Marginal rates, interest rates, and NZ monetary policy

One of the things that I find fascinating at the current time is the enormous gap (see page 9 of link) that has developed between marginal bank funding costs and the official cash rate.

By setting the OCR the RBNZ commits to borrowing an infinite amount off banks for 25bps less, or loaning an infinite amount too banks for 25bp more than the OCR.  Of course, this is now constrained by prudential regulation – but at the margin, the RBNZ sets the opportunity cost of bank borrowing and lending, and so can move around interest rates (which also depend on borrowers risk profile etc).

The increase in the “margin” on top of this has been assumed by many people to be permanent.  The main calls are:

  1. It is the result of higher risk, which is not going to abate soon
  2. It is the result of new prudential regulation

In part these are true.  However, is the assumption that this increased margin will remain forever really the best assumption when looking at how the OCR translates into interest rates?  Furthermore, as the OCR rises, is it fair to expect that the margin will remain unchanged, and marginal costs will keep rising by 25bps?

I’m not so sure – as I’m not convinced the Bank completely controls the marginal cost of funding right now.  Here are a few reasons off the top of my head:

  1. The Bank also focuses on financial regulation – as a result, borrowing from and lending too the Reserve Bank provides a signal of an individual banks quality.  Even though the RBNZ is willing to borrow and lend an infinite amount does not mean that individual banks will work on this basis – and marginal funding may infact come from other sources for new loans.
  2. Individual banks are constrained in setting lending rates on what they have set for deposit rates.  As deposit rates have been pushed up due to prudential regulation this has set a “floor” on lending rates – even when the marginal rate is lower, implying that the reaction to a rising OCR will be muted.
  3. International interest rates, even for moderately long maturities, are low.  This will, in turn, have an impact both on demand for funds from banks and the cost of funding from banks.  Note that, even with the new prudential regulation longer-term foreign lending can still often be used – and so could help to determine the marginal price for longer term lending.
  4. The new prudential regulations (will) mean that a bank has to fund 75% of a loan (currently 65%) from outside the RBNZ right.  So if they loan a new $1, the marginal cost of that dollar will be 3/4 set by the underlying market and 1/4 set by the OCR – at least this is my impression of how banks have to respond.

Ultimately, any factor that ensures that the “marginal $ borrowed or lent” is not coming from the RBNZ could also provide an explanation for why this “margin” has grown.  If this factor is the result of the OCR being historically low, then we can expect the OCR to have LESS punch as it rises.

This is fascinating – and I’m surprised that we haven’t seen more work come out about it.  By the end of next year, it will be very interesting to see how rates have responded to a rising OCR.  I am currently not convinced that the working assumption a perfect feed through is Bayesian rational 😉