Soaring inflation raises mortgage rate risks

Soaring inflation raises mortgage rate risks

Bird soaring in the sky

For quite a few months now my central theme with regard to interest rates has been fairly clear. Inflation risks are rising, the Reserve Bank will tighten, and chances are they will tighten by considerably more than people are comfortably thinking.

To justify this view I often cited the June quarter inflation outcome which was 0.5% higher than expected, taking our inflation rate to 3.3%. I noted that it is very unusual for inflation to surprise on the high side 0.5% above expectations and could recall it happening only on two other occasions since returning to New Zealand in June 1987.

It is therefore extremely unusual to have exactly the same thing happen again this past week

The rate of inflation for the year to September did not simply rise from 3.3% to 4.4% as had been commonly predicted. It jumped to 4.9% with increases in the cost of living for households across a wide range of items.

Just five months ago the Reserve Bank was predicting that the inflation rate right now would be just 2.5%. Their error of 2.4% tells us they no longer have an ability to accurately predict inflation (and they have no house price forecasting model of any use either).

This means that we can place essentially no faith in soothing comments they have been making for many months regarding the pace with which monetary policy will be tightened this time around.

Ahead of the inflation data this week the Reserve Bank had been predicting the cash rate would increase from the recent record low of 0.25% to 2.0% in September 2023. My personal view has been that the peak will instead be 2.5%. Now I think 3% is more likely.

Borrowers should brace themselves

That means borrowers should prepare for the likes of the one-year fixed mortgage rate rising from what are still exceedingly low levels below 3% at the moment, to somewhere above 5% come perhaps early-2023.

Now, perhaps too late for many people, we can clearly see why I so strongly advocated in this column and elsewhere that borrowers forsake the candy-like one-year 2.19% fixed mortgage rate and instead fix five years at the record low level of 2.99%.

The data tell us that not many people were able to walk past the candy on offer and lock in the long-term rate.

Will there now be a scramble to fix?

There has certainly been a strong shift in term preference from one-year to three years. History tells us that is about as long as the majority of Kiwis are prepared to fix – except when something special happens.

Borrowers in New Zealand tend only to fix five years in large numbers when it is the wrong choice to make. This arises because people largely base their fixing decisions on whichever tern offers the lowest rate. In each monetary policy tightening cycle we reach a point where the short-term rates are higher than the long-term rates.

When that happens people fix five years. But the only reason the yield curve as we call it is sloped downward (short rates above long rates) is because the financial markets are expecting monetary policy to be eased in response to falling inflation forecasts based around solid evidence of gross weakness in the economy.

We are a long way from that point – but it will come. For now, fixing three years may well be the optimal decision for most people. But there are still some low five-year rates on offer and in a world where we seem to get shocks quite frequently and where accurate predictability of inflation even five months ahead has become impossible, fixing at least some of one’s debt at a long-term rate could be a good risk management decision.

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