Tony Alexander Update July 2021
Debate has now lifted to a high level regarding central banks around the world pulling back from extremely loose monetary conditions put in place to fight the effects of Covid-19. We can see evidence of economies growing quite strongly now with support not just from low interest rates and printing of money.
In the likes of the United States and United Kingdom there is confidence returning as vaccination rollouts proceed rapidly, plus in the US a large fiscal stimulus is underway with more to come. In China factories are busy producing the many goods householders around the world have been binging on since Covid appeared.
In Australia there is no vaccination boost evident yet and clearly the Delta variant of Covid-19 is causing problems. But there is a fresh fiscal stimulus in play and strong growth occurring in the minerals sector thanks to strong demand for the likes of iron ore coming from China. The rains have fallen in eastern states, so the farming sector is looking good, and there is a house building boom underway.
The appearance of better growth and lifting of growth forecasts has shifted attention to the risk of inflation rising and already we can see a headline rate in the US of 5%, and one measure in China hitting 9%. Every week brings new price increase announcements from suppliers of building materials, and tight labour markets are starting to cause wages growth to accelerate – most notably in the United States.
Here in New Zealand we are likely to soon see the annual rate of inflation rise from 1.5% to close to 3% and though there are many temporary factors which will explain the increase, there are plenty of indicators suggesting inflation may prove less sanguine than desired.
For instance, in the ANZ’s monthly Business Outlook Survey a net 63% of businesses have said that they plan raising their selling prices over the next six months. The average for this measure is 22% and the latest reading is the highest on record.
We can also see tightness developing in the labour market and that is important in two ways. First, labour shortages will eventually boost wages. As yet one cannot see this effect showing through and that is perhaps understandable as many employees still feel very uncertain about the future as Covid-19 remains a problem.
But perhaps the greatest relevance of the tightening labour market is that it means the Reserve Bank is very close to satisfying the requirement under its Remit from the Finance Minister to try and achieve sustainable maximum employment.
The need to maintain extraordinarily loose monetary policy to contain unemployment has almost vanished and that is a key reason why the financial markets have now fully priced in an expectation of the Reserve Bank raising its official cash rate from 0.25% come February next year.
That timing is six months in advance of the indication which the Reserve Bank recently gave of tightening starting just after mid-2022. But since they published that interest rates track, we have learnt that the NZ economy grew by 1.6% during the March quarter of this year and did not shrink 0.6% as the Reserve Bank had predicted.
How high might interest rates go? The Reserve Bank have pencilled in 1.5% worth of rate rises stretching over a two-year period. Those rises would represent an unwinding of the 1.5% worth of rate cuts between May 2019 and March last year. But there is a risk they need to raise rates 2% given the way in which the labour market is set to tighten up in New Zealand.
The government has clearly indicated that they are adopting more of a fortress New Zealand approach to immigration policy than a focus on boosting the pace of economic growth. Their concerns about some groups in society potentially failing to keep up because of competition for work from low skilled migrants on working visas is driving a focus on effectively forcing businesses to hie Kiwis – no matter how low skilled they may be.
There are merits to such a policy. But there is a cost which will be borne by the business sector and that risks higher selling prices to recoup higher labour costs.
In addition, there is very strong demand coming out of Australia for New Zealand staff. Australian employers are desperate for people across a very wide range of sectors and New Zealand is the only pool they can fish in with reasonable expectation of new hires being able to start almost immediately. The rest of the world is still largely denied entry through Australia’s quarantine system – to a deeper degree than is the case in New Zealand.
As Kiwis head across the Tasman we can reasonably expect additional upward pressure on wages here. But does this mean a severe rise in inflation lies ahead and that we should expect interest rates to rise a lot more than 1.5%? Not really.
Back in 2008 when interest rates were last at high levels at the end of a 3.25% tightening cycle (peak cash rate of 8.25%), the level of mortgage debt in New Zealand stood at about $150bn. Now it stands near $310bn and allowing for principal repayments, sales and purchases by existing borrowers, maybe 80% of the debt is new in the sense of borrowers having no familiarity with the old, high, mortgage rates which we used to have in New Zealand.
This means that when mortgage rates start going up, we are likely to see a fairly strong pullback in spending by borrowers which means rates won’t have to move all that far for the Reserve Bank to get the restraint which it will need on our pace of economic growth.
Could rate rises cause big problems in the housing market? Probably not. The days of irresponsible mortgage lending in New Zealand disappeared a long time ago, and for some years now banks have assessed the ability of borrowers to service their mortgage at rates around 3% higher than what they actually signed up to.
This is good news for the business sector in that financing costs this cycle will go nowhere near the levels of past monetary policy tightening cycles. But it is very good news for exporters because the absence of extreme hikes in NZ interest rates means the absence of the large cash inflows seeking high yield which have characterised past tightening cycles.
This effect will in particular be dampened by interest rates offshore rising perhaps not long after they have started to be pushed higher here by our central bank.
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. After all, most of our forecasts have been wrong since 2007 with regard to first of all not picking the GFC, then second continually over-estimating inflation and interest rates from 2010. The trouble is we’re not sure which way the errors will lie this time around. Will we under-predict rate rises or over-predict? Time will tell.