The market processes information about economic growth and inflation quicker than the Reserve Bank, which is quite slow to respond to the new information in making OCR decisions.
Understanding interest rate behaviour is important because it is the major driver of residential building. The first chart shows the inverse relationship between the average mortgage rate and consents for new dwellings. The best fit is with the mortgage rate line shifted into the future by 13 months, with some threat still in the pipeline from the increase in mortgage rates over the last 13 months.
The bank economists focus too much on the OCR the Reserve Bank sets and have a poor track record at predicting it beyond the next few decisions. More important, is understanding the role the market plays in driving interest rates.
The second chart compares the average six-month and fiveyear fixed mortgage rates with the OCR. The six-month rate is quite closely linked to the OCR but increases in the five-year fixed rate have been well ahead of OCR in two cases, while in one case the OCR didn’t subsequently increase, and the five-year rate reversed its increase.
Longer-term rates can move ahead of the OCR because they are based on what the market expects the OCR to be in the future. The five-year fixed rate at any point is based on what the market expects the OCR to be over the next five years.
The market processes information about economic growth and inflation quicker than the Reserve Bank, which is quite slow to respond to the new information in making OCR decisions. If there are signs the economy is improving, implying higher inflation, the market revises up what it expects
the OCR to be in the future, boosting the current five-year rate. However, at times, the market gets it wrong as it did in late 2016 when the increase in the five-year rate was not subsequently vindicated by OCR hikes, so was subsequently reversed.
The six-month mortgage rate is based on what the market expects the OCR to be over the next six months, limiting how much it can move ahead of the OCR. The level of interest rates shown in the charts is based on what they were at the time of writing and may have changed a bit since.
With the six-month mortgage rate heading above the five-year rate, it signals the market expects the OCR to be cut at some stage over the next five years, but not much. This reflects an expectation the battle against inflation will be drawn out, but it could end up being less so than the market expects.
