Higher inflation means higher interest rates

Higher inflation means higher interest rates

Hand holding magnifying glass over coins

New Zealand’s inflation rate has just lifted from 4.9% to its highest level in three and a half decades. For some people the quick lift from 1.4% a year ago to near 6% now might sound shocking and must surely lead to a return of interest rates to levels such as last seen ahead of the Global Financial Crisis.

Back in 2007-08 the likes of the one-year fixed mortgage rate rose to almost 10% while floating mortgage rates peaked at just below 11%. Currently those rates are around 3.7% and 4.6% respectively. But we are not going to see interest rates back at those levels for a range of reasons.

First, we have all become used to much lower interest rates over the past few years.

Back then we considered mortgage rates above 8% to be high. Now the benchmark level at which we would start feeling the same way is probably close to 4.5% or 5%. This means that we will start to pull back on our debt-funded spending at interest rates much lower than pre-GFC.

Second, even though the unemployment rate has fallen to an equal record low of 3.4% there is less chance of high cost of living increases translating into high wage claims as back then. It is not just that the workforce is less unionised outside of the public sector. People increasingly have learnt to gain wage rises through changing employer rather than seeking higher remuneration where they currently work.

There is a good and a bad in that for employers

The good is that while people still remain concerned about the pandemic, they are unlikely to want to shift jobs and risk being last-on first-off if things turn to custard. The bad is that once we get past the Omicron wave, and assuming no new bad Covid-19 variant comes along, staff are likely to let themselves feel the best level of job security most will have ever seen.

Staff turnover is likely to lift from late this year with a potentially large number of people shifting to Australia to get not just a 10% wage rise but perhaps something closer to 50%.

Third, a lot of the jump in inflation this past year is because of supply chain problems caused by temporary lockdowns. As sea containers get to where they should be and inventories build up we are likely to see shipping rates fall and firms find flows of materials getting freer. That latter effect may not happen until next year.

But the important point to note is that changes in monetary policy now have their biggest impact on inflation in a year and a half’s time. The easing away of current transitory inflation pressures then means central banks will not tighten as much as would be the case if they thought inflation would persist.

Fourth, back during the policy tightening from 2005-08 fixed mortgage rates took a long time to rise as the Reserve Bank increased its official cash rate. That was because participants in the financial markets did not believe the Reserve Bank would raise its interest rate much at all.

This time around we have already seen near 2% increases in some fixed mortgage rates as investors and borrowers factor in an expectation that the central bank definitely will raise the official cash rate from the current 0.75% towards 2.5% - 3.0%. This time around the Reserve Bank is being helped by a belief that they are serious. Last time that was not the case.

Borrowers should expect to see interest rates rise further this year. The likes of five year fixed mortgage rates will probably only rise a small amount more while the one year and floating mortgage rates have capacity to lift near 2% perhaps from current levels.

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