LVRs, interest rates and so on

I was recording an interview earlier this afternoon, in which the focus of the questioning was the Real Estate Institute’s call for some easing in the Reserve Bank’s LVR restrictions.

Of course, I never favoured putting the successive waves of LVR restrictions on in the first place.  They are discrimatory –  across classes of borrowers, classes of borrowing, and classes of lending institutions –  they aren’t based on any robust analysis, as a tool to protect the financial system they are inferior to higher capital requirements, they penalise the marginal in favour of the established (or lucky), and generally undermine an efficient and well-functioning housing finance market, for little evident end.  Oh, and among types of housing lending, they deliberately carve-out an unrestricted space for the most risky class of housing lending –  that on new builds.

That doesn’t mean I think it is remotely likely that the Reserve Bank will be easing the restrictions any time soon –  apart from anything else, it would leave their consultation paper on debt to income ratio restrictions looking a little silly.   Of course, it would be good if the Reserve Bank did lay out some specific criteria for lifting these ostensibly temporary restrictions, but with the toxic brew of rapid population growth and continuing land use restrictions in place, if I saw the world as they seem to, I wouldn’t be in a hurry to lift the restrictions either.

In any case, it isn’t that clear quite how large a role the LVR restrictions are playing in the reduction in sales volumes.   They must be playing a part, but so too will higher interest rates, and the apparent increase in banks’ own lending standards, and pressure through the parents from APRA (on the lending standards across the whole of Australian banking groups).  Which, of course, is also why it isn’t clear quite how much difference any easing back in the New Zealand LVR controls might make.  Some presumably, but even the Reserve Bank has never claimed that LVR controls would have a very large impact on house prices, or housing market activity, for very long.   And while I noticed an article this morning about negative equity, it is worth bearing in mind that, on the REINZ index (not using median prices), house prices have risen 65 per cent in the last five years, and are currently 0.6 per cent off their peak.

But what of interest rates?  A year ago, the OCR was 2.25 per cent, and today it is 1.75 per cent.  Thus, the Reserve Bank talks of having eased monetary policy.   Here are mortgage rates though.

mortgage ratesI don’t suppose anyone is taking out four or five year fixed rate mortgages, but across the entire curve, interest rates are higher not lower.   Or we could go back another year or so, to just prior to when the Reserve Bank began cutting the OCR.   The OCR has been cut by 175 basis points since then.   Even at the shortish end of the mortgage curve, rates are down only 50-70 basis points.

Having been reflecting this morning on Graeme Wheeler’s performance over his term, I had a look back at where interest rates were when Wheeler took office in September 2012.

mortgage rates sept 12Barely lower, even though core inflation –  on their own favoured measure – is as low today as it was then (and has been consistently low throughout his term).

I wondered if there were offsetting factors but:

  • Two year ahead inflation expectations are about 25 basis points lower than they were then (largely offsetting any reductions in nominal mortgage rates, to leave real rates little changed)
  • the TWI measure of the exchange rate is a bit higher than it was then,
  • the ANZ commodity price index, in inflation-adjusted world price terms, is hardly changed from what it was then.

Of course, the unemployment rate has fallen since September 2012, but there hasn’t been any sign of a pick-up in the best indicator of labour scarcity –  real wage inflation.

So, overall, it is a bit of a puzzle how the Governor expected to get core inflation back to fluctuating around the target midpoint without actually easing monetary conditions.  I don’t happen to agree with him on this one, but he keeps talking about how the huge migration inflows have reduced net inflation pressures (supply effects outweighing the demand effects).  If he really believes that it is even more puzzling that monetary conditions haven’t been eased.

I’m not sure how he’d respond.  But perhaps he could explain that too in the forthcoming speech.


Interest rates, supply restrictions, and house prices

There was an interesting post from Peter Nunns on Transportblog the other day, attempting a bit of a back-of-the-envelope decomposition of how various factors, including land use restrictions, might have contributed to the rise in real Auckland house prices over the 15 years since the end of 2001.

Nunns starts his decomposition with the suggestion that:

One simple way to disentangle these factors is to look at the relationship between consumer prices, rents, and house prices:

  • When rents rise faster than general consumer prices, it indicates that housing supply is not keeping up with demand
  • When house prices rise faster than rents, it indicates that financial factors – eg mortgage interest rates and tax preferences for owning residential properties – are driving up prices.

and with this chart


Disentangling the contribution of various factors isn’t easy.  A lot depends on what else one can reasonably hold constant.  Nunns seems to assume that holding real rents constant is a reasonable benchmark, and that we can then think about the change in net excess demand for accommodation by looking at deviations from that benchmark.   Thus, roughly, he suggests that a 31 per cent increase in house prices can be accounted for by supply shortfalls.

Over this period, I’m not at all convinced that is right.  Why?

Largely because of the big changes in long-term interest rates, which –  all else equal –  should have affected supply conditions in the rental market.  Specifically, when interest rates fall a long way it is a lot cheaper than previously to provide rental accommodation (the available returns on alternative assets having fallen so much).

And what has happened to interest rates over this period?  Well, here is a chart of the 10 year bond rate since the end of 2000.


There is always a bit of noise in the series, but long-term nominal government bond yields are now about 350-400 basis points lower than they were in 2001.  A little bit of that is falling inflation expectations (around 50 basis points according to the Reserve Bank survey).  But fortunately in 2001 we also had a 14 year government inflation-indexed bond outstanding, and we do so now as well.  In late 2001, that indexed bond yielded about 4.6 per cent, and the current yield is around 1.6 per cent.  Real long-term bond yields look to fallen by at least 300 basis points (and around two-thirds of that fall has taken place in just the last five years or so).

Short-term real interest rate haven’t fallen that much.  Short-term rates are more volatile, so here I use a two year moving average.

1st mortgage rate 6mth term deposit rate
   Dec 2001 7.99 5.86
  Sept 2016 6.14 3.59

Even on these measures, real interest rates have fallen by perhaps 1.5 percentage points.

In a well-functioning housing supply market, those sorts of falls in real interest rates might reasonably have been expected to be reflected in lower real rents.

Quite how much a fall one might have expected in such a market will depend on a variety of assumptions one makes.  But if landlords had been looking for an 8 per cent annual real return on rental properties back in 2001, then even a 2 percentage point fall in real interest rates, might readily have been consistent with a 25 per cent fall in real rents –  in a well-functioning housing market.  If real risk-free rates have fallen by more like 300 basis points –  as the indexed bond market suggests –  that would be consistent with more like a 40 per cent fall in the rental cost of long-term assets.

These are all illustrative hypotheticals. They assume that new assets can readily be generated.  But in a well-functioning housing markets, new houses can be readily generated.  New unimproved land can’t be (there is a given stock, only what it is used for can be changed).  But in well-functioning housing markets, the unimproved land component of a typical new house+land package will be quite low.  Think of dairy land prices at perhaps $50000 a hectare and you start to get the drift.  All else equal, in well-functioning housing supply markets, when interest rates fall unimproved land values should be expected to increase, but the value of land improvements and houses shouldn’t be much affected at all.

But even that story is a cautious one (biased to the upside).  After all, interest rates typically fall for a reason –  big trend falls don’t occur in isolation.  One such factor is low expected future returns (eg lower expected rates of productivity growth).   And interest rates are not a trivial factor in the cost of land improvements, associated infrastructure, and house building itself.  Again, all else equal, lower interest rates should lower the real cost of bringing new houses onto the market –  reinforcing the expected fall in real rentals.

Of course, this is so detached from the reality of Auckland (or New Zealand more generally) housing markets that it is difficult to even envisage such a scenario.  We have land use restrictions  –  which tend to produce high land prices and high rents –  and when those restrictions run head on into severe population pressures (especially unanticipated ones), it is hardly surprising that house and land and rental prices rise.  But when that clash (between land use rules and rising population) occurs at time when real interest rates have been falling a lot, looking at trends in rents can badly confuse the issue.

I’m not wedded to a story in which all the increase in real house prices in recent years is down to supply restrictions interacting with rapid population growth.  In his piece Nunns notes a couple of other possibilities

some other ‘financial’ explanations could include:

  • New Zealand’s tax treatment of residential property, and in particular investment properties – unlike many of the countries we ‘trade’ capital with, we don’t have any form of capital gains tax on property. All else equal, this means that we should expect structural inflows of cash into our housing market, driving up prices
  • The impact of ‘cashed-up’ buyers coming in without the need to borrow money to invest in properties – including, but not limited to, foreign buyers.

But….our tax treatment of investment properties has become less favourable not more favourable over the last few years  (reduced and then abolished depreciation provisions, the introduction of the PIE regime, lower maximum marginal tax rates.  If these arguments have force at all –  and they typically don’t when supply is responsive –  they should have worked in the direction of (modestly) lowering house prices over the last decade or so.

And while I suspect there is something to the “cashed-up foreign buyer” story, again any such demand only raises house prices when supply is unresponsive.  If supply is responsive –  which it would be without all the land use restrictions –  such demand would be just another export industry.

Of course, the common story is that lower interest rates have raised house prices.  And perhaps they have to some extent, but (a) recall that interest rates are lower for a reason, and real incomes now (ie the expected basis for servicing debt) are much lower than would probably have been expected a decade ago, and (b) lower real interest rates do not raise the equilibrium price of even a long-lived asset if that asset can be readily reproduced.  In well-functioning housing markets, houses can be, and unimproved land is a small part of the total cost.  If lower interest rates raise house prices, it is only to the extent that land use and building restrictions make it hard to bring new supply to market.  (As it happens, of course, in much of New Zealand real house prices are no higher than they were a decade ago when interest rates were near their peaks.)

To a first approximation, trend rises in real house prices are almost entirely due to supply constraints.  There can be all sorts of demand influences –  some government-driven, some not –  and it can be useful to identify them, but in well-functioning housing supply markets they don’t generate rising real house prices.


As just one illustration, here is a chart of nominal house prices for Atlanta over the last decade. Atlanta has had rapid population growth, has experienced significant falls in real interest rates (like the rest of the US), is in a country with mortgage interest deductibility for owner occupiers, and is not obviously a worse safe-haven for Chinese money fleeing the weak property rights of China, and yet nominal house prices are no higher than they were in 2006.





NZ interest rates: why are they persistently higher than those abroad?

In my post yesterday, I noted (with illustrations) that looking back over at least the last 20 to 25 years:

…our interest rates (a) are and have been higher than those abroad, (b) this is so for short and long term interest rates, (c) is true even if we look just at small countries, and (d) is true in nominal or real interest rate terms.  And the gap(s) shows no sign of closing.

Not much about that is really controversial at all.  But quite why these gaps have been large and persistent is more contested.  It isn’t the sort of stuff the mainstream media focuses on –  they tend to be more interested in the historically low level of (New Zealand and foreign) interest rates –  but getting to the correct answer matters, not just analytically but in thinking about policy responses to New Zealand’s long-term economic underperformance.

In thinking about the issue, it is important to bear in mind a few things:

  • short and long term interest rates are related, and there can be information in the relationship between them,
  • short-term interest rates are set by the central bank in response to (perceived) domestic inflation pressures, and
  • interest rates in different countries are related at least in part, by expectations (implicit or explicit) about movements in the exchange rates between those two countries’ currencies.

Broadly speaking, I think there are three hypotheses that are canvassed when these issues are discussed in New Zealand (and there is a fourth, suggested by some recent literature, that a few commenters here have raised).

But first, lets clear away some of other possible answers.

The explanation isn’t domestic monetary policy.  Sometimes people have argued that (a) our target was more demanding than those in other countries, or (b) that our Reserve Bank was excessively “hawkish”, inclined to see inflation under every stone, and so holding short-term interest rates persistently higher than they need to be.  In fact, our inflation target is very similar to those in most other advanced countries.  The Reserve Bank makes mistakes – sometimes they even persist for a couple of years –  and sometimes gaps between our interest rates and those abroad are affected by those mistakes. But other central banks make mistakes too (all of them are human, with much same limitations).  And taking a longer-term perspective, on average over time our Reserve Bank actually delivered inflation outcomes a bit higher than the target they’d been given.  Given the target, monetary policy (pre-2008/09 was typically a little loose  (since then it has probably been a little tight).   All in all, differences in monetary policy conduct or targets just can’t explain those persistent differences in real interest rates.

There is another possibility that be cleared away even more quickly.  If a country had very strong persistent productivity growth it would tend to have higher interest rates than would be seen in other countries.  There would be lots of profitable investment opportunities in that high productivity growth country, lots of (expected) income growth to consume in anticipation of, and so on.  And over time, that high-productivity growth country could expect to see its real exchange rate rise.  Unfortunately, high productivity growth isn’t the story of New Zealand in the last few decades.  Indeed, more often rather the reverse.

Here is a chart I haven’t shown for a while: total factor productivity for New Zealand and for a median of the large group of advanced countries for which the Conference Board has estimates back to 1989.


Rapid productivity growth isn’t even close to a relevant story explaining New Zealand’s persistently high real interest rates.

There is another possible story which hasn’t really entered the mainstream of the New Zealand debate, but should be covered off for completeness.  It notes that New Zealand is a small country, with quite a volatile terms of trade, and that the currencies of such countries offer less good diversification opportunities, suggesting that anyone investing here would require a higher return than elsewhere.  It sounds initially plausible, but it has a number of problems.  The first is that our interest rates have been persistently higher than those in other not-large countries with their own currencies (I showed the chart against the median on Australia, Canada, Sweden, and Norway in the previous post).  And the second is that if this were an important channel, it would suggest that small countries face a higher cost of capital than large ones, which would limit the growth prospects of small countries.  But (badly as New Zealand specifically has done) there is no real sign that small countries typically grow (per capita, or per hour worked) more slowly than large ones.  At present, I don’t think it is a particularly strong candidate to explain New Zealand’s persistently high interest rates.  Apart from anything else, if this were the story, why would New Zealand have accumulated –  and maintained – such a large negative net international investment position (NIIP) (still among the largest of the OECD countries)?

Perhaps somewhat related, but from an older set of models, is the idea that New Zealand has some combination of persistently good investment opportunities, and modest national savings rates, and requiring foreign funding for such opportunities needs to pay a premium rate of return. It is nothing to do with specific New Zealand risks (small, volatile etc) simply that capital needs a premium to attract it away from home, no matter where home is.  Again, it sounds plausible, but runs into some problems.  Perhaps the most important is that this story cannot explain why the real exchange rate should also have been persistently high  (on a pure time series basis for at least the last decade, but relative to the growing productivity differentials for rather longer than that).   Typically, part of the way New Zealand might attract the foreign capital it needs is through some mix of a lower (than usual, or easily explainable) exchange rate, and higher interest rates: from a foreign investor’s perspective it is the total return that should matter, not just the interest rate.  Senior Reserve Bank people have, at times, sought to invoke this explanation as at least part of the story.

A more prominent explanation for New Zealand’s persistently high interest rates points to the large negative NIIP position and asserts that the explanation for high interest rates is pretty straightforward: lots of debt means lots of risk, and hence the need for a substantial risk premium on New Zealand interest rates.  Taken in isolation –  if someone told you only that a country had a large negative NIIP position this year –  it might sound plausible.  Once you think a bit more richly about the New Zealand experience it no longer works as a story.

First, our NIIP has been large (and negative) for a very long time now –  for at least the last 25 years, and over that time there has been no persistent tendency for the NIIP position to get better or worse.  By contrast, 20 years earlier than that New Zealand had almost no net foreign debt.  The heavy government borrowing of the 70s and 80s had markedly worsened the position.  It is quite plausible that foreign lenders might then have got very nervous and wanted a premium ex ante return to cover the risk. In fact, we know some (agents of) foreign investors got very nervous –  there was the threat of a double credit rating downgrade in early 1991.  But when lenders get very nervous, borrowers tend to change their behavior, voluntarily or otherwise, working off the debt and restoring their creditworthiness.   And in New Zealand, the government did exactly that –  running more than a decade of surpluses and restoring a pretty respectable government balance sheet.  But the large interest rate differential has persisted –  in a way that it did in no other advanced country (including those that went through much worse crises and threats or crises than anything New Zealand has seen in the last 25 years).

We also know that short-term interest rates are set by the Reserve Bank, in response to domestic inflation pressures. But long-term interest rates are set in the markets.  If investors had really been persistently uneasy about New Zealand’s NIIP position, we might not have seen it much in short-term interest rates, but should certainly have expected to see it in the longer-term interest rates. (That, after all, is what we see in various euro countries that have lapsed in and out of near-crisis conditions).   But one of the other features of the New Zealand experience is that over the last 25 years is that New Zealand’s long-term interest rates have been a bit lower relative to New Zealand’s short-term interest rates, than is typically seen in other countries.   In one obvious place one might look for direct evidence of such a risk premium, it just isn’t there.

yield-gap-2016In fact, on this measure we look a lot more like Norway –  which has a huge positive NIIP position (net foreign assets) and very little government debt.

And remember, too, the point I made earlier about the exchange rate.  When risk concerns about a country/currency rise, one of the first things one typically sees –  at least in a floating exchange rate country –  is a fall in the exchange rate.  It is a bit like how things work in equity markets.  When investors get uneasy about a company, or indeed a whole market, they only rarely succeed in getting higher dividends out of the company(ies) concerned.  If the companies were sufficiently profitable to support higher dividends the concerns probably wouldn’t have arisen in the first place.  Instead, what tends to happen is that share prices fall –  and they fall to the point where expected dividends, and the expected future price appreciations of the share(s) concerned, in combination leaves investors happy to hold those shares. In that process, an increased equity risk premium is built into the pricing.

At an economywide level,  if investors had had such concerns about the New Zealand economy and the accumulated net debt position, the most natural places to have seen it would have been in (a) higher long-term bond yields, and (b) a fall in the exchange rate (and perhaps a persistence of a surprisingly weak exchange rate). But we’ve seen neither in New Zealand.  Had we done so, presumably domestic demand would have weakened, and net exports would have increased.  The combined effects of those two shifts would have been to have reduced the negative NIIP position, and reduced whatever basis there had been for investors’ concerns.  Nothing in the New Zealand experience over the last 20 years or more squares with that sort of story.

And that is the really the problem with the most common stories used to explain New Zealand’s persistently high interest rates. They simply cannot explain the co-existence of high interest rates and a high exchange rate over long periods.

My alternative approach seeks to do so.

It involves looking at the stylized facts and suggesting that perhaps they point in the direction of an abundant supply of credit from abroad (perhaps something almost like the horizontal supply curve of the textbooks), combined with some factors that give rise to persistently strong demand for scarce domestic resources.  That in itself shouldn’t really be terribly controversial.  There are pleasing stories which, if true for New Zealand, would produce that sort of combination.  If New Zealand individuals and firms were generating a world-beating stream of new ideas and business opportunities, business investment would be strong, productivity growth would be strong, and a “strong demand meets ready supply” story would have everyone nodding approvingly.    But….we know that productivity growth has been persistently weak (there are good years and bad ones, but the trend story is pretty disappointing) and business investment has also been weak (in long-term cross-country comparisons).  And with that disappointing productivity growth, households also wouldn’t have been rationally consuming in expectation of even stronger future income growth than we see in most countries.

So I’ve suggested looking at “demand shocks” instead, and particularly those that might arise from outside the system (the private economy), focusing on activities/choices/initiatives of government.   Governments are not as responsive to market prices as the rest of us.

Again, there is nothing overly controversial about this idea in principle.  A big increase in domestic government spending on goods and services, for example, will tend to push up the real exchange rate, and quite possibly push up domestic interest rates as well. My favourite example is prisons.  Relative to a no-crime hypothetical, a government that finds itself needing to build more prisons, needs to get command of the resources to build those prisons, and then staff them.  Doing so will tend to bid up the price of domestic goods and services (including labour) –  and raising the price of non-tradables relative to tradables is one of the definitions of the real exchange rate.  Resources used for building and staffing prisons (and actually, the people imprisoned and no longer in the labour market) can no longer be available for generating tradable products.  The higher real exchange rate squeezes some of that production out.

But my specific version of the demand story looks at our immigration policy.  Government decisions on how many non-New Zealanders too admit each year –  themselves largely reached independently of the state of the New Zealand business cycle – can be presented, quite reasonably as a “demand shock”.   The net impact of additions to the population from outside the system –  births are conceptually a little different –  tends to boost demand more than it does supply in the first couple of years after the migrant arrives.  And if there was simply one wave of migrants –  as in some of the events studied in the literature –  the effects would wash through fairly quickly.  But in fact, we have a new large wave each year, and have had really ever year since around 1990 (immigration was being liberalized over several years around that time).    Each new migrant needs –  just as they did at time Belshaw was writing – quite a lot of new physical capital (houses, roads, schools, offices, factories etc) and they bring almost none of it with them.  Additional demand for those real resources has to be met by squeezing out other forms of demand –  and that is what persistently higher real interest rates and exchange rate tend to do.  The fuller version of my story was in a paper I wrote a few years ago for a Reserve Bank and Treasury forum on exchange rate issues.

Some people worry that I must be assuming some irrationality or market failure (crutches which, quite rightly, economists are wary of relying on).  But I’m not.  Recall that the active agent here is mostly a body outside the market: the government, which for whatever reason decided that it wanted to bring in 45000 to 50000 non-citizens per annum.  The people who come are presumably being quite rational.  The people whose firms respond to new fixed capital demands (and other requirements of a growing population) are being quite rational.  There is quite real new demand in front of them.  The central bank which raises interest rates, and the markets which push up longer-term interest rates, are also presumably being quite rational.  There is more demand pressure in the New Zealand economy. Perhaps the one area in the story that is a bit of a surprise is that long-term interest rates haven’t stayed up as high, relative to short-term interest rates, as we might expect.  I’m not sure why that is –  but it is a hard observable fact, present in the data without any need to torture it first.

My own hypothesis –  and it is pretty tentative –  is that few people in international markets really realise the importance of persistently high immigration in boosting demand.  And most of them –  quite rightly – operate with a mental model that envisages convergence with world real interest rates in the long haul.  If immigration policy were overhauled and drastically cut back, exactly that sort of long-term interest rate convergence would occur.  In a way, it might be just as well that many investors haven’t quite realized –  over many years –  how persistently large the gap between New Zealand and world interest rates would remain.  If they had (or even did today), the rational response would have been to bid the exchange rate quite a lot higher than it has actually been.  Investors  –  and international agency experts –  have often expected New Zealand’s exchange rate to come down, partly because they kept, mistakenly, expecting the interest rate convergence that never happened (yet).  Expectations drive pricing, and if people think the interest rate gap will remain larger for longer, relative expected returns on different assets are only roughly equalized if the exchange rate goes still higher now, so that it can fall further some time in the future.

Is my story the correct one?  I don’t know, but I’ve been running it now for six or seven years, and as the ideas have had more exposure I’ve not been presented with any counter-arguments or evidence that would undermine my sense that “repeated demand shocks” (largely resulting from our immigration policy) are a material part of the story for why our interest rates have remained so persistently high relative to those in the rest of the world.  It is a difficult story to test in a formal empirical way –  something that probably frustrates me as much as it does some of the sceptics –  partly because it isn’t some generalized global story about all immigration everywhere, but about how events and policy interventions have unfolded in his specific economy, with its own specific set of other stylized facts (including, for example, the modest national savings rate).

Like all hypotheses, mine is put out in part to prompt reactions, to identify holes in other stories, and to help prompt alternative, perhaps richer, stories. For now, however, I’m pretty confident that mine is the only one of the stories on offer that can reasonably account for the combination of:

  • persistently high (relative to other countries) real interest rates,
  • a persistently high real exchange rate,
  • long-term interest rates lower relative to short-term rates than is typically seen,
  • a high (almost entirely private) negative NIIP position,
  • all over a period where productivity growth has continued to lag behind that seen in most other advanced countries.

It might not be the whole story, but it feels a lot like a significant step towards such a story.

New Zealand interest rates: persistently higher than those abroad (Part One)

New Zealand’s interest rates have been higher than those in the rest of the advanced world for decades.  Making sense of why is one element –  I argue an important one –  in getting to the bottom of why New Zealand’s relative economic performance has been so poor, and in particular why we’ve made up no ground relative to most other advanced countries in the last 25 years or so.  Our productivity growth has been slower than that of most other advanced countries, and after a disastrous few decades we entered the 1990s already less well off than the typical advanced country.

If we had good comparable data for the earlier decades (say 1950s to 1970s), and market prices had been free to reflect underlying pressures, our interest rates would have been higher than those in the rest of the advanced world then too.  Instead, we made much greater use of direct controls (on imports, credit, foreign exchange flows) than most advanced countries did.  We don’t really get comparable interest data again until the mid 1980s.

When I say that our interest rates have been higher than those in other advanced countries, I really mean “real” interest rates.  Differences in inflation rates really complicate the picture at times in the past –  in the 1970s and 1980s for example, New Zealand had some of the highest inflation rates in the advanced world.   But over the last couple of decades, inflation rates have been much lower and much more stable, across time and across countries. I could spend a great deal of time constructing estimates of “real” interest rates, but none of them would be ideal (eg there are no consistent cross-country measures of inflation expectations) .   And so the charts I’m showing in this post, will use nominal interest rates.  Where relevant, I will mention changes in inflation targets, actual or implicit.

And when I say that our interest rates have been higher than those in other advanced countries, I don’t necessarily mean “in every single quarter, against every single country”, but on average over time (actually, in the overwhelming majority of quarters, against the overwhelming majority of countries).   New Zealand’s OCR actually got as low as the US federal funds rate target in 2000 (both were 6.5 per cent), but it didn’t last more than a few months.  Changes in inflation targets do make a bit of a difference: in the early 1990s for example, we were targeting 1 per cent inflation.  Australia didn’t have an explicit target at all for a while, and when they adopted one it was centred on 2.5 per cent.  So our nominal short-term rates were somewhat relative to theirs in the early 1990s.   Adjusting for (say) differences in inflation target, our policy rates have been higher than theirs throughout the last 20 years, with the exception of the peak of mining investment boom.

The point of this series of posts isn’t really to establish that our interest rates are, and have been, higher than those in other advanced countries.  No one seriously contests that.  But just to illustrate the point briefly, here are a couple of view ofs the long-term bond yield gap.


One line shows the gap between New Zealand and the median of the all the OECD countries for which there is data since 1990 (ie mostly excluding the eastern European countries), and the other is the gap between New Zealand and the median of Australia, Canada, Sweden and Norway, four not-large countries that control their own monetary policy.

The gap is larger than it was in the early 1990s –  when we had an unusually low inflation target –  and even if you take just the last 20 years (or even the last 10) there is no sign of the gap narrowing.  There are cyclical fluctuations, of course, but our long-term interest rates are well above those in other advanced countries (with mostly quite similar inflation targets).

And here is the same chart for short-term interest rates (again, OECD data).


Again, no sign of any convergence occurring.  Even the latest observations (on which almost no weight should be put –  rates fluctuate) aren’t much different from the averages for the last 20 years.

And since commenters sometimes highlight small countries, here is the short-term interest rate gap between New Zealand and the median of the seven smallest OECD countries that have their own monetary policy for the last 20 years (a period for which the OECD has data for all of them).


So our interest rates (a) are and have been higher than those abroad, (b) this is so for short and long term interest rates, (c) is true even if we look just at small countries, and (d) is true in nominal or real interest rate terms.  And the gap(s) shows no sign of closing.

But the really interesting question isn’t whether our interest rates are higher, but why.  That will be the focus of the next post.


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?


Retail interest rates and the OCR

Various media outlets over the last day or so have asked for my views on whether banks will, or should, pass through yesterday’s 25 basis point cut in the OCR into lower retail rates.

My bottom line was

“I think there will be political pressure on the banks to cut to some extent, but I’d be surprised if it [any cut in floating mortgage rates] was anything like 25 basis points.”

It didn’t even seem a terribly controversial point.

After all, the Reserve Bank had included this chart in the MPS yesterday

funding costs

And they could have included one of credit default swap spreads for Australasian banks (as per this one at

The Bank even commented in the MPS that:

the cost of funding through longer-term wholesale borrowing has risen with the pick-up in financial market volatility (figure 4.3). The increase in longer-term wholesale costs this year adds to the increasing trend since mid-2014, which reflects a mix of global regulatory changes, concerns about commodity markets and emerging economies, and broader financial sector risks. To date, strong domestic deposit growth has limited the need for New Zealand banks to borrow at these higher rates. However, acceleration in credit growth over the past year might increase banks’ reliance on higher-cost long-term wholesale funding, leading to higher New Zealand mortgage rates.

It has been a commonplace in the recent Australian discussion that unless the Australian cash rate is lowered higher mortgage rates seem quite likely because of the rising funding spreads.

And so I was slightly taken aback to see the Governor, and his offsiders, quoted as having told Parliament’s Finance and Expenditure Committee that

“I’d expect the floating rates to come down by 25 basis points,” Wheeler told the select committee.

and that

“Banks are only raising a relatively small share of their funding from overseas at this point in time. They’re continuing to see very strong deposit growth. Most of the credit expansion that’s going on has been funded through deposits,” Hodgetts said.

Central bank governors aren’t there to provide defensive cover for banks’ pricing choices, but neither should they be winning cheap popularity points in front of committees of politicians by calling for specific cuts in retail interest rates that don’t even look that well-warranted based on their own analysis (eg the MPS quote above).

Bernard Hodgetts, head of the Bank’s macro-financial stability group, argues that rising offshore funding costs aren’t really relevant because banks haven’t raised much money in those markets recently.  But surely he recognizes the distinction between average costs and marginal costs?    For the banking system as a whole, the place where they can raise additional funding –   much of which has to be for term, to satisfy core funding ratio (and internal management) requirements  – is the international wholesale markets.  And what banks would have to pay on those markets in turn affects what they are each willing to pay for domestic term deposits.

There isn’t a one-to-one mapping between rises in indicative offshore funding spreads and spreads of domestic terms deposits, but hereis a chart showing the gap between term deposit rates (the indicative six month rate on the RB website) and the OCR.

6mth TD less ocr

Unsurprisingly, it looks a lot like the indicative offshore funding spreads chart above.

And what about the relationship between floating mortgage rates and the OCR?  Here I’ve shown the gap between the floating first mortgage new customer housing rate and the OCR.  I’ve included yesterday’s OCR cut and assumed that banks eventually cut their floating mortgage rates by the 10 basis points the ANZ, the biggest bank, announced yesterday.

mortgage rates less ocr

The resulting gap doesn’t look particularly surprising.  The gap between mortgage rates and the OCR blew out during the 08/09 crisis when funding spreads and term deposit margins blew out. It came back from those peaks and has been fairly stable since –  narrowing a bit further a couple of years ago, when it looked as though funding spreads might continue to narrow (and when banks were trying to get loans on their books in face of the new LVR controls).  And now, perhaps, those spreads are widening out again –  as one might expect given the persistence of the rise in the offshore funding spreads.

All these points are really illustrative only.  I don’t have access to more precise data.  But as in any business, pricing involves some judgements.  Perhaps the political and customer pressures will mount and banks will find themselves having to pass more of yesterday’s OCR cut into lower retail lending rates than they would really like. But this is a repeated game.  Even the Reserve Bank expects one more OCR cut before too long, and many of the banks now expect at least one beyond that.  Over the course of the rest of the year, it seems likely that unless those international funding spreads start sustainably falling again, that retail interest rates will fall by less than the fall in the OCR.  It has happened before –  most notably in 2008/09 –  and will happen again.  And it works both ways: if funding spreads ever go back to pre-2008 levels, retail rates will fall further than (or rise less than) the OCR.  The Reserve Bank takes those factors into account when it sets and reviews the OCR every few weeks.

From my perspective, the prospect that retail rates might fall less than the OCR is neither good nor bad, it just is.  As in any business, costs are an important consideration in pricing, but retail mortgage banking is also a pretty competitive business.  Banks don’t need our sympathy, but we also don’t need populist anti-bank cheap shots.

The right answer for the Governor, asked by MPs whether banks would pass on the lower OCR, would surely have been something along the lines of  “That is up to them.  They operate in a competitive market, and they face a variety of cost pressures.  We’ll be keeping an eye on each stage of transmission mechanism –  between OCR changes and eventual changes in medium-term inflation –  and will adjust the OCR as required to deliver on the target set for us in the PTA”.

Some Great Depression comparisons

Back in the early days of this blog, I illustrated how for advanced countries as a group cumulative growth in real GDP per capita in the period since the peak of the last cycle (2007) to 2014 had been no better than that in a comparable seven year period from 1929, during the Great Depression.

Here is an updated version of the chart I ran then for all the OECD countries

real pc gdp growth 07 to 14

The median growth rate –  o.22 per cent in total over seven years –  is so small as to be almost invisible on the chart.

And here is the comparable chart, using the Maddison database of historical estimates, for the years 1929 to 1936

1929 to 1936b

I wouldn’t want to make much of the differences in the median growth rates –  given the imprecision of many of the historical estimates, and the likelihood of revisions to the more recent ones.  I was more struck by the lack of any material real GDP growth per capita in either period.

The Great Depression is seared in historical memory –  and whole generations of politicians came afterwards telling themselves and voters “never again”.  It is too soon to know whether the most recent period achieves the same permanent imprint on historical memories.  Perhaps in part it will depend what comes next.    But I’ll be a bit surprised if this episode has quite the same impact.  The Great Depression hit popular consciousness particularly hard because unemployment rates in so many countries rose very high, and stayed high for a long time, and in an age when government income support for those unemployed was typically less generous than it is today.

There aren’t (at least that I’m aware of) any consistent cross-country estimates of the unemployment rates in the 1930s.  But in most countries, the increases in the unemployment rates were very substantial (in the US, the unemployment rate is estimated to have peaked well above 20 per cent, and remained high for years).

By contrast, here is what has happened to advanced country unemployment rates in the last decade or so.

oecd U since 04

Whether one takes the median OECD country or, say, the total for the G7 countries, there was an increase in the unemployment rate of around 2.5 percentage points, which has been substantially reversed over the subsequent years. Unemployment rates are typically around where they were in 2006.  There are still awful cases –  Spain and Greece still have unemployment rates in excess of 20 per cent –  but the defining character of the last few years has not been very stubbornly high unemployment rates.

What really marks out the last decade  –  and contrasts it with the 1930s – is how poor the productivity growth has been. Without productivity growth, one can still end up with plenty of jobs, but they tend not to offer much in way of wage increases.

I’ve drawn attention previously to the work of US economic historian Alexander Field, who devoted a book to illustrating the very strong productivity gains (TFP) that the US had achieved in the 1930s.  A few weeks ago, I saw a nice summary of a new study by some other economic historians.   On the basis of their new work, they no longer see the 1930s as the period of fastest TFP growth in US history, but it was still very strong –  reflecting rapid technological and managerial innovations.  Here is the key chart.

Figure 1. TFP growth in the private domestic economy, US, 1899-2007 (% per year)

crafts us productivity

By contrast, here is a picture that uses John Fernald’s (FRBSF) business sector TFP estimates for the US over the last 25 years.


Business sector TFP growth is typically faster than for the entire economy, but for the last 10 years Fernald estimates average annual growth of  just over 1 per cent, dramatically slower than the 7 per cent average growth over the previous 10 years.

The slowdown in productivity growth isn’t unique to the US –  indeed on some measures, the US has done better than most –  and was becoming apparent in the data (again, not just this dataset), if not in the public consciousness, before the great recession of 2008/09 and its aftermath.

The contrast with the 1930s is striking.  That was, overwhelmingly, a failure of demand and of the global monetary system, and as those constraints were removed, the underlying lift in productivity supported a recovery in investment.  For the US, for example, post-war per capita GDP is on the same growth path as it had been pre-1929: output wasn’t permanently lower.

What about the current situation?  Taken together, falling rates of population growth and falling rates of TFP growth materially reduce the volume of investment that is likely to be required, and profitable, at any given interest rate.  Add in apparently high desired savings rates around the world, and it is hardly surprising that real interest rates have fallen away so much.  Add declines in inflation expectations to the mix, and it has reinforced the decline in nominal interest rates.  The problems are mostly structural in nature, but they have been amplified by the reluctance of central banks to do what is required to keep inflation (or other nominal measures) up around target, in turn driven by a constant focus on a desire for “normalization” and a focus on some sense of where real interest rates “must” (in some sense) be in the very long term.  The reality, and perceptions, of the near-zero lower bound haven’t helped in many countries.

I’m pretty confident that in the longer-term real interest rates around the advanced world will be positive –  land is still fertile, as is the human imagination (so there will be a flow of new innovations and opportunities.  But there is no guarantee of such positive real interest rates in any particular decade (any more, in a New Zealand context, than there is a guarantee that our real interest rates will converge with those of “the world” in any particular decade).  It seems likely that some mix of lower global savings rate, higher birth rates, and structural reforms that create a better climate for productivity growth and investment are likely to be required to put the world economy on a better path –  one that, inter alia, might put us back on a path that supported more “normal” levels of nominal and real interest rates.  But those interest rates will be an outcome of a successful overall policy mix, not an intermediate target in their own right.  Monetary policy –  here and abroad –  in recent years has come too close to treating them as an intermediate target, rather than focusing on, and responding to, the data flow.