This is the way monetary policy works when the Reserve Bank wants to slow the economy and get inflation down from a high level back towards the target range of 1% to 3%. They raise the official cash rate and this causes an increase in the cost to banks of borrowing money at a floating rate in the private wholesale markets in order to lend at a floating rate. With decreasing impact the longer the term this also places upward pressure on fixed rate borrowing costs which banks face.
As a rule we can expect a 0.25% increase in the official cash rate to lead to the same increase in floating mortgage rates. Fixed interest rates however will only change if market expectations for what monetary policy is going to do actually alter. That is, if the markets had fully anticipated that the cash rate was going to rise by 0.25% this will already be factored into fixed rate wholesale borrowing costs which banks must pay.
Therefore in the event the cash rate does rise 0.25% there is no impact on wholesale borrowing costs and therefore no shift in fixed mortgage rates.
That is what has happened so far following the Reserve Bank’s monetary policy tightening on February 22. The 0.5% increase was expected in the markets so there was essentially no change in bank wholesale borrowing costs for loans with interest rates fixed from one to five years.
But what about floating mortgage rates?
They should have gone up 0.25% by now. They have not. Why is it that banks this time around have not increased their floating mortgage rates when the cost of them borrowing to lend floating has gone up?
One reason is likely to be that with turnover in the residential real estate market in January at the lowest level for that month in at least three decades, banks are failing badly to meet their mortgage sales targets. When any retailer of goods and services finds that demand has fallen away they will cut prices to try and boost sales.
We have seen this recently with some banks offering heavily discounted one and two year fixed mortgage rates. But it looks like we are seeing another version of that with floating mortgage rates.
Many people are likely to be happy about this absence of a rise in mortgage rates following the February 22 tightening of monetary policy.
But that would be a mistake.
The only reason the Reserve Bank increases its cash rate is in order to place upward pressure on bank lending rates. If those lending rates do not go up, then the Reserve Bank will rightly conclude it needs to move the official cash rate up by more in order to get banks doing what they expect them to do.
On the face of it this means we should expect extra tightening of monetary policy beyond what people were expecting before February 22. In reality however things may not be that bad. This is because only 10% of home borrowing undertaken in New Zealand is at a floating interest rate. And for those people with floating rate mortgages the amounts are usually quite small.
Therefore, the tightening pressure on the economy from increasing floating mortgage rates is actually very small. The bigger impact comes from fixed rates going up and that is where things get interesting.
Over the coming 12 months, over $170 billion worth of fixed rate mortgages will come up for renewal. People are going to roll off of interest rates near 3.5% on average to something close to 6.5%. There is already an extensive amount of monetary policy tightening in the works which is yet to see the light of day but will do so more and more as every week goes by.
The Reserve Bank is well aware of the lags in monetary policy especially for a country like New Zealand where most of us borrow at fixed interest rates. In contrast, in Australia most people borrow at floating mortgage rates and cash rate changes initiated by the Reserve Bank of Australia tend to have an immediate impact on the economy and inflationary pressures.
Considerable uncertainty remains here and offshore regarding how quickly inflation will respond to rising interest rates. We may not get a definitive answer for New Zealand and true insight into when interest rates fall by decent amounts until late this year. Until then borrowers should anticipate interest rates remaining close to current levels but perhaps with some slight falls in coming months, assuming we economists are right in our expectation that policy tightening to date is having an impact which is not quite yet showing up in the data.
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