Bernard Hickey looks at how to think about whether to fix or float, and what bank economists are saying about interest rates and house prices

By Bernard Hickey

The Reserve Bank will release its quarterly Monetary Policy Statement (MPS) on Thursday, including its latest view on where the inflation rate and interest rates are headed.

It faces a difficult situation. Auckland's housing market appears to have taken off again in October and November, thanks to lower fixed mortgage rates, high net migration and the election result's removal of uncertainty about foreign buyer restrictions and a Capital Gains Tax. The Reserve Bank's high LVR speed limit is still in place, but the one-off shock of it appears to have worn off in Auckland.

The bank remains worried that another housing boom in Auckland would endanger financial stability because New Zealand's banks are heavily exposed to mortgage debt, which was why it decided in early November to leave the high LVR speed limit in place until well into 2015. Normally, the Reserve Bank would be increasing interest rates at this point in the economic recovery, which would take some steam out of the Auckland housing market, but annual inflation is surprisingly low at 1% and it is also worried that higher interest rates would pump up an already 'usustainably and unjustifiably' high New Zealand dollar.

Calls are growing from business and union groups for the Reserve Bank to lower the Official Cash Rate (OCR) from 3.5% because inflation is at the bottom of the Reserve Bank's 1-3% target range and the OCR is helping to keep the New Zealand dollar stubbornly high, despite the 50% fall in dairy prices since February. But the bank itself said as recently as November 12 that monetary policy remained stimulatory and the OCR was still below what it viewed as the 'neutral' rate of 4.5%. So although some would like a cut, the bank is expected to hold at 3.5% when the decision is announced at 9 am on Thursday.

Economists and banks will look closely at the Reserve Bank's forecast track for the 90 day bill rate, which is seen as a proxy for the OCR. The bank's last published forecast track from its September MPS saw the 90 day bill rate rising another 1% to 4.7% by late 2016. Since then, New Zealand inflation figures have been weaker than expected, dairy prices have slumped further and European and Chinese growth has slowed. Most economists now expect the Reserve Bank to leave the OCR on hold until September next year at the earliest, and possibly all through 2015.

This still leaves the thorny issue of Auckland's housing market. Some economists have begun talking in recent weeks about the potential for the Reserve Bank to dip into its bag of Macro-Prudential policy tricks for another high LVR-style policy to slow the housing market without having to put up interest rates for everyone. Most think it's unlikely the bank would further lower the 'speed limit' on high LVR lending.

There are a couple of other options, including forcing banks to hold more capital to back housing loans generally, or just for multiple property landlords. That would see banks put up interest rates for mortgages and multiple property landlords a bit. The central bank could also force the banks not to lend to someone with a debt servicing ratio above a certain level, which is something the Bank of England is planning. See more on these options in this Gareth Vaughan article.

City of Sales

Annual house price inflation has halved since mid 2013 to around 5% nationally and 10% in Auckland, but there were signs in November's sales figures from Barfoot and Thompson and from QV that Auckland took off again through the spring open home season. Sales volumes in Auckland rose 17.7% in November from October and the median price rose more than 5.5% in one month to a record high.

Net migration jumped to a fresh record high in October and is headed over 50,000 for the year, with much of that going to Auckland. Also, fixed mortgage rate cuts are adding fuel to the fire. Three year fixed mortgage rates have dropped to just below 6% from over 6.6% as recently as April as banks have passed on the very easy and cheap money being printed hand over fist in the rest of the world. That is keeping Greater Auckland and Canterbury prices buoyant, although much of the rest of the country remains subdued.

These continued cuts in fixed mortgage rates and more signs of a weaker than expected global economy are making fixing rather than floating increasingly attractive for those calculating what is purely the cheapest deal. See the table below for the latest calculations on a NZ$500,000 mortgage.

Fixed and floating combo?

The answer depends on the interest rates being offered, your outlook for interest rates and your personal situation. A combination of both floating and fixed may also work, particularly if you want to be able to be more flexible in how you pay off your mortgage. It may also make sense to fix short term rather rather than longer.

A flat-to-falling OCR makes floating more attractive, while a fast-rising OCR makes fixing and fixing for a longer time more attractive.

It all depends on whether actual interest rate increases are close to the forecast track laid out by the Reserve Bank and expected by the financial markets. That's because fixed mortgage rates are heavily based on the 'swap' rates in wholesale markets and those 'swap' rates are dependent on those market expectations for future interest rates.

If interest rates move as expected then there's often not as much benefit in fixing as you might think. But if, for example, inflation is consistently weaker than the Reserve Bank expects and it has to keep delaying its plans for rate hikes, then fixing may look more attractive.

The main benefits come from the banks accepting a lower 'profit' margin on fixed mortgages than advertised floating mortgage rates. Sometimes a floating rate borrower can get a better deal than a fixed mortgage simply by directly challenging your bank or working with a broker to challenge the bank to offer a better floating deal than the advertised deal.

But there is a way to work out which deal is cheaper over the full term of a mortgage. Interest.co.nz has a calculator that allows you to compare the costs of fixed vs floating over the full term, remembering that often the floating rate is cheaper in the first few months than a fixed rate, but then more expensive later in the term.

It's the total benefit that's important over the term of the mortgage and also whether rates actually rise faster or slower than the expected track built into your fixed rate mortgage.

I have argued for years that interest rates are likely to stay lower for longer than most expect and that's proving to be the case again. That's because there are strong structural forces building in the global economy to press down on inflation, including ageing populations, weak wage growth for low to middle income earners, increasing use of labour-saving technology and the increasing globalisation of services. That means I take the view that shorter term low rates are better than much higher long term rates.

Calculating the gains

Here's a table that shows the benefits of moving a NZ$500,000 mortgage from a floating rate of 6.75% to the various fixed options, assuming different interest rate tracks. The gains are indicated as a positive and the losses are negative. The middle track for the OCR is in line with market expectations. See all mortgage rates here.

The latest estimates, given the drop in fixed rates in recent months, suggest fixing is cheaper than floating across the board.