Monetary policy tightening soon

Monetary policy tightening soon

Person tightening bolt with spanner

Things have changed a bit since I wrote my last column discussing interest rates a couple of weeks ago. The spread of the Delta variant of Covid-19 around the world has led to some scaling back of immediate growth projections for a number of economies, and expectations for how quickly interest rates rise in the likes of the United States.

That’s the “good” news for borrowers. The bad news is that in New Zealand this factor has been more than swamped by the June quarter inflation rate turning out to be 0.5% higher than expected. Our inflation rate now sits at 3.3% compared with 1.5% for the previous six months.

It is extremely rare for inflation to come in so much above expectations.

I can recall only two other instances over the past three and a half decades. Because of this rarity and because the Reserve Bank in May had already signalled its expectation of interest rates rising next year, predictions for when rates go up in New Zealand have quickly changed.

Could the OCR go up earlier than expected?

The common forecast now is that on August 18 the Reserve Bank will raise the official cash rate from the record low of 0.25% it was taken to following an emergency meeting in March last year, to 0.5%. There is a chance they hike the rate to 0.75% but these are very uncertain times, and they might want to tread lightly at first to gauge what the impact will be these days of interest rates going up.

That strong need for caution exists because we have not had a proper monetary policy tightening cycle since 2004-07. Back then the official cash rate was increased from 5.0% to 8.25% and the one-year fixed mortgage rate peaked at about 9.9%.

We simply don’t know how borrowers, businesses, investors will react in a modern world, let alone one affected by the global pandemic. More than that, back in 2010 and again in 2014 the Reserve Bank raised the official cash rate – by 0.5% and 1.5% respectively – but had to cut rates back to 2.5% again very quickly when the economy proved less strong than expected and inflation fell away.

This signals something very important to borrowers.

One should not expect any particular set of interest rate forecasts to be accurate. We learned something unexpected about inflation just a fortnight ago. Who knows what we will learn in the next few months and quarters regarding our economy and inflation?

For borrowers the optimal approach to managing interest rate risk is either to sit back and enjoy the 2.99% five-year fixed rate which I so strongly advocated for people generally up until it disappeared in May, or to fix across a range of terms.

There is simply no way any of us economists can state strongly that we see interest rates rising such and such an amount and peaking at such and such a time – let alone how long rates will be high then start falling again.

Having said that, with probably 80% or more of the $315 billion worth of housing debt being owed by people who have known nothing other than low and falling interest rates, when they start rising the Reserve Bank is likely to see a good pullback in household spending. This pullback will likely be reinforced eventually by a strong loss of Kiwis to Australia because of their very high demand for labour over there.

For the record, I maintain a view that interest rates will rise by 2%. Next week I could easily maintain a different view if we learn something else new about our economy!

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