Tony Alexander Update August 2021
Interest rate outlook quickly changes Towards the end of the article I wrote last month was this sentence.
“These are extremely uncertain times which we are living through, and no-one should be under any illusion regarding the accuracy of interest rate predictions which we economists are making.”
Every day brings new information which we need to take into account as we try to get a feel for where our economy is at now and where it is headed. Back on July 16 we learnt that the annual inflation rate in New Zealand jumped 0.5% more than expected to 3.3% from 1.5% over the previous two quarters.
This is an important development as I can recall only two other instances in the past three and a half decades when the quarterly inflation outcome has surprised on the high side by 0.5% or more. One of those was back in the middle of 1987 just before mortgage rates went above 20% for some people.
We are not going to see anything approaching that happening this time around. But the shock high inflation outcome has caused a sharp shift in market expectations for what interest rates are going to do. There has not been a change in the extent to which people think interest rates will rise. Those forecasts still sit between roughly 1.5% and 2.0%.
But the expected timing of monetary policy being tightened has shifted to August 18 rather than the November period commonly expected before the inflation number. Only a few weeks before that the common view had been that tightening would start in February next year, and a few weeks before that it was May of 2022.
We have seen one of the most rapid periods of shifts in policy expectations ever and already this has produced a round of mortgage rate increases in response to bank borrowing costs going up. The five-year fixed mortgage rate for instance was commonly sitting at 2.99% back at the end of April. Now it sits near 3.79%.
The popular one-year fixed mortgage rate now sits commonly near 2.5% from 2.19% just four weeks back.
As noted last month, because most borrowers know nothing other than low and falling mortgage rates, the rises are likely to elicit some good restraint in household spending – by those borrowers at least. And there is unlikely to be a period of any major weakness in the housing market because lenders have required borrowers be able to service mortgage rates 3% or so higher than they were actually paying. The buffer against higher rates is strong.
But history has taught us many things and one which I can attest to, having been back in New Zealand since 1987, is this. At the start of every monetary policy tightening cycle we say that this time around interest rates will not need to rise by all that much because people have so much debt. That is what we are seeing this time also.Frequently in the past we were wrong, and we could be in error this time around also.
Why might we be under-cooking the potential upside for interest rates? Perhaps because the true effects of labour shortages have yet to be seen. So far there is no statistical evidence of a generalised increase in the pace of wages growth in New Zealand. We all have anecdotes. But the key measures which will influence our and the Reserve Bank’s forecasts of inflation have yet to start moving. That boost to inflation has not arrived yet.
Helping this boost will be the fact that as yet the tight labour market does not seem to be either realised by staff or be something they wish to act on by demanding higher wages and better conditions. The risk is that at some stage people do feel secure enough in the world around them (and with the Delta variant of Covid-19 in play that feeling of comfort may be some ways off) and they ask for more money.
More than that, at some stage we are likely to see many Kiwis leave for Australia in order to earn higher incomes over there. Employers may not like it, but unless they increase remuneration 20% or so they are going to lose people and have to either cut outback, hire and train up potentially unsuitable people, or invest heavily to boost labour productivity. In practice all three things will happen but there will also be a fourth development. Some first will find that the best thing they can do is close their doors.
Many businesses in New Zealand in recent years have existed on the basis of cheap, compliant, migrant labour coming in with dreams of residency. But not only are fresh staff no longer accessible, the government has made it very clear that they will issue fewer working visas when the borders one day open up than was the case for the years leading into last year’s lockdown.
Switching back to the housing sector now, over the coming 12 months the chances are very strong that prices will rise some 5% - 10%. This will be on the basis of construction costs rising very strongly because of shortages of materials sourced from overseas, as well as staff shortages curtailing some materials production here in New Zealand.
Section prices continue to rise (14% on average for the past year) and it will take some time for councils to go through the lengthy processes required to allow the carving up of additional blocks of land – especially in the face of strong opposition from those living near the planned new developments.
There is also a large backlog of frustrated house buyers, and as waiting times for new houses to be built stretch out many frustrated buyers will switch back to searching through and bidding on existing houses.
But housing markets move in cycles. In many parts of New Zealand markets look to be at their peaks and prices are a long distance from their trend relationship with the all-NZ average. Perhaps 18 or so months from now, the combination of interest rates being 2% higher, much greater house supply, and net negative migration flows, will cause these markets to flatten out with prices reverting to trend levels over the following 3–5-year periods.
Note that according to my calculations, there are only three regions in the country where prices are well below trend and a period of relative prices “catch-up” lies ahead. They are Queenstown Lakes, Canterbury, and Auckland.
By Tony Alexander