Another increase to the OCR as monetary policy continues to tighten

Guest post from Tony Alexander

The Reserve Bank met expectations this week with another 0.5% increase in the official cash rate so it now sits at 3.5% compared with the record low just over a year ago of 0.25%. Perhaps it is useful just to remind ourselves about why interest rates were so extraordinarily low a year ago.

On average since 1992 the inflation rate in New Zealand has averaged 2%.

But between 2012 and 2019 the average was only 1.2% and in New Zealand and overseas there were deep concerns about deflation. This is a situation where average consumer prices are falling, or to put it another way, the cost of living is going down.

On the face of it that sounds quite good, but it does tend to mean that business debt ratios blow out and there is always a risk that when a period of economic weakness comes along, the extra downward pressure on prices causes people to pull back even further on buying things amid expectation that during these tough times they will get cheaper. That can lead to extra closures in the retail sector which feed through to manufacturing and so on.

To combat this the Reserve Bank took the official cash rate down by 0.75% in 2019 so it sat at 1% when the global pandemic came along. With universal expectations that the global pandemic would lead to deep economic weakness and falling prices, central banks slashed their interest rates and our own rate went down to 0.25%.

One day the current tightening cycle for monetary policy will have ended, interest rates will have topped out, they will start falling, and all attention will be on how low interest rates will go. Unless we see a repeat of the recent unique combination of events it's quite unreasonable to expect that the cash rate will go back to 0.25% and that the likes of the five year fixed mortgage rate will get back down to the glorious level over a year ago of 2.99%.

For the moment of course all attention is on the levels interest rates are going to peak at and when this will happen and most definitely not on where they will bottom out.

But that's interesting to think about. The sharp sell off in financial markets over the past few weeks in response to higher than expected inflation worries in the United States and the unexpected easing of fiscal policy in the United Kingdom has generated deep worries about the heights to which interest rates will go.

Volatility in borrowing costs has been high and there is a risk that some people who have their fixed interest rates priced off the wholesale yield curve would have locked in high rates for long time periods in order to avoid even more expensive borrowing costs down the track. History tells us that during these times such mistakes can prove quite costly.

Banks know this and they know that during these periods of extreme volatility it is best to sit back for a while and see where things settle down rather than run the risk of putting one's interest rates up one week only to cut them again the next week and then put them up again a week afterwards.

Banks have already initiated some increases in their fixed mortgage rates

Their borrowing costs have been trending upward since the first week of August.

But it doesn't look like any have properly factored in the rise in borrowing costs attributable to the easing of fiscal policy in the United Kingdom in particular. Thank goodness they did not, many will be saying, because the changes now occurring in the UK mean that wholesale borrowing costs facing New Zealand banks are largely back to where they were before the UK eased fiscal policy.

This still leaves pressure on the banks to increase their interest rates further and it's entirely possible in the next couple of weeks we will see some further upward movements. But I'm still prepared to stick with my view that apart from the one year fixed mortgage rate, interest rates for other terms hit their peaks back in the middle of June.

I'm also sticking with the view that in a years time interest rates will be tracking downward and a key factor likely contributing to that will be the wholesale switch in market attention away from picking how high interest rates get and when they get there towards how low they will go and when they will get there. Such as the nature of financial markets. They are always forward-looking and they more often than not will overshoot in their predictions on the high side and on the low side.

For the moment if I were borrowing I'd probably still be quite happy to fix for one year maybe with some portion of my mortgage also fixed for a 2 year. But going longer than that I feel is a bit expensive given what the history of financial market movements tells us is going to happen somewhere down the track with the switch towards focusing on interest rate lows and not the highs which dominate debate at the moment.

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