SHAMUBEEL EAQUB & THE FEDERAL RESERVE
US interest rates are rising, with implications for us,
The era of low interest rates is over. The US central bank has started to increase interest rates and the ripple will reach us in New Zealand too.
The US central bank, the Federal Reserve, has started increasing interest rates. They were slashed in the aftermath of the global financial crisis and supplemented with massive purchases of other bonds and securities, which reduced the cost of borrowing for every type of risk.
This broad approach to reduce the cost of borrowing for everyone had far-reaching effects. It helped stabilise the US and global economy.
It also made borrowing very cheap. Some would say too cheap relative to risk.
The flood of cheap money went into increasingly risky investments in search of better returns. Asset prices of all sorts are at near records.
The solution of the crisis may have sown seeds of a different kind of calamity for the future.
New Zealand also benefited from this flood of cheap money, which came largely via our banks. Our central bank also cut interest rates, but the bigger impact was from banks borrowing cheap money from overseas.
This helped banks lend aggressively and cheaply, more for buying existing houses than other investments.
But now the Federal Reserve is raising interest rates in the face of gradually increasing inflation and a long and lumbering economic recovery which is finally becoming broad based.
The bank expects to increase interest rates by around 1 per cent this year and again next year. The era of ultra-low interest rates is over.
The picture is not so different here. Compared to past cycles, the recovery from the recession over the past decade has been slow. The missing ingredient has been inflation.
But with good growth in employment, there are now increasing shortages. In the US at least, wages are beginning to accelerate.
In New Zealand, wage growth remains subdued outside of a few sectors like construction which are facing an unprecedented mismatch between supply and demand.
Our own central bank left interest rates unchanged and does not expect to change soon. This makes sense.
Rising global interest rates will gradually lean against the economy and we should not be trying to cool the economy too much.
Even though the economy is
’’Relative to income we have never had more debt. So we are more sensitive to interest rates.’’
growing at a reasonable pace, too much of this growth has been from population growth and not actual improvement in economic performance.
Even if our central bank doesn’t move, the cost of borrowing is set to rise. The wholesale cost of borrowing for banks is increasing. Some measures are at the highest level in a decade.
More detailed measures of risk premium on bank funding have risen sharply in the last two months. These will flow through to bank lending rates in the next month or so.
But it is unlikely that we will have interest rates rise up to the levels we had seen in 2008. The floating mortgage rate was nearly 11 per cent in mid-2008, when the central bank was desperately trying to cool an overheated economy and even more overheated housing market.
New Zealanders have borrowed even more since 2008. Relative to income we have never had more debt. So we are more sensitive to interest rates.
If interest rates rise to 7 per cent, the comparable effect will be how 9 per cent interest rates felt in the 2000s.
Ultra-low interest rates are gone. Our central bank may be sitting pat, but the cost of borrowing is rising.
Borrowers should be planning for interest rates to rise after a decade of favourable lending.