As interest rates fall, will the economy rise again?

Not so long ago, Reserve Bank (RBNZ) Governor Adrian Orr often appeared intent on pulling the rug out from under the financial markets.

Now, he’s rolling out the red carpet for them.

Often times, particularly during the monetary policy tightening of 2021-2023 Orr and the RBNZ’s Monetary Policy Committee produced Official Cash Rate (OCR) decisions and commentaries that seemed aimed at blindsiding financial markets. And they did.

If it was indeed a strategy, you can see logic in it. Upward spikes in wholesale financial interest rates due to the markets being caught off guard are useful if the desired effect is to get banks to raise retail rates – IE mortgages and deposit rates – to customers.

But now we’ve seen two consecutive OCR decisions – the last one for 2024 on November 27, and the first one for 2025 on February 19 – followed by media conferences at which Orr has given clear indications of what comes next. 

In November Orr virtually promised a 50 point cut at the next decision – and this was duly delivered on February 19. And then in last week’s post-OCR review media conference Orr again all but promised there will be follow-up cuts of 25 points in both the April 9 and May 28 reviews.

Assuming that comes to pass, on May 29 the OCR will be standing at 3.25% – a long way below the 5.50% level it was on till August of last year. The revised OCR forecasts contained in the RBNZ’s February Monetary Statement (MPS) strongly suggest we might see a 3.00% OCR before the end of this year, and possibly as soon as the July 9 decision.

I’ve found the change in tack by Orr fascinating. There’s certainly logic being applied though. On the way ‘up’ for interest rates you may as well get there as fast as possible and if that includes having financial markets sometimes reacting in a fairly volatile way, well that’s fine, it just means mortgage rates will go up faster.

But on the way down you want things to be a bit calmer, structured. Volatility is good for driving rates up, calmness is good for sending them down. If the market ‘knows’ OCR cuts are coming then this will help to put downward pressure on wholesale interest rates.

It could, however, be that the RBNZ is a little more nervous than it’s letting on about how quickly the economy can recover from the effects of the interest rate hikes. And that might explain the telegraphing of OCR moves so that wholesale interest rates drop – and so that banks keep reducing mortgage rates NOW, thus giving householders more money in their pockets.

The RBNZ wanted to slow the economy so that the friction and heat, and resultant inflation, saw particularly through 2021-2022 would abate. The RBNZ, however, did not want to kill the economy, even though there was the frank admission it was looking to engineer a recession. 

The GDP shocks 

The GDP figures for the September quarter released just before Christmas were a nasty shock, showing as they did a 1.0% fall for that quarter and a revised 1.1% fall for the June quarter. 

There was a lot of detail in the pre-Christmas GDP figures release. But in simple terms, we now have in front of us a picture of an economy that was travelling better than previously thought up to the middle of last year. But the drop-off in activity in the middle part of 2024 was much, much more precipitous than had been thought.

In layperson’s terms, the economy’s now not in a very different position to where we thought it was, but the recent past has been far worse than was widely believed. And that’s a worry.

Economists reckon GDP probably turned mildly positive in the December quarter. The RBNZ picks that GDP grew 0.3% in the period. Not flash at all, but a positive number. 

And there are definitely signs of life. Retail trade figures released this week, for example, showed a seasonally adjusted 0.9% rise in sales volumes in the December quarter. That’s only the second quarterly rise since March 2022. 

The business community is more optimistic about prospects in coming months. The exports situation looks very favourable when we look at things like the current high dairy prices. And the much lower Kiwi dollar is good news for the exporters. But not the importers, of course. And the global geopolitical situation is currently looking about as flammable as we feared it might be this year. Confidence can be brittle. The situation still looks very fragile.

So, how can the fledgling signs of a recovery be converted into something more substantive?

What about those mortgage rate reductions?

Well, a key factor will be how quickly those with mortgages get interest rate reductions and have more cash to spend in order to make the economy’s wheels turn. 

With Kiwis anticipating falls in interest rates this year, mortgage holders have been going shorter and shorter with their fixed terms, which, as we know has resulted in some 55% of the $370 billion mortgage pile due an interest reset in the first half of this year and over 82% of it across the whole of 2025.

Now that the RBNZ has put its cards on the table about what OCR cuts can be expected this year, a lot of people are facing the decision of where to next? Do they stay ‘short’? Or go ‘longer’? 

Looking at the advertised ‘special’ rates for new residential mortgages we can see that already since the peak of late 2023 the popular shorter term rates (six months-two years) have dropped by between about 160 basis-points (for six months) and about 200 points for the one and two year terms. (I did those rough calculations based on the RBNZ’s monthly compilation of new residential mortgage ‘special’ rates combined with current rates on interest.co.nz.) 

From its peak of 5.50%, the OCR has currently been dropped by 175 basis points, with another 50 virtually promised by late May.

That means by the end of May we will have had combined OCR cuts of 225 basis points (bps).

However, already before we’ve got into March, popular mortgage rates have been dropped 200 bps from their peak levels.

Mortgage cuts front-loaded

That tells us the mortgage cuts are being front-loaded ahead of OCR cuts. 

It suggests mortgage rates may not have as far to fall from here as some existing mortgage holders might hope.

What do we think mortgage rates may go down to? Say 4.5%? Maybe 4.25%? That’s a lot lower than the 7+% rates seen till quite recently. But it’s still well above the 2.2% to 2.5% rates seen in mid-2021.

In terms of what people are currently paying, the RBNZ’s yields on loans figures, showing what banks are actually receiving from mortgages, tell us that the overall yield only started to fall, slowly at the end of last year. 

As at December (latest available figures) the total yield on mortgages was 6.29%, down from the peak 6.39% in October 2024. However, the fixed rate yield has barely moved thus far, having dropped just one basis point from its peak, to 6.33% in November and then staying static at 6.33% in December.

Clearly, as we see some of the torrent of mortgage resetting during the first half of this year, and we are talking about an average of more than $30 billion a month worth of mortgages to be reset, those yield figures will start to drop more meaningfully.

After last week’s OCR decision and MPS release, financial market pricing has very neatly aligned with the RBNZ view and a low point of somewhat above 3.0% is seen for later this year, followed by a slight rise next year. But market pricing can be wrong. And it wouldn’t take much to change things.  

Inflation ‘under control’

The RBNZ is confident it has inflation under control – although there are those who wonder if it should be that confident. The RBNZ is itself now forecasting that annual inflation as measured by the Consumers Price Index (CPI) will rise from the 2.2% reported for the December 2024 quarter to 2.7% by the September quarter of 2025.

That’s still within the aimed for 1% to 3% range, but is well above the explicit 2% target. The RBNZ’s current working assumption is that domestically sourced inflation will continue to ease, while the spike in the ‘headline’ figure will be due mainly to higher oil prices and the lower exchange rate.

The RBNZ tries to ‘look through’ one-off impacts of overseas sourced inflation. Where it can come unstuck is if spikes in the ‘headline’ inflation figure then lead to an increase in inflation expectations. While the RBNZ’s latest Survey of Expectations showed the ‘experts’ see future inflation comfortably settling in and around 2%, the companion Household Expectations Survey showed the average householder is less convinced. To say the least.

Clearly, having engineered what turned out to be a pretty nasty recession, the RBNZ is keen to believe that it can now be ‘hands off’ with the OCR and inflation for the foreseeable future. 

But what if it’s not the case? And what if something crops up between now and May that undermines the RBNZ ‘promise’ of 25 point OCR cuts in both April and May? It would put the central bank in a tricky situation. 

Having seen the economy have a rough time in 2024, we all want 2025 to be better. And it could be. But nothing’s guaranteed.

*This article was first published in our email for paying subscribers early on Thursday morning. See here for more details and how to subscribe.