Bad news has become good news with interest rates coming down, setting in motion a better economic climate for 2025.
The catalyst has been a third recession in two years, only this one has really broken the back of pricing behaviour. Tough times have crimped spending, meaning discounting has become more widespread as firms seek to shift product.
Firms have spare capacity for work, so the pricing of work becomes sharper, especially in construction. Higher unemployment has tempered wage demands as job security becomes more important.
This is the basic disinflation playbook.
There are still some sticking points that will add some persistence to inflation. Local authority rates and energy prices being examples not linked to the economy at all. Geopolitical concerns at any time could set of further disruptions to supply chains or oil prices.
However, there are enough “bad news” economic disinflation forces that point lower for inflation to give the Reserve Bank of New Zealand comfort to start cutting the Official Cash Rate (OCR).
With an easing cycle underway the obvious question is how fast and low will interest rates go?
The trajectory for inflation will have a big say over how fast they can fall. A steady decline in interest rates over 2025 is dependent on the RBNZ’s “confidence that pricing behaviour remains consistent with a low inflation environment, and that inflation expectations are anchored around the 2% target”.
Let’s assume it all goes to plan and inflation keeps falling.
The first port of call for assessing how low they will go is the neutral OCR. This is where the RBNZ has the foot on neither the accelerator nor the brake. Think of it as when the RBNZ is on holiday basking in the sunlight of having inflation at 2% and not having to do a lot.
The neutral OCR has moved over time. Back in 2000, it was up around 5% and the OCR wobbled around it. By 2020 it was estimated to have fallen to 2%, allowing interest rates to be a lot lower on average.
If policy rates are below the neutral rate, policy is stimulatory and, conversely, rates above neutral make policy contractionary.
The RBNZ estimates the neutral OCR is now around 2.75-3%, which it is projecting the OCR will fall to. Demographic changes, productivity growth, and changes in consumers’, businesses’, and governments’ attitudes towards savings and investment can all influence the neutral OCR. Future neutral interest rates may be higher due to de-globalisation (adds to costs), ageing populations as they start to spend as opposed to save, decarbonisation (adds to costs and inflation), and higher government debt.
Westpac economists and I put the neutral OCR around 3.5-4%.
Irrespective of the RBNZ or Westpac view of the neutral OCR, the good news is that they are both well below the current level of the OCR.
Historically, monetary policy spends periods both contractionary (above neutral) and stimulatory (below neutral), and here we are simply talking about rates going back to neutral from a period of being contractionary.
Other factors will also play a role over the coming years on borrowing costs. Two key ones are bank funding costs, of which the OCR is one factor, and the pricing of risk relative to the taking of it.
As people have invested more in term deposits in recent years, this has added to bank funding costs. As the Funding for Lending (FLP) programme also winds down (which gave the banks cheap funding from the RBNZ), banks will likely replace FLP funding with retail and/or wholesale funding, although this is more expensive.
New Zealand has a clear structural problem where home lending is being prioritised at the expense of lending into the real productive sector. There is also a related issue regarding the pricing of risk (think bank margins, which drive profits) relative to the taking of risk (think about the volatility of bank earnings, which tend to be very stable). The Commerce Commission has highlighted an inconsistency between the two. Banks deliver superior returns without the risk.
This is where a key part of the upcoming Finance and Expenditure Committee’s inquiry into banking competition needs to focus.
Rural lending will always be more expensive than residential lending. Banks need to hold more regulatory capital against the former. This inquiry needs to put the spotlight on the risk-adjusted returns across residential, business and rural lending, though. We need to see attention on the return on capital from business, rural, and residential mortgage lending.
The bottom line is that lower interest rates are welcome news but there is still some uncertainty over the magnitude of the decline we will see. Assuming inflation remains contained and monetary policy goes back to neutral, a 150-225 basis points drop in borrowing costs from the peak seems in the ballpark with the lower estimate based on a higher assumed neutral rate and the impact of some changes in bank funding costs.
More sunlight on bank rural lending margins could accentuate more competition and that projected decline in borrowing costs.
