Don Brash worth his increase if he can handle conflicting issues

By Peter V O'Brien

Friday 20th October 2000

A 3% inflation rate for the year ended September has renewed speculation about the future trend in interest rates and specifically what the Reserve Bank will do when it reviews the official cash rate (OCR) in December.

The bank lifted the rate twice this year in moves of 0.25% each. It is now 6.5% and could go higher before the year ends if the bank decides inflation is pushing too far away from the target rate of 3%.

It is not certain the bank will do anything before the end of the year because the September inflation figure included hefty increases in petrol and tobacco which could be considered one-off events.

A solid rise in the dollar's value against other currencies would dampen imported inflation but that is unlikely in the immediate future and certainly not in time to offset rising prices for imported goods that will show up in the December inflation rate.

Market interest rates rose this year in line with movements in the OCR, particularly the retail rate for term deposits with registered banks and other financial institutions.

The table shows yields on a range of wholesale and retail securities for various terms. Rates this week were compared with the situation on April 18, the last time the fixed securities market was surveyed in detail in The National Business Review, and at the end of last year, the latter date being a convenient benchmark.

Yields for government stock at various maturities need to be treated cautiously because they alter marginally as the securities get closer to maturity, particularly relatively short-dated stock.

The marginal effect lessens when the market is dealing in stock with, say, a maturity in 2009 and the comparison is with yields only six months ago.

Yields on government stock were lower this week than in April but well above the figures at the end of 1999.

Retail rate lag movements in the wholesale market, which explains why they increased since April after being close to the December figures for the preceding three months.

The Reserve Bank has a juggling act with the OCR in December. Bank governor Don Brash warned about stagflation recently and he knows more than most people how increases in interest rates can reinforce the stagnant part of the compound word as he deals with the inflation part.

The juggling becomes intricate when the effect of interest rates on some aspects of the consumer price index are mixed in. Rising interest rates extend their way through the economy, beyond the impact of servicing house mortgages. Business costs go up when interest rates rise and either have to be absorbed in lower margins or are reflected in higher prices.

The media has been flooded with reports that businesses can no longer absorb rising costs and are, or will be, passing on higher expenses to consumers.

It should follow that a lift in interest rates over the next six months or so will be passed on in higher prices, irrespective of the proportion interest bears to a business' total outgoings.

The Reserve Bank has, or should have, another problem with setting interest rates in relation to inflation.

Consumer price index figures are based on a basket of items, averaged across the community, and have little relationship to the spending patterns of particular regions or individuals.

Some examples illustrate the point. The latest inflation figures include price rises for petrol and tobacco.

Fuel costs are a component of every product, to a greater or lesser degree, but consumers who drive feel the biggest impact. Anyone who does not drive (yes, there are may of us, including me, who have never driven) do not worry about the effect of petrol prices on the portion of their household costs marked for individual vehicle expenses.

The inclusion of tobacco in the CPI is a weird, but apparently necessary, statistical phenomenon. Many anti-smoking programmes operate in the community, either government-sponsored or under the aegis of busybodies. The percentage of the population dragging on that particular weed (as opposed to other weeds) has decreased steadily over the years.

A recognised health hazard, with heavy medical costs but also tax benefits for the government, is in the consumer price index.

The key is that different individuals have different personal price prices, depending on lifestyle and age. There are also different regional patterns. Aucklanders do not like the point, but the rest of the country has suffered past increases in interest rates because of the northern city's inflation.

Dr Brash will earn his salary increases if he and his colleagues work successfully through these conflicting issues.

INTEREST RATES YIELDS

	Rate (%) 16.10.00	Rate (%) 18.4.00	Rate (%) 31.12.99
Government. stock maturity
Mar 2002	6.78	6.73	5.33
April 2004	6.76	6.81	5.42
Nov 2006	6.75	6.84	5.47
July 2009	6.75	6.82	5.49
Retail rates
Three months	6.05/6.5	5.5/6.1	5.0/5.4
Six months	6.3/6.8	5.8/6.3	5.0/5.4
Bank bills
Three months	6.70	5.55	6.49

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