Monetary policy tightening all around the world

Monetary policy tightening all around the world

Hand holding globe

It seems like we cannot get through a week at the moment without some fresh news suggesting inflation around the world will be more problematic than thought, and that interest rates will need to rise earlier and potentially higher than previously believed.

The most recent king hit came last Friday night in the United States.

The monthly labour market report for January showed that job numbers in the US rose by over 450,000. This was well above expectations of a gain near 150,000.

Not only that, but the previous two month’s reports were revised up to show 700,000 greater jobs growth than earlier reported. In other words, come the end of January job numbers were one million more than thought.

Unsurprisingly, wages growth in the US is starting to reflect this extreme employment growth and the fact that job numbers are now only about 3 million below pre-pandemic levels after being over 10 million weaker at one point. Wages have risen 5.7% in the past year and that news has generated a new wave of expectations for higher interest rates in the US.

The markets are now factoring in five rate rises from the Federal Reserve through 2022 and the rise in US bond yields has fed straight through to higher medium to long-term borrowing costs here in New Zealand. But before noting some of those changes we should also take into account comments from the European Central Bank suggesting they will take their -0.5% cash rate to 0% soon.

Plus, for the second meeting in a row the Bank of England tightened monetary policy last week.

These developments have taken the three-year swap rate which forms the base for bank three year fixed mortgage rates in New Zealand to 2.7% from 2.6% a fortnight ago and 2.5% at the start of the year. These are not big moves admittedly because last year NZ markets adjusted for expectations of the Reserve Bank raising its cash rate following every Monetary Policy Committee meeting this year.

But the rate rises do place new pressure on banks to undertake another round of fixed rate increases. The timing for such a round may align with the first monetary policy review for 2022 which occurs on February 23.

The markets have fully factored in a rise in the official cash rate from 0.75% to 1.0%.

But the chances have increased that the Reserve Bank will look to strengthen their anti-inflation credentials which have been badly dented by over-stimulating the economy and housing market last year. So, a 0.5% rise is quite possible.

If this occurs, we can expect floating mortgage rates to rise close to 0.5% while fixed rates might go up 0.25% or so.

Over the past six months borrowers have shifted away from favouring fixing for just one year towards fixing at either or both of the two and three year rates. Such terms will probably remain optimal for most borrowers this year.

But people need to be aware that the longer rates go up and are high the more the markets will start to price in easing monetary policy somewhere down the track. As that happens, we will eventually reach a point where it is cheaper to fix five years than float or fix one year.

When that happens borrowers will need to be careful not to lock in a rate for five years because history tells us something quite clear regarding what happens a few months after the NZ yield curve goes inverse (short rates above long rates). The economy and inflation tend to weaken away, and all interest rates fall quite quickly.

My aim for the next two years will be to try and pick when that point is going to come. My current best guess is late-2023. But we’ll have to wait and see what really happens with inflation from the current 5.9% level and by how much wages will rise in response to this hike in the cost of living.

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