Every monetary policy tightening and loosening phase of the interest rates cycle is a complete suck it and see exercise. That is, there is never any certainty with regards to how quickly inflation will respond to interest rate changes.
Each cycle we do not know the extent to which people’s expectations of where inflation is headed will alter in response to actual and expected changes in interest rates and the words from the Reserve Bank.
We do not know how wages growth will be affected from one cycle to the next, and we can only take a wild stab as to how business pricing decisions will be influenced by changes in the strength of consumer demand and comments from the central bank.
That is why people should always take interest rate forecasts with a large grain of salt
When we economists make them we know there is a near 100% chance we will change them before the period in question comes around. We focus our efforts not on making a forecast which will prove correct right from the get go but on recognising when our forecast needs to change.
Then the challenge becomes not changing too quickly and being caught out by having to flip back quickly the other way, and not changing too slowly and looking out of touch. Finding the sweet spot is difficult and I have seen large institutions suffer from moving too quicky and too slowly.
This is why people need to think not in terms of picking the top or the bottom of the interest rates cycle in order to determine what term to fix at. Instead a risk management approach needs to be followed which explicitly recognises the certainty involved.
Invariably this means both fixing slightly longer than has tended to be the case in New Zealand for many years – one year for most people. It also can mean fixing portions of one’s debt over different time periods.
Of course there are now and then unique periods when the choice of what to do is blindingly obvious
That was the case 15 or so months ago when the five year fixed mortgage rate was typically 2.99%. Fixing for five years was a complete gimmee. But few Kiwis did so, preferring the cheap one year rate of 2.19% or 2.49%. They are now paying the price for their inability to consider interest rates as something which follow a cyclical pattern.
So, where things sit right now is that earlier optimism about inflation quickly falling away next year has retreated both here and overseas. Local data have proved to be stronger than expected including the residential real estate market showing some new stirrings of life with the return of first home buyers. Measures of the strength of the labour market have also held up very well and the chances of the unemployment rate rising comfortably above 4.5% now look very low.
Offshore central banks have responded to some higher than expected monthly inflation outcomes and concerns that the markets are overly optimistic about the inflation and interest rate tracks by accelerating the pace with which they are raising rates. Projections for where rates will peak have gone up and these alterations help account for a lot of the recent rise in bank wholesale borrowing costs in New Zealand.
The result has been newly compressed bank lending margins on fixed rate products and additional increases in fixed mortgage rates to follow those of 3-4 weeks ago.
Given these changes and the decreased probability that our central bank will be in a position to cut its official cash rate before the end of 2023, don’t completely dismiss the idea of fixing a portion of one’s debt for longer than the currently very popular one year term.
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