Interest Rates

While a few have flexible rate mortgages, most households in New Zealand hold fixed-term mortgages with a one or two-year term. As these fixed-term mortgages have been coming due for renewal, the cost of higher interest rates has begun to bite, and households are feeling the pain. Most are hoping that interest rates will fall quickly.

I believe that is a false hope. The problem is that the low interest rates that prevailed for most of the twenty-first century were abnormal. Following the global financial crisis, the US Federal Reserve pushed interest rates low and kept them at that level for the following decade.

Modern central banks manipulate interest rates to control the supply of money in the economy. Keeping interest rates near-zero for so long would normally significantly increase the supply of money and cause massive inflation. That did not happen for two reasons. Firstly, most of the additional money flowed into the share market, causing a massive increase in share prices (some also flowed into the commercial property market). This was inflation contained in a financial asset market, so most people perceived that to be good.

Secondly, during the first two decades of this century, Western nations started importing most of their consumer goods from China and other parts of Asia. Due to production efficiencies, the prices of consumer durables and vehicles dropped massively. So, the inflationary effect of low interest rates was cancelled out by the effect of cheaper imports from China. In this context, the inflationary policies of central banks benefitted richer people who owned financial assets while not harming poorer people because they had access to cheaper consumer goods.

Unfortunately, this situation will not continue. If central banks reduce interest rates significantly, the increase in the supply of money will cause inflation. If financial markets lose confidence, excess money will not be able to flow into financial asset inflation as it did previously, so it will tend to move into consumer inflation. The Chinese will not come to the rescue with cheaper goods, because their incomes are rising and because the United States is deliberately trying to reduce dependence on Chinese imports.

If central banks reduce interest rates too far, they will create a problem with inflation and will have to raise interest rates again, to compensate.

Exacerbating this problem, the United States is running massive fiscal deficits, nearly a trillion dollars per year. That money has to be raised with borrowing. China is becoming less enthusiastic about holding US Treasury debt because it no longer needs to push its currency down to support its exports, so it will require high interest rates to compensate for the risks of holding US Debt. The need for the US Treasury to borrow to cover big fiscal deficits will require it to keep offering high interest rates on Treasury bills and bonds. These high interest rates will nullify the attempts of the Federal Reserve to reduce interest rates.

People hoping for a significant reduction in mortgage interest rates should understand that the low interest rates that prevailed during the 2010s were abnormal. In the current situation mortgage interest rates will go back to normal, which is significantly higher than the abnormal low rates that many assumed were normal.

My father bought a farm in 1946. He took over a mortgage on the farm held by an insurance company. The interest rate was 6 percent. It remained at 6 percent for the next thirty years. This is probably a more normal level for mortgage interest rate than what prevailed during the 2010s. That is probably the normal that we will go back to in New Zealand. If governments in the western world keep increasing their debt, rates may need to go higher than that.