Monetary policy to tighten before it loosens again

Monetary policy to tighten before it loosens again

Hand in glove squeezing lemon

On April 13 the Reserve Bank raised its official cash rate by 0.5% so it now sits at 1.5% compared with the record low of 0.25% in place from March 2020 until October last year. The need for a cut in interest rates was clear because of the dire economic outlook associated with the global pandemic and closure of our borders.

But from over a year ago it was clear that our economy was not still shrinking, that house prices were booming, house construction soaring, and people were spending on things like spas and couches as if there were no tomorrow.

The Reserve Bank should have started taking away the emergency 0.75% cut in its official cash rate early last year. Now they are having to raise interest rates rapidly not just because the economy does not need the extra stimulus but because inflation has surged on the back of supply chain disruptions and now Russia’s war against Ukraine.

Our central bank is playing catch-up, and the same period of accelerated interest rate rises is also getting underway in many other countries. The one of greatest importance to us is the United States. Over there, expectations of rapid interest rate rises have caused medium to long-term interest rates to jump rapidly higher.

This has fed through into new jumps in our own medium to long-term interest rates. To put it more accurately, the fixed rate costs to banks of borrowing money to lend at fixed interest rates have soared in recent weeks. That is why we are still seeing fixed mortgage rates go up even though they have already risen a lot since this time a year ago in anticipation of the Reserve Bank picking up the pace on tightening monetary policy.

For the moment it remains cheaper to fix one year than for all other terms.

In fact, fixed rates continue to rise the longer the term. As yet the curve showing these rates is not flattening out. What that means is that the gap between the likes of fixing three years and five years is not yet closing up.

Three months ago, the gap between the best rates offered by major lenders for three and five year periods was 0.26% and now it is 0.7%. The gap between the one year and three year fixed mortgage has held steady near 1%.

But at some stage these gaps will shrink

That generally happens when traders in the financial markets start thinking about when monetary policy will be eased rather than thinking only about the upcoming tightening. We are not quite at that point in New Zealand. But potential for further rises in the five year fixed rate is diminishing by the week, especially as the markets look to have got ahead of themselves picking that the cash rate will go to 4%.

My pick has long been 3% and I am sticking with it.

The Reserve Bank’s pick is 3.25% or just above that. At some point markets will adjust their time horison and become less worried about inflation. When that happens the curve of fixed mortgage rates will start to flatten out and shortly after we will see the five year rate potentially falling while floating and short-term fixed rates continue to rise.

I will write a lot about that when it happens because some people will look to jump from fixing one year or floating to locking in a five year rate. But that will be a mistake and I will explain a lot more why that is the case when we get to that situation developing.

For now, more and more people are shifting back to fixing one year, feeling they have missed the boat on at least the three to five year rates. Many people are still fixing two years, but that will ease off probably well before the end of this year.

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