As you should know by now, the Reserve Bank of New Zealand decided on Wednesday to slash the Official Cash Rate from 1.75% to 1.5%…which is the lowest it has ever been for this country.

It’s a monumental decision…and is important not just for those in the financial industry, but also everyone else who owns a home, has savings, or will be making a major purchase within the next year. If you haven’t read it already, Simon wrote a top-notch analysis of the decision on Wednesday, which you can read here.

The most immediate impact was felt on the New Zealand dollar…which crashed in the minutes following the release, then surprisingly recovered nicely throughout the rest of the day.

The news also spurred some cheery buying on the NZX, bolstering stock prices a touch.

And, theoretically, this decision should prop up the housing market a little longer…encouraging buying through cheaper mortgages.

But the truth is that it doesn’t always work as planned. Investors might read into the rate cut as a sign of storm clouds on the horizon. Homebuyers may be eyeing the price trends and deciding to wait for prices to fall further before entering in the market. Savers might defiantly hold on to their now less-lucrative deposits in preparation for a potential crisis around the corner.

All of those responses would be completely rational…and yet opposite to what the RBNZ hopes to achieve.

A tough spot to be in

RBNZ Governor Adrian Orr is tasked with two main goals: maximising employment and wrangling inflation to a target of 2% per annum.

And to achieve those goals, he’s been handed a single tool — the Official Cash Rate (OCR). He can give the economy a little gas by lowering the rate…or put on the brakes by raising it. That’s what we call ‘monetary policy’.

The idea is that when the OCR is high, it makes borrowing more expensive and therefore less attractive. It also pushes up the return you can expect on your savings, so you’re more inclined to put cash in the bank.

On the flip side, when the OCR is low, households and businesses can borrow easily and cheaply, which boosts consumption. Savings also return less, so people choose to spend that money instead of leaving it wasting away in the bank.

More consumption = economic growth.

And the RBNZ’s unofficial role is to move that lever back and forth, trying to disrupt the economic cycle…and generate consistent upward economic growth. Which, of course, is not natural. Markets naturally move up and down. That’s just how they work. [openx slug=inpost]

So you’ve got Adrian Orr in the blue corner, armed with the OCR and his team of PhDs.

In the red corner, you have what Adam Smith called the ‘Invisible Hand’, the natural cyclical movement of the economy.

Place your bets.

The academic world puts money on Orr in the blue corner. They believe in the Keynesian idea that central institutions can and should intervene…and in the end, central bankers like Orr can defeat the cycle.

The underdog in this fight comes from the free-market thinkers who come from the Austrian school of thought. They reckon that intervention is fruitless and tends to make things a little bit worse. Better to let nature run its course, however painful it can be during the downturns.

It’s no wonder that prominent Keynesians like Paul Krugman call that opposing idea ‘defeatism’.

Personally, I’m staunchly in the Austrian camp, which puts me at odds with my mainstream financial brethren…but that position comes after making a career and getting a degree in studying this dark art of economics…and finding that the cycle always wins, despite decades and decades of interventionalists trying to fight it.

But who knows? Maybe Adrian Orr will be the one to crack the egg…

Read between the lines

And speaking of Orr, I wanted to quickly highlight a couple of nuggets from his Wednesday press release.

  • He recognises that the economy is actually doing pretty well. Employment looks good right now. Inflation is pretty close to the bullseye. And yet he still decided to cut rates. Odd.
  • His reasoning is that he anticipates a major slowdown in the global economy, starting with China and Australia. In other words, he’s pre-emptively hitting the gas pedal…
  • Then, in the Q&A with the press, Orr threw out a couple of statements which really concerned me. For one, he suggested that we’ve entered the new normal for interest rates, far below the 3.5-4.5% range. That’s problematic because it limits his ability to react to market conditions — to use the OCR in a crisis.

As a reminder, when the Great Financial Crisis hit in 2008, the RBNZ dropped the OCR by 6%. If something happened today, they only have 1.5% to work with.

  • The follow-up thought, then, is how low is he willing to go? Zero? Negative (where you pay the banks to hold on to your savings)?
  • Alarmingly, he said something to the point of, ‘The Swiss have gone negative and it’s gone smoothly!’ The fact that he’s even considering negative interest rates is terrifying. The fact that he thinks there’s something to it is shocking. If you have savings, this is the alarm bell blaring.
  • Then Orr went on to say that his committee is looking at all sorts of scary scenarios. Large-scale bailouts. Sub-zero interest rates. Emergency housing market asset takeovers.

Do you see what’s happening? The Governor of the RBNZ, our Wizard of the Economic Oz, is prepping for doomsday. He’s desperately looking for gimmicks and gizmos to keep the NZ economy afloat…because his trusty OCR lever is already as low as it’s ever gone.

As the IMF said, there are ‘storm clouds building’ here in New Zealand.

While at a surface level, a 25 basis-point cut in the OCR will cheer up the market, the underlying message is far more sinister. Don’t let it slip past you…or you might be kicking yourself in a year or two.


Taylor Kee
Editor, Money Morning New Zealand