Interest In Interest Rates

It seems to me everyone is talking about interest rates at the moment. I've been catching snatches of conversation on trains, planes and restaurants. The topic has featured heavily on TV and in newspapers. Dinner with friends at my home on Saturday night was no exception. It didn't take long before the theme dominating the table was interest rates and the property market.

Then again, we are in Auckland and there's nothing like these two subjects to really spark interest amongst Aucklanders. So, as the subject seems so dear to people's hearts and minds, I thought I'd jot down my thoughts on the matter.

Factors that affect interest rates

There are a variety of factors that can affect interest rates. Broadly speaking we refer to these as internal and external factors. Internal factors refer to things that occur within the borders of the long white cloud. Often we have control over these factors. External factors are those that can affect interest rates that occur outside of New Zealand. We have very little influence over these.

Internal factors

Most of us know that the entity that establishes and implements policies regarding money is the Reserve Bank. It affects monetary policies by setting the Official Cash Rate (OCR). The main aim of this is to control and influence economic activity and inflation. Whilst people are familiar with the job the Reserve Bank has, not many people are clear as to how its work actually affects interest rates.

In very loose terms, banks borrow money which they then lend on to us. Banks borrow money from several sources, such as from overseas lenders, term deposit holders and of course, the Reserve Bank.

When a bank borrows funds from the Reserve Bank, it usually does so at a rate around the OCR. When a bank then lends funds on to us, it does so by putting a bit of a margin on those funds. So if a bank borrows funds from the Reserve Bank at say 5% and if it adds a mark up of say 2%, we can expect that bank to lend those funds to us at 7% or thereabouts.

Accordingly, when the OCR moves, it affects the wholesale rates banks borrow funds at, which in turn, affects the interest rates the banks are prepared to lend money to us at.

When setting the OCR, the Reserve Bank looks about 2 years out. In other words, the Reserve Bank doesn't just deal with what is going on right now in our economy when it sets the OCR. Rather, it looks about 24 months ahead and sets the OCR on what it expects is going to happen in the future. This is something that people often don't know and as such, frequently can't fathom why the Reserve Bank changes the OCR when it does.

Housing market

The Reserve Bank will look at the state and pace of the economy when setting the OCR. With respect to the housing market, the Reserve Bank won't be too concerned despite the fact that there is a good upturn in the Auckland and Canterbury areas. These were the forerunner cities when prices started to turn but it seems the rest of New Zealand is now on the rise. Albeit the market was coming from a very weak initial place, so the fact that sales and prices are climbing in most main cities won't worry the Reserve Bank much at this point in time and won't therefore lead it to tamper with existing monetary policy right now.

Economic activity

Reviewing data, we can see that confidence in the economy is on the rise. There has also been reported a lift in retail sales and spending. Export growth has occurred as well in the oil, dairy, wool and electrical equipment categories. That said, some areas of the economy aren't doing so well. Unemployment is still up and job growth has slowed. Maybe this is a reason Kiwis aren't that keen to truly increase their spending and borrowing. Overall, because the economy isn't in a state where the Reserve Bank thinks it needs influencing, the general consensus is it will leave monetary policy untouched at this stage.

External factors

Another issue that affects interest rates in New Zealand is what is occurring overseas.

For example, if our banks borrow funds from overseas sources, and if at the time of borrowing, money is in short supply, the banks will tend to pay a premium for the money borrowed. Of course, the cost of that increased borrowing is then passed onto New Zealand borrowers when the New Zealand banks on-lend the money to Kiwis. Accordingly, the events occurring worldwide, and in particular in Europe, are of great interest because they have the potential to affect interest rates.

One matter that needs to be balanced against the above is the demand for money. As I've previously said, borrowers' appetite for taking on more debt seems somewhat curbed. New Zealanders aren't much different from Americans and Australians – they are more focused on getting their debt levels down rather than borrowing further. This means demand for money is still subdued. When demand is short and doesn't exhaust supply, the fact that our banks borrow from overseas and then pass funds on to us ultimately means interest costs aren't that much of a worry.

Crystal ball gazing

Given the above, it appears to me economic growth in New Zealand isn't going to dramatically increase this year. Nor will inflation. If we were looking at these issues only, I think I could confidently say I don't think interest rates will rise on the back of a change in monetary policy by the Reserve Bank. However, and it's a big 'however', the circumstances in Europe are worrying. Money supply could become short, which is likely to push the price of borrowing up, assuming Kiwi demand for money is present. That is on the cards given the rebuilding of Christchurch and the state of play many New Zealand businesses will have to confront in the next 12 months. So overall, my money is on interest rates rising. The next big question to answer is when is that increase going to occur?

Some economists are predicting an increase in rates at the end of the year or maybe even early next year. Others are of the opinion rates will increase earlier. My pick, however, is around August. I'm basing this on the fact that the current low interest rates will start to stimulate our economy more so (especially with housing), demand for funds will become heightened, and costs of borrowing funds off-shore will increase.

Summary

Right now you might be trying to decide whether to fix your loans. In order to do this, you need to get some good information before you implement your decision. Do the numbers. Work out the figures. Check to see which alternative will be to your financial advantage. Get help from someone independent. By the way, your bank is not independent. If you need help doing this financial check, then talk to us. Over the years we have helped thousands of clients with their affairs. Of course a large part of our role is working out what is advantageous to clients from a financial perspective. So if you need help, call us on (09) 522 7955 for a chat or fill out our online form.

Until I meet you, I wish you short spendings and long earnings, as the Russian Money Barons say.