Interest rates: A puzzle of uncertainty

Interest rates: A puzzle of uncertainty

Woman putting a puzzle together

In a few days (August 16) the Reserve Bank will review their 5.5% official cash rate and indicate if they feel it needs to go up to impose more restraint on the economy and inflation, down because there is too much restraint, or remain unchanged because enough tightening has been done but pain has to continue for a while longer.

The chances are extremely high that they will choose the last option – no change.

I won’t run through the many factors which they will consider when reaching their decision because there are simply too many of them. But the bigger things in play which they will pay most attention to include these.

Headline inflation is 6%, underlying inflation is higher than they expected near 6.5%, and it is not certain that everyone accepts inflation will get back into the old and still targeted 1% - 3% range. In fact, in the ANZ Roy Morgan Consumer Confidence Survey released recently the average rate of inflation expected in two years time lifted slightly to 4.7% from 4.3%.

At the same time however, the net proportion of businesses planning to raise their prices in the coming year has declined to 48% from 54% three months ago and 62% six months back. But this is still twice the long-run average, and the speed of decline is extremely slow. That is because many businesses are still being hit with rising costs and more are wanting to pass on cost increases of the past in order to maintain profit margins.

These forward-looking inflation measures are still too high for comfort.

It would be risky to assume the downward track in them will continue. But then again, there is still a lot of downward pressure on the economy to come from the many people who have yet to experience a resetting of their mortgage rate from 3.5% to near 7%. There has also been a deterioration in New Zealand’s economic outlook recently. Dairy prices have fallen, China’s economic prospects have soured, and the incoming government will need to tighten fiscal policy to get finances back on track.

Also, assisted by a surge in net immigration, the labour market is marginally less tight than the Reserve Bank assumed in their most recent set of economic forecasts. Wages growth has also slowed by a bit more than they expected. But the divergences from expectations are very small, and it remains the case that skilled staff are still hard to find, and firms are not investing enough to sufficiently boost productivity to be able to comfortably afford higher wage rates.

For borrowers my message here and the one I expect the Reserve Bank to deliver is two-fold.

First, we have probably seen the peaks for mortgage interest rates this cycle. But declines outside of a potential discount or two by banks as Spring mortgage campaigns get rolled out look very unlikely until the very end of this year at the earliest.

Second, there is no strong reason for believing that when interest rates start falling, they will decline by large amounts. While the outlook for global growth remains challenging, the outlook for inflation is very different from what it was ahead of the pandemic. Back then inflation was too low, and we worried about deflation. Now, we must factor in extra inflation associated with the costs of climate change, rising local authority rates, higher insurance premiums, and recognition of the structural tightness of New Zealand’s labour market.

We’d best also throw in a new upturn in the housing market, though not for construction for which falling activity remains strongly in prospect for the next 1-2 years.

For borrowers, we seem to be at the wrong point in the interest rates cycle to firmly consider fixing three years or longer. But beyond that, it is an individual toss of a coin as to whether in hindsight we will be able to say fixing one year, 18-months, or two years is the best thing to do at the moment. Probably some sort of a mix will be best for most borrowers.

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