Rate forecast: Can you hear the interest rate tom-toms?

I write this article a day after the consumer price index (CPI) inflation rate came out at 5.3% and already you can hear the beat of the interest rate tom-toms. Before I go any further I have to admit to being addicted to news. I think I’m waiting for the economic equivalent of 9/11: a single defining economic moment. Every morning and every night I am compelled to scan the news headlines. Our global economic situation is scary and exciting, and so far 2011 has not disappointed. At some point it seems inevitable that Greece will default and kick-start round II of the global financial crisis. However, I have to say the New Zealand media has been useless at reporting on global economic events. We hear about the odd riot in Athens, but we don’t get any of the context.

I think the “Top 10 at 10” at interest.co.nz has to be one of the best daily economic commentaries we have here and I read it religiously. Even our media reporting of what is going on in New Zealand is poor. The media seem to lurch from one sensationalist headline to the next. You can guarantee that every weekend either property prices are up or down, or interest rates are up or down. And when we're not worried about property we're overindulging in tabloid Israeli spy conspiracies. With such a small population, commercial reality traps us in the mainstream. We just don't have the scale to have viable fringes.

Let’s get back to inflation. The headline today was “Inflation in New Zealand hits 21-year high.” It is blatant sensationalism but unfortunately 80% of the population believe Elvis is still alive and take these sound bites as the absolute truth. Somewhere buried in the eighth paragraph is the fact that at least 2.0% of the inflation figure is due to our GST increase. Okay, so now it is 3.30% and not nearly as scary. If we look further into the CPI figure, fuel costs and food prices jump out. From what I can see, a decent chunk of the increase in food prices is seasonal, due to the Queensland floods. I can guarantee that tomatoes won’t be as expensive next season. This year I’m doing more carbonara sauces with my pasta, and if tomatoes are this expensive next year I’ll start converting my minor dwellings to hothouses. Scarcity is a natural part of economics and I just see prices in New Zealand doing what they should do - forcing reprioritisation and substitution.

I also struggle with the focus on fuel price inflation. I see this as completely uncontrollable and an inevitable consequence of using up a scarce resource. I don’t think there is a correlation between fuel prices and interest rates. It would be stupid to increase interest rates because we’re running out of oil. Duh! The real question is whether the current spike in inflation will increase wages and property prices. I doubt it! Good luck asking for a pay increase in this environment especially if you work in the public sector. And if you own a property in Rotorua the last thing you’ll be thinking of is the price going up! Has the current spate of inflation made us poorer (in the sense that we can buy less?) Hell yeah!

My view is that New Zealand and Australia are not in as good shape as you might think. Australia seems to be coming off the boil. The retail sector is really struggling as Aussies keep their wallets closed and property prices are starting to decline.  It’s a two-speed economy with resources going gangbusters and the rest of the economy struggling to maintain a pulse. The same has, and is, happening here albeit at a more pedestrian pace.  There is no quick fix, no matter how desperately we look, or hope, for it. I think a full-blown recovery is still a pipe dream, but then maybe I’m turning into a pessimist!

Back to what matters to you – interest rates. Clearly rates have to increase from here as they can’t go much lower! If rates are expected to increase, then it isn’t really news. Is it? At squirrel we’ve been preparing clients for an inevitable increase in rates for the past six months. Up until now we’d been talking about November but it looks like it could come sooner. Fixed mortgage rates are driven mostly by consumer behaviour which is influenced by media headlines. If the CPI scaremongering takes hold we could see rates starting to jump earlier than expected. I’m hopeful of a big negative headline in the next few weeks to bring the masses back to reality. Who knows? I’ve always said that rate increases will be fuelled by irrational consumer fear of interest rates. Let’s see what happens.

I’m picking the official cash rate (OCR) will go up in two lots of 0.25% later this year or early next year and maybe another two 0.25% increases next year. That will take floating rates up to around 6.50% - so nothing to be afraid of.  However, if rates keep you awake at night then I’d fix half and float half now.  We are getting two-year fixed rates in a range of 6.05% to 6.20% and three-year rates ranging between 6.70% and 6.80%. If you’re game (and have sufficient surplus income should rates go up) then float the lot. Personally I think discounted floating rates will continue to outperform fixed rates. We are currently getting floating rates between 5.20% and 5.50% which still looks darn good compared to 6.80% for three years.

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