Many factors to blame for high interest rates

Press, 19 May 1989, Page 19

Many factors to blame for high interest rates

By

ROD ST HILL,

senior lecturer, agricultural

economics and marketing, Lincoln College.

Neither the banks nor the Government are wholly responsible for high interest rates. Several factors have combined to hold interest rates at high levels and allow only a slow reduction.

One important influence is people’s expectations of future inflation. If savers anticipate higher inflation they will require a high enough interest rate to compensate them. If borrowers anticipate higher inflation they might be prepared to pay higher interest rates because they will assume that their incomes will rise at about the same rate as prices.

Given that surveys of inflation expectations by the National Bank and Reserve Bank show that inflationary expectations are falling more slowly than inflation itself, we should not be too surprised that interest rates are still high. Probably the most important reason is that a whole generation of New Zealanders has grown up in an inflationary environment with interest rates pegged at low levels by governments. The old homespun truths like, “Buy now because it will never be cheaper” and “Buy a house, don’t rent one” are out of step with the new market place realities. New Zealanders have to learn new behaviours that are appropriate in an age of low inflation and mar-ket-determined interest rates. Many borrowers have been chastened by their experiences in recent years. There are now sighs that people are becoming more attuned to the new environment.

Outstanding credit card advances rose about 13 per cent during 1988, half the growth recorded in 1986. New Zealand’s balance of payments position has improved quite dramatically in the last fifteen months, indicating that we are moving closer to balancing current expenditure with current income. Demand for loans should steadily decline in the medium term and this will bring interest rates down slowly but surely. A third reason for sustained high interest rates is deliberate government policy. Since late 1984 the most important anti-infla-tionary policy of the Labour Government has been “tight” monetary policy. This has been achieved through Reserve Bank actions designed to control the growth of bank lending. Control has been achieved by requiring all transactions between the Reserve Bank or Government and the private sector, mainly banks and non-government businesses, to be settled by credits or debits of deposit accounts that the major banks hold with the Reserve Bank. If the Reserve Bank sold a government bond to the private sector, it would accept as payment only a debit to the deposit account of one of the major banks. If the Reserve Bank sold many millions of dollars worth

of government bonds to the private sector, then the major banks face a big debit on their deposit accounts at the Reserve Bank. In order to counter this debit, they must either borrow from other banks or increase the deposits that their customers hold with them. Thus competition for loans and deposits will increase, driving up both loan and deposit rates.

Another influence on interest rates has been higher risk of default by borrowers, a consequence of rapid economic change. Restructuring of the economy which began in the mid-19705, was sped up by the Labour Government. Most subsidies for exporters, including farmers, were rapidly phased out after the November 1984 Budget and protection of New Zealand manufacturers against import competition has been consistently whittled away. Banks can no longer rely on government to artificially prop up business enterprises. Therefore, the banks must assume more risk and this is reflected in interest rates on loans.

Undoubtedly, economic vandalism exposed by the share market crash of 1987 has also increased

banks’ perceptions of loan default risks. Political turmoil has also played a role in the maintenance of high interest rates, the main problem is that New Zealand has lost the sense of direction that was demonstrated at the time of the 1987 election. The more uncertain the future, the longer it will take for interest rates to fall because everybody adopts a “wait and see” attitude. Fortunately, this is only a short-term problem and will disappear as soon as politicians and lobby groups back away from their petty, short-term self-interests.

Two more reasons for high interest rates are worth considering. First, banks themselves are usually slow to lower interest rates on loans. The reason is that they tend to determine loan rates as a markup on their average cost of deposits. The average cost of deposits falls only slowly because fixed deposit contracts do not usually allow banks to change interest rates on existing deposits until they are due for renewal. Therefore, interest rates on new deposits fall faster than rates on existing deposits. Second, the financial market is not truly com-

Banks all differ slightly in terms of their services and they tend to compete with each other by making small changes to those services and running large advertising campaigns. Thus all banks are different, but their interest rates seldom vary enough to make it worthwhile transferring an existing fixed deposit or loan between banks. An individual, bank will rarely break ranks with all the rest and lead interest rates down. Given all these reasons for high interest rates it is quite incorrect to argue that the Government or banks themselves are wholly responsible. There are many influences at work and their interaction is very complex.

We can take some comfort in the fact that interest rates are not rising and that they are very much lower than they were two years ago.