Preparing for rising interest rates

A key influence on market interest rates is what the Reserve Bank of New Zealand (RBNZ) does with the Official Cash Rate (OCR). The OCR is the interest rate set by the Reserve Bank that influences the price of borrowing money in New Zealand (including mortgage rates). This provides the RBNZ with a means of influencing the level of economic activity and inflation. The RBNZ adjusts the OCR to help it achieve its price stability (inflation) as well as employment objectives. The RBNZ has a 1-3% target range for inflation and would like it to be around 2% per annum on average. Similarly, it would like employment to be as close as possible to its maximum sustainable level.

Inflation describes a rise in average prices through the economy (i.e. money is losing its value). New Zealand's Consumers Price Index (CPI) measures changes to the prices of consumer items that Kiwi households buy. Over the past 10 years the New Zealand CPI has generally been below the 2% mid-point of the RBNZ's 1-3% target range. That has changed quite rapidly over the past year. Annual CPI inflation has spiked and is running at a rate around 7% in 2022. CPI inflation is not expected to fall below 3% until 2025. Inflation is now too high from the RBNZ's perspective.

As a result of the stronger inflation outlook and limited spare capacity and strength of the local economy, the RBNZ delivered its first OCR increase in over seven years in October 2021. The RBNZ delivered further OCR increases at all its subsequent meetings in late 2021 and 2022. We are seeing similar developments happening offshore. These developments help to explain why there has been upward pressure on mortgage rates over the past year.

Clear risks remain to the outlook, particularly with COVID-19 continuing to throw up ongoing challenges. However, if the New Zealand and major economies continue along the path we expect, mortgage interest rates are expected to keep lifting as the world gets past the worst of the pandemic, and central banks battle with inflation. The ASB Economic team expects the OCR will peak at 5.50%, and in addition to our assumptions about bank funding costs and inflation forecasts, we expect fixed-term mortgage interest rates will lift slightly higher than they are now over the next year. We expect most fixed rates to settle in a 6.5% - 7.5% range over the year ahead. However, as is often the case, the outlook is far from certain.

We think it is prudent for borrowers carrying debt for longer than the next couple of years to budget on mortgage interest rates being higher than they are now. Lenders will likely do budget calculations for loan eligibility using interest rates that are noticeably higher than those currently being used to account for the risk that interest rates may go higher than actual loan rates today. It's always the case that mortgage rates could dip lower, due to anything from RBNZ actions through to renewed threats to the economic outlook.  But right now - even as NZ and many economies face several challenges - the risks still appear skewed to higher mortgage rates in the foreseeable future.  We suggest all borrowers pick a strategy that suits personal budgets (including a tolerance for changing interest rates) and need for flexibility, as well as the goal of minimising interest rate costs. Reading our ASB Home Loan Report is a good place to get more information to help you identify what is best for you.