Inflation’s threat to mortgages
Higher interest rates will benefit savers but hurt those who have borrowed heavily to fund property, says Shamubeel Eaqub.
The economy is moving back to some semblance of normality and so should interest rates. Economic growth and inflation, the two big indicators for the Reserve Bank, are approaching historically normal conditions. However, many parts of the economy, such as house prices, borrowing and immigration, are highly abnormal.
Nevertheless, the time has come for the Reserve Bank to begin increasing interest rates. It is no longer right to keep fuelling a borrowing binge and housing boom for the sake of abnormally low inflation. Interest rate increases after nearly a decade of historic lows will shock some. It will be frightening for those who have borrowed large sums recently, but will be a welcome increase for savers.
Consumer price inflation tells the story of the economic changes well. Inflation has been subdued in recent years. Despite a seemingly sustained economic recovery from the recession in 2008, price increases did not go back to what we would consider normal.
This was partly because the recovery was uneven. Some parts of the economy grew strongly, such as construction in Canterbury. But in other parts of the country, activity and prices were tepid. Recently, construction-related inflation has been accelerating in Auckland, but also more broadly across the country.
Also, the recovery in incomes has been slow to materialise. This has kept consumers addicted to discounts and merchants have not been able to raise prices. Businesses wanted to raise prices and pass on costs, but they have not been able to follow through.
There is a glut of global manufacturing capacity, particularly in Asia. That has kept the price of imported items low, particularly electronics.
But for most of us, the cost of living will seem to have increased much faster. This is because the things we buy frequently have increased sharply in price recently. While the total increase in the cost of living was 2.2 per cent over the past year, the cost of food, power, housing and transport rose by nearly 3.5 per cent. Government-affected prices of cigarettes and booze meant rates rose even faster, at nearly 6.5 per cent.
But the Reserve Bank cannot really influence the global price of goods, or the weather influence on food prices, or central and local government decisions to raise taxes or rates. Understandably, it has looked past the ups and downs in these prices. But the Reserve Bank still had to keep interest rates low because underlying inflation it can control had been unusually low and the economic recovery was uneven. Both of these are reversing.
When I look at the prices of goods and services the Reserve Bank can influence, there have been three big episodes since the early 2000s.
First, the long boom of the 2000s that peaked in 2008. The bank influenced inflation averaged just over 3 per cent a year.
Second, the recession and global financial crisis. The bankinfluenced inflation fell away and troughed at just 1 per cent. It is unusual for the domestic price of goods and services to fall outright, because often they have a large labour component and wages don’t tend to fall, but can stagnate for a period.
Third, the recovery, when the bank-influenced inflation was averaging just 2 per cent. But the pace has been accelerating since the middle of last year and looks likely to return to the levels we last saw in the 2000s.
This means that inflation is behaving more normally. Persistently anaemic inflation and an uneven economic recovery had forced the bank to keep interest rates low, even though it was leading to a debt binge and housing boom.
There are enough signs of normalcy in inflation for the bank to also move interest rates to a more normal level. This means increasing the floating mortgage rates from about 5.7 per cent now, towards 7.5 per cent.
This will hurt those who have borrowed large sums recently. But surely no-one borrows, and no bank lends, a 30-year mortgage expecting interest rates to stay at historic lows forever. If borrowers have overstretched, the bank will need to raise rates carefully, to avoid widespread banking distress.
For savers, particularly pensioners, this will be a welcome lift in interest income.
A return to normal for inflation heralds a return of higher interest rates.
Interest rate increases after nearly a decade of historic lows will shock some.