just taken for granted.

Of course, setting the OCR isn’t the same as setting the individual interest rates for each borrower, but I’m sure that if he gave it any thought that isn’t what Little means either.  Perhaps he just means that the Reserve Bank should be able to direct set some commercial bank base lending rate against which all other lending rates have to be calculated? It seems administratively cumbersome, and perhaps prone to being circumvented –  not unlike much other government regulation, including (for example) direct restrictions on mortgage lending of the sort once unknown in New Zealand but now imposed by the Reserve Bank and accommodated by the current government.  And it is not as if governments universally eschew price-setting in other markets either –  the government recently proudly announced an increase in the regulated minimum price for labour, talking of wanting to push that price (once just a market price) up as fast as possible.

One of the attractions of an OCR-type arrangement is that it is a fairly indirect instrument.  The Reserve Bank can put the OCR pretty much wherever it needs to to deliver on an inflation target.  That is an imprecise linkage, but it works pretty well (at least if the Reserve Bank is reading underlying inflation pressures correctly) and it does so without needing lots of direct controls or impinging very directly on anyone’s business or financial affairs.  The OCR is simply the rate the Reserve Bank pays on deposits banks (and any other settlement account holders) have at the Reserve Bank, and the rate at which the Reserve Bank will lend to banks on demand (against good quality collateral) is pegged to the OCR.   The amounts banks borrow from and deposit with the Reserve Bank aren’t that large : bank balance sheets total almost $500 billion, and bank deposits with the Reserve Bank are fairly stable, currently around $9 billion.  And yet changes in the rate paid on these balances, which don’t move around much, provide substantial and sufficient leverage (partly signaling, partly a change in pricing on one component of the balance sheet) for macroeconomic stabilization purposes.    It isn’t a mechanical connection, but it works.

A variety of other models might too, but the judgement has been –  not just here, but in other similar countries – that an indirect approach like the OCR is less intrusive and has fewer efficiency costs than the alternatives.

And it is not as if there is some obvious problem.  Here is a chart, drawn from data on the Reserve Bank website, showing floating residential mortgage interest rates and six month term deposit rates since 1965.  (It is an ugly chart because the mortgage rate data are monthly throughout, but the term deposit rates are quarterly until 1987).

retail interest rates

Largely, lending rates reflect deposit rates (and to some extent vice versa).   These aren’t perfectly representative indicators, just what we have.  But for the almost 30 years for which we have the full monthly data are available, the average spread between these two series was 2.45 percentage points, with a standard deviation of 0.6 percentage points.  The latest data are for February, and the spread was 2.49 percentage points.  One would expect spreads to move around a bit –  demand for individual products ebbs and flows, and the links between foreign funding markets and domestic term deposit markets aren’t instant or mechanical –  and they do, but there is no obvious or disconcerting trend.

Through the period since 1965 we have had all manner of regimes.  Direct controls on lending rates, direct controls on deposit rates, indirect controls on one, other or both, no controls at all, and then for the last 17 years direct control of the interest rates on one small component of bank balance sheets.  Go back far enough, and during the 1930s a conservative government legislated to lower all lending rates.  But it just isn’t obvious that there is any need to change the operating system now.

To a mere economist, it is a bit of a puzzle what Little is up to.  No doubt the Opposition needs to be seen to be offering alternative policies, but these issues (bank lending rates and dairy foreclosures) don’t seem like an area where there is a substantive policy issue (while there are many other areas of policy where the same could not be said, such as New Zealand’s continuing slow relative decline).  But there does seem to be quite a strain of anti-bank sentiment in New Zealand –  perhaps especially anti foreign banks, the same sentiment that gave us state-owned Kiwibank under the previous Labour-Alliance government.  Perhaps people on the left here are looking to the US and the striking degree of response Bernie Sanders is achieving for his populist message, much of which is centred on an anti Wall St message?


18 thoughts on “Setting interest rates: no need to change the system

  1. Michael
    I’m sure the NZ’s mortgage lending market is the most competitive market in New Zealand. Every feature of it would point to that being the case.
    Any government intervention will produce distortions and inefficiency.
    There is ample evidence.
    In the 1980s when I started at Southpac, the bill discounting subsidiary of National Bank, there were all manner of interest rate controls, and al manner of loopholes.
    Absolutely no one was a winner except the middlemen who manufactured the loopholes.
    Perversely the loopholes were actually encouraged by regulatory agencies and politicians as they wanted money to flow and realised the impeding effect of interest rate controls and restrictions on aspects of bank funding and lending.
    It is disappointing that Andrew Little has stumbled into this in the way he has.


  2. Entirely agree – which is why I reckon it has to be some strategy about playing a populist card (perhaps in this case, partly about undermining the NZF vote). There is plenty of evidence internationally these days that it can work, whether from the left or the right.


  3. yes, but in NZ mostly to manage the day to day flows in and out (net) of bank settlement accounts (ie mostly govt tax and spending and debt flows, which even out over time but not day to day). Some central banks still use OMOs to target the market rate to their announced policy target.


  4. It boils to whether the banks are exhibiting monopolistic behaviour and whether there is fair competition.

    When a bank competes for new business there is a lot of competition but these are not the published retail rates. The banks would make all sorts of offers from reduced interest rates to offerings of cashbacks or Ipads to a new borrower but they have a reluctance to put their published rates down as that would affect their established core borrowers.

    Every bank has a established base of core borrowers. They make their most money from this established base. There is very little incentive for a core borrower to take a competitive rate when their bank may drop their rates in a few months knowing the hassles with changing all the auto payment details, informing your payroll of your changed bank accounts etc. The banks core borrowers are like a cow, which the banks milk by delaying the dropping of the published rates. The banks make most of their money from that lag time. The longer that lag time the more money they make.

    It is this lag time that needs to be policed. How long can they drag before it becomes frustrating enough for a core borrower to shift banks and that is where the monopolistic behaviour resides


    • Also a established core borrower never gets the same incentives or the low interest rates offered to a new borrower. Therefore it is also difference between the published rates and the true competition interest rates offered to new borrowers that needs to be policed.


      • The margins are already sufficiently wide that all the banks make compound record profit year on year. If it is not in the margin spread then it is the lag time.


      • I’ve always been a bit skeptical about the suggestions of excessive ROE. The equity in the NZ subs is implicitly quite heavily supported by the equity in the parents (which are presumed to support the subs in a time of stress). That supports the ratings and keeps funding costs well below where they would be on a standalone basis. True ROE from the NZ operations is at least a bit smaller than the accounts show


      • Sure it may look reasonable from a ROI. Don’t forget the management fees, the shared services billings, the royalties for the brand, the transfer priced cost of funds, etc


  5. On the latter question, perhaps people remain skeptical re the supposed end of ‘TBTF’ which, if correct, suggests those on the ‘inside’ of the large domestic / global banking groups still benefit – to a greater degree relative to other stakeholders – from an implicit public guarantee: risk taking today, rewards for a few tomorrow and re-capitalisation by all the day after tomorrow?


  6. The interesting question is who captures any TBTF perceptions. Not obvious it is today’s creditors (who rationally should price it) or today’s shareholders (who shld have bought at a price that reflects any benefit). Perhaps management – but they do tend to lose their jobs even in bailouts. I’m not saying there is no TBTF perception, just that like tax advantages to housing it is long since capitalized into some price or other, and today’s holders aren’t earning super profits.


  7. Many quite sensible countries set fixed exchange rates.

    Timely discussion I suspect.
    I have been pondering this for a couple of days and was going to reply about it last night. But sleep prevailed.

    As you know i consider wealth creation for Kiwi’s much more important as a goal than inflation fighting which in the end is shadow boxing with no one able to actually predict what that will be, where it will end and what the results will now be as that effort stalls into deflation.

    I have been thinking that perhaps we should focus considerably more on our exchange rate. It affects everything that happens to and inside of NZ. More so than inflation.
    The thing that has always bugged me is how our currency for our tiny nation can be the forth most traded currency in the world. I heard all sorts of reasons, excuses and failed logic but have yet to be convinced that it si anything but currency traders making a profit from our weakness and leaving our citizens to suffer the consequences. Trader really don’t give a stuff as long as they get their profit but it sure has a huge effect on our exporters. Talking to one today. Just a great problem for them
    Add to that a great pile of unwashed currency traders skimming off the top all of all the transactions that the exporters have to make. Ditto of course for importers.

    Now I have to say that when R Douglas floated the currency I thought it was a good idea but good idea’s sometimes are good for only a time and then another good idea is needed.
    It seems to me that we are past that time with floating rates and have been for a longtime.
    The objective as I understand of on inflation fighting was to achieve stable prices.
    Now you can throw all the charts you like but life tells us that prices are never stable for long and in NZ are certainly influenced by exchange rates to a very high degree.

    One learns say in the market place for housing that house prices are never stable for long yet we wouldn’t suggest for a second that councils raise or lower rates to control house prices so why would we argue that setting a base interest rate at the RBNZ would create stability. It is just not that powerful among all the influences that are visited upon the economy.

    Don Brash argued some time back that using fuel tax would be a good way of influencing the economy. Perhaps but would simply alter the amount of cash in the system and who had it. Not a stability project because the govt. would then spend it like they are doing now.

    How ever what would happen if we reverted back to a controlled exchange rate?
    Based around a basket of currencies say10 or whatever was deemed appropriate.
    It would be an interesting exercise (and one that I don’t have the skills to do), to look at what would have happened had we done this say 15- 20 years ago when the currency traders like Key etc began to bugger our currency for exporters.


  8. Sorry posted that before it was finished and edited for spelling.

    As you noted above many sensible countries have fixed exchange rates. I’m not sure of all of them but of course the standout is China with who we are now having lots of exporting difficulties that were supposed to be displaced by the FTA. China on the other hand has a free hand to sell what it likes to us no barriers and it seems that they can also buy what they want with impunity. Our biggest apple exporter has just succumbed to them.

    I see Kiwi’s exporting more, working like fanatics and us being no better off than we were in the sixties and 70’s when life was fun and easy and we all made lots of money. Since 1982 its just got harder and harder and we now own less and less of our country, our businesses and our future.

    Something needs to change to set that right.

    If we keep on doing what we have been doing (and much of it needed doing) we will continue to slide backwards. Its the inevitability of the system.


    • That’s not necessarily true, volatility creates opportunity. Change, flexibility and adaptability are the only constants.


  9. That’s not necessarily true, volatility creates opportunity. Change, flexibility and adaptability are the only constants.

    Daily changing currency rates create opportunity for currency traders but not for those that make and sell.

    Who will pay the most wages long term?


    • It is when you try and fix an exchange rate that you could go broke trying to buffer the exchange risks.China has been able to maintain a fixed rate Yuan to the USD by buying up trillions of US bonds ie taking on USD debt. It is still subject to the exchange risk associated with a falling USD. It has been able to do that by inviting US companies to invest heavily into its manufacturing facilities and selling cheap chinese manufactured product back to the US, owned by American companies. All the largest US companies have massive investments in China.

      New Zealand cannot afford to fix a NZD to USD as we do not have the same attraction for US companies to invest in NZ. The NZ Reserve Bank only has around $9 billion in its Foreign Currency reserve to defend the currency. That would blink out in a matter of minutes to try and hold a USD peg. The NZD is the 10th most traded currency in the world after China. There is not enough reserves that the RBNZ can muster to defend the NZD. The NZ government would be broke in a matter of weeks.


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