High inflation and low unemployment, mean high interest rates

High inflation and low unemployment, mean high interest rates

Two men walking around factory

The Reserve Bank has so far raised its official cash rate by a small 0.25% yet bank fixed mortgage rates across the 1–5-year terms have risen by between 1% and 1.5%. Why such disparate changes?

The official cash rate largely directly influences floating interest rates, but banks do not fund fixed rate lending with floating rate borrowing. When a bank lends to someone at a fixed rate for three years it borrows at a fixed rate for three years in the wholesale markets on the same day. That way it locks in a margin.

This practice means banks are minimally exposed to sudden shifts in financing costs, and in New Zealand we have a history since the 1980s deregulatory period of sometimes rapid changes in short-term interest rates.

Bank borrowing costs have gone up

For banks borrowing to fund their fixed rate loans, costs have risen by some 1% to 1.5% or so over the past few months. These cost increases partly reflect higher interest rates offshore. But largely they reflect market expectations that the Reserve Bank will be raising the official cash rate a lot more than just 0.25% in the near future.

In fact, the markets largely anticipate that the cash rate will be close to 2% come the end of 2022. But the risk is that the rate is higher than that by then, and that the peak is closer to 3% than the commonly assumed 2%.

Two weeks ago I discussed the surprising jump in the inflation rate from 3.3% to 4.9% and how inflation is now double what the Reserve Bank predicted it would be just six months ago. This week we received data showing that New Zealand’s unemployment rate has fallen to an equal record low of 3.4%, and wages growth by some measures is at a decade high.

The labour market is extremely tight, raw materials are in short supply, and businesses in most sectors have customers they cannot supply. The situation is one in which the Reserve Bank has kept monetary conditions too loose for too long and over-stimulated the economy.

Going by some recent words from the Reserve Bank Governor, there are no plans to rapidly increase interest rates in the near future. That brings a risk that in the end interest rates will need to go higher than would otherwise be the case.

For borrowers, there is still time to lock in a good rate for a three-year period.

But the days of my much-favoured 2.99% five-year fixed rate ended some months back and may never come back again in our lifetimes.

Will higher mortgage rates shock the economy and housing market?

Almost all of us say no, and note the way banks have required borrowers be able to service a mortgage rate 3% or more above their actual borrowing rate before they could get finance. But therein lies the problem.

With household balance sheets boosted $400 billion over the past 18 months courtesy of a 35% jump in house prices, and with firm rate-rise buffers in place, the Reserve Bank may not easily get the restraint on economic growth it will want to see from rising interest rates.

This means they will probably have to raise rates even higher than they are currently thinking and indicating. Hence, borrowers need to pay attention to the worthiness of fixing a good portion of one’s debt for longer than just the one-year period.

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