Higher mortgage rates give Reserve Bank ‘a bit of breathing space’, chief economist Paul Conway says

“I think if that wasn’t the case, we would have been more likely to have voted for a hike.”

The Reserve Bank’s Monetary Policy Committee kept the OCR at 2.25% on Wednesday last week.

The committee’s three internal members, who work at the Reserve Bank full time, voted for a hold; its three external members voted for a hike.

Governor Anna Breman used her casting vote to keep the rate at 2.25%.

The bank shifted its outlook to align more with the market by suggesting the OCR could be lifted sooner and more aggressively than previously expected to nearly 3% by the end of the year.

“We’ve sort of come to meet the market,” Conway said.

“Tightness in the market is still there and we are comfortable with that from an inflation control perspective.”

Markets have been pricing in OCR hikes since late last year.

This has resulted in two-year mortgage rates rising to about 5.2%, from a trough of 4.5% in November, despite the OCR not increasing over this time.

Floating and shorter-term interest rates haven’t risen much over this time, as they tend to move with the OCR.

Conway said tight financial conditions had given the Reserve Bank “a bit of breathing space to wait and see how things evolve over the next six weeks”.

“Markets are already doing some of the work for us.”

When interest rates rise, this has a cooling effect on the economy.

Borrowers have less disposable income to spend in the economy. This makes it harder for businesses to hike prices or pay higher wages.

Conway expected the average interest rates paid on the country’s stock of mortgages would start rising soon.

This rate sat at 4.9% in March, according to the latest available data. The Reserve Bank expects it to climb to 5.4% by March next year.

Mortgage rates haven’t moved over the past week, as the Reserve Bank’s outlook now aligns with market pricing.

However, in its Monetary Policy Statement, the Reserve Bank noted retail interest rate increases hadn’t kept up with wholesale interest rate hikes – exacerbated by conflict in the Middle East.

It noted the spread between retail and wholesale interest rates had decreased to historic lows.

The Reserve Bank’s explanation was that banks and other financial institutions had been cautious about passing on changes in wholesale interest rates too quickly, as the environment was uncertain and volatile.

It also noted that because banks weren’t lifting their term deposit rates by much, they didn’t need to lift their mortgage rates by much either, despite wholesale funding costs rising.

Coming back to the Monetary Policy Committee, Conway said the six members agreed on the future OCR track but had different views on when to start lifting the rate.

“It depends on what you’re seeing [in the economy] and where you are,” Conway said.

“That’s why diversity [in terms of who is on the committee] is a wonderful thing.”

Conway said one of the external members, who voted to lift the OCR, was South Island-based and plugged into the rural sector, which is doing well.

“I don’t love the two-speed economy sort of terminology, but the economic performance is quite varied across different sectors and geographies across the country.”

Conway repeated one of the Reserve Bank’s key messages – that it was focused on ensuring higher fuel costs didn’t translate into generalised widespread inflation above the Reserve Bank’s target in the medium term.

He said it was a matter of weighing up “two big forces acting on medium-term inflation” – higher fuel costs and weaker demand, because of there being spare capacity in the economy.

“The interesting thing is, price setting behaviour versus economic slack and us having to thread an interest rate through that so that medium-term inflation equals 2%,” Conway said.

“I just think the challenge of doing that is … well, I’m a bit obsessed with it at the moment, as you’d expect.”

Jenée Tibshraeny is the Herald’s Wellington business editor, based in the parliamentary press gallery. She specialises in government and Reserve Bank policymaking, economics and banking.