The carry trade and mortgage rates: Shifts and movements

Anyone who has done first year economics will know about shifts and movements.  When I tutored the course I would make funny hand gestures trying to illustrate it, hand gestures that were mildly less weird then when I talk about price floors and ceilings.

Still, there has been a lot of banging on about the carry trade and mortgage rates, and I think some of it stems from a little confusion regarding shifts and movements.  As an example I’ll work with this post from the Standard (ht BK Drinkwater).

Note: This is being added to the inflation debate, as a discussion of interest rate determination in a small open economy.  Starting from the bottom, the combination of posts under that tag gives a fuller idea of what we are talking about with inflation targeting and our (narrow) view of monetary policy.

Let us start with the facts.  There has been a carry trade.  We have had relatively higher interest rates then most countries.  There was a housing bubble.  Our currency did appreciate above historic norms.  We did have high capital inflows.

No-one disputes these facts.  However, recently people (mainly associated with Labour) have been putting them all together and saying “Aha! The Reserve Bank has caused all these things by lifting the OCR”.  However, once again the gap between correlation and causation has struck.

Now over the past decade we haven’t just experienced a change in the official cash rate.  Asian nations have begun saving like crazy, they have built up reserves to lower their currencies.  Furthermore, the US has run a “strong currency program” while keeping interest rates low – which in essence is just saying that they have allowed other countries to peg their dollar at an artificially low level.

Furthermore, unrealistic expectations regarding house prices in developed economies combined with easy credit overseas saw house prices climb to levels that did not seem (and in the end weren’t) sustainable.

These factors “shifted” the demand and supply curves for credit in New Zealand.  A belief that house price appreciation was sustainable (combined with the tax treatment of housing) saw demand for credit rise.  Easy credit availability from overseas increased the supply of credit at each and every interest rate – implying that the supply curve also “shifted”.

So what about the OCR!

The official cash rate has some ability to change domestic interest rates, by changing the opportunity cost of borrowing/lending from the RBNZ.  Using this mechanism the Bank can cause a movement along the demand and supply curve.  In the end, the quantity of credit equal the smaller of the demand or supply of credit at that interest rate.

Now conceivably, if we have a shortage of credit (given demand) an increase in the OCR could increase the quantity of credit by moving us up the supply curve.  However, New Zealand is special.

New Zealand is a small open economy – implying that we have access to an infinite (as much as we can eat) amount of credit at the world interest rate. This implies that the carry trade argument is IRRELEVANT for NZ!

As a result, ALL that matters is the demand curve.  As long as demand for credit is falling in the domestic interest rate (so people borrow less as the interest rate goes up) then a higher OCR does reduce these capital inflows we have randomly become scared of.

As this is a more than fair assumption, I’m sticking with it.

But people did borrow more, especially in housing!

Yes they did.

And we should be asking why people borrowed more.  What structural factors have driven the imbalances in the New Zealand economy?

Ultimately, monetary policy in its essential form (targeting inflation) has served us well.  However, other “shifts” in the domestic and international economy have caused issues.  Instead of attacking one of the parts of the economic establishment that is actually working we should be trying to figure out what parts are broken!


I wrote this on Friday and published it on Tuesday.  Since then I have seen this quote from the Standard:

Our current setup is causing the housing bubble, the high currency, and the current account deficit.

That is exactly the error in thinking I mention in this post.  Don’t get me wrong this is an incredibly common error, and plenty of very intelligent people have gone down this track.  But we DO NOT have causation just because some numbers run together.  This is the problem with looking at data without having a coherent logical model in mind.

Also note that I have nothing intensely against the mortgage interest levy – I just think that if we had a tax system that treated assets equally there would be no need for some arbitrary other tax …

9 replies
  1. Miguel Sanchez
    Miguel Sanchez says:

    A good start, but it gets more complicated when you try to consider what *the* interest rate actually is. Your example is based around no risk and a single time period (a day, since you’re talking about the OCR). Once you introduce ideas like yield curves and term risk premia, then no amount of semaphoring will help to make things clearer.

  2. Matt Nolan
    Matt Nolan says:

    @Miguel Sanchez

    The example is based on a fixed level of risk, and is independent of the yield curve – as that is merely based on expectations anyways.

    The key additional issue is regarding the composition of risk. Now I think even this is a relative small issue.

    The main claim I hear is that as the domestic interest rate increases, foreign lenders are willing to invest in more risky domestic assests. However, this “interest rate” they are discussing is the risk free rate – and if the risk free return is rising why would the supplier of credit want to take on more risk for less additional return?

    The issue stems from the demand side. If an increase in the OCR mainly convinces low risk borrowers to pull out of the market, the composition of lending becomes more risky.

  3. Chino Hills Homes
    Chino Hills Homes says:

    Looking at where the US economy is today after most people over leveraged themselves with a bad mortgage notes. Consumers over spending with credit cards, I would say you are spot on with your analyst. In the US the economy is based in part with how much we can consume, with credit now so tight recovery will be long and slow.

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