Frank Newman: Interest rates down, dairy prices up

Last week the Reserve Bank reduced the Official Cash Rate (OCR) by 25 basis points to a new low of 2%. The downward shift was widely expected.

Their main reason for doing so was low global inflation and the prospect that domestic inflation would remain below the 1 to 3% target range. Internationally interest rates are at record lows, as economies struggle to gain economic momentum in the face of a slow-down in China and a domino effect elsewhere.

The dilemma for our central bank is that our interest rates remain relatively high against other counties. That's increasing demand for the kiwi dollar and the exchange rate. They say, "The high exchange rate is adding further pressure to the export and import-competing sectors and, together with low global inflation, is causing negative inflation in the tradables sector.  This makes it difficult for the Bank to meet its inflation objective.  A decline in the exchange rate is needed."

Given the exchange rate imperative, there is every prospect that our Reserve Bank will lower the OCR even further this year and next. Some bank economists are picking it may go as low as 1.5%. Whether this will have much effect on mortgage interest rates remains to be seen, but the message for those with mortgages is that staying with short term fixed rates is likely to be the best mortgage strategy for the moment.

Some are saying the Reserve Bank will have to look to other measures if it wants to bring house price inflation under control and reduce the risk to the financial system should house prices fall. The Reserve Bank itself says, "House price inflation remains excessive and has become more broad-based across the regions, adding to concerns about financial stability. The Bank is consulting on stronger macro-prudential measures that should help to mitigate financial system risks arising from the rapid escalation in house prices."

So what may those other measures be?

The most obvious one is strengthening the loan-to-value ratio (LVR) restrictions that are already in place. The LVR is a measure of how much a bank lends against a property, compared to the value of that property.

Last month the Reserve Bank announced new LVR restrictions will apply nationwide. Those restrictions come into force on 1 October but most banks have already adopted the new standard. Here's a summary:

• Banks will be forced to require a 40% deposit for at least 95% of the loans they make to property investors.  That is not likely to affect property investors who will have adequate equity in their existing portfolio. It will most affect those just starting out on the property escalator and the speculative investors with high gearing.

• When lending to home buyers banks will require a 20% for at least 90% of bank lending. This will most affect first home buyers and those trading up.

• The restrictions do not apply to owner-occupiers or investors who are constructing or purchasing a new dwelling (to encourage the supply of new housing stock).

Other options that could be considered by the Reserve Bank  include:

• A cap on debt to income ratios for home loans. The bank has already stated it is looking at this as an option, but says more work is required before it could be implemented.

• Putting an end to interest-only loans. These loans are more popular with property investors than home owners, so in that sense they would be more targeted, but it is debatable whether this would add much to the controls that are already in place.

Dairy higher

Elsewhere in the economy, dairy farmers would have welcomed the outcome of last week’s GlobalDairyTrade (GDT) auction.

Overall, dairy prices gained 12.7% on the auction two weeks earlier. Whole milk powder prices were up 18.9% to US$2,695 a tonne.

While that is still less than the US$3,000 a tonne required to put dairy farmers back in the black, many commentators are now seeing this as the sign that the long-awaited turnaround is underway. My reading of previous boom and bust cycles suggests that is likely.

It seems the rise comes as supply moderates - out of Europe in particular - and demand from Chinese buyers picks up.

These things are never as quick as one would hope, but the prospect of better times to come is now coming into focus.