Interest rates on an upward march

Interest rates on an upward march

Stairs with white picket fences

The long-awaited monetary policy tightening cycle has now kicked off in New Zealand as the need for record low interest rates to combat feared effects of Covid-19 has disappeared, and the need to fight rising inflation has soared.

Our central bank was going to raise its official cash rate from 0.25% to 0.5% on August 18 but held off doing so until this week because of the nationwide shutdown announced by the Prime Minister the evening before their planned rise.

Are we alone in seeing record low borrowing costs being removed?

No. The central bank of Norway raised its cash rate last week and the central bank in Poland did the same this week.

Does this week’s rate rise mean that a new round of increases in mortgage rates is going to occur? For floating rates yes as they are closely tied to the official cash rate which is itself floating. But for fixed mortgage rates the rises have already occurred in anticipation of this move plus another increase on November 24 and a further rise on February 23.

Fixed rates have already started going up

Fixed mortgage rates have already risen by between 0.6% and 1.0% roughly across the one to five-year terms compared with where they were five months ago. So, for the moment, fixed rates may not change much. But the direction of travel is clear and well before Christmas we are likely to see further rate rises.

One factor driving borrowing costs higher over and above shifts in the official cash rate is the desire by banks to rebuild their lending margins for fixed rate loans. These margins are running about 0.5% lower than average for the past two years. Banks are highly likely to take advantage of the fog of confusion surrounding rate rises to add that extra 0.5% to fixed lending rates in the coming year regardless of what happens to the OCR.

A second non-OCR factor is rising interest rates overseas

What happens in Poland and Norway is not really relevant to anything here. But the Federal Reserve Board in the United States has indicated they may start raising interest rates next year, and the Bank of England has suggested rates may rise this year.

Around the world inflation rates are rising and the earlier hopes that disruptions to supply chains would prove short-lived are evaporating quickly. That increases the time period over which one can reasonably expect wages to be boosted as employees seek compensation for the increase in their cost of living.

Rising wages then bring an added risk of further increases in business selling prices, especially in an environment where materials and transport shortages mean customers will have difficulty finding alternatives to their traditional supplies who can deliver within an acceptable time frame.

How high might interest rates go in New Zealand?

The markets here are increasingly factoring in an expectation that the cash rate will go to 1.5% by early-2022. That rise of 1.25% from the recent OCR low is actually less than the Reserve Bank’s indicated 1.75% increase. It is also less than the extra 2.25% I think borrowers should allow for.

History tells us that our central bank often under-estimates inflationary pressures and ends up having to take interest rates higher than they initially thought over a longer than anticipated period of time.

It is not at all likely that we will see mortgage rates back at pre-GFC levels given that most people with debt have become used to very low rates so will react more to the likes of a 5% mortgage rate than we ever would have before a few years ago.

But borrowers should allow for the risk that many people are being too complacent about how high interest rates may go. That is why there is value in having a good portion of one’s debt at a fixed interest rate for at least the next three years.

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