The tail-end of the OCR cuts in 2025 were based on overly negative expectations by the Reserve Bank, writes Kiwi economist Rodney Dickens...
Even before the US-Israel war on Iran, there was a threat to residential building from rising interest rates. This is shown in the first chart, by swap or wholesale interest rates rising ahead of the Reserve Bank (RB) starting to hike the Official Cash Rate (OCR). The rise in swap rates has started to filter through to higher mortgage interest rates.
The one-year swap rate, for example, reflects what participants in the money market expect the OCR to be on average over the next year. With the one-year swap rate at 3.2% at the time of writing, and the three-year rate at 3.9%, it means the market expects the OCR to increase faster and more than the RB was predicted. The second chart shows that, at the time of writing, the RB didn’t expect to start hiking the OCR until the end of the year and predicted it only reaching 3% by early-2029.
Prior to the war, I saw good reason for the market to start nudging up interest rates in expectation of future OCR hikes. In my assessment, the tail-end of the OCR cuts in 2025 were based on overly negative expectations by the RB about the recovery from the 2024 recession, and too optimistic RB expectations about inflation. I agreed with the market.
In response to the war, the market has pushed swap rates higher. It is more worried about the inflationary implications of the war, most evident in higher fuel costs, than it is about the negative impact it will have on economic growth.
If the RB revised up its OCR forecasts on 27 May, it would in part at least vindicate the market, expecting earlier and more OCR hikes than the RB was predicting. However, I suspect the market is currently putting too much emphasis on the boost to inflation from the war and not enough on the negative impact it will have on economic growth.
There is still spare capacity in the economy from the 2024 recession, like a somewhat elevated unemployment rate. This should limit how much the boost to inflation from the war persists.
The first chart shows there have been periods when the market pushed up swap rates too much ahead of OCR hikes, just for swap rates to subsequently fall because the OCR did not increase as much as it expected. This occurred in 2009-10 and again, to a lesser extent, in 2013-14.
The market is much quicker than the RB to respond to new information, in part because the RB only adjusts the OCR eight times a year, outside of emergencies. However, the market does not always get it right. These are particularly difficult times to predict the future, but best I can tell, the market is currently expecting more OCR hikes than will eventuate.
