Why low inflation is toxic for the economy.
The economy suffers when people expect long periods of low interest rates and low inflation, writes Bernard
Expectations matter a lot in the economy and investing. They are hard to create and just as hard to shift once they’re bedded in. Expectations of high inflation and high unemployment set in during the 1970s and early 1980s during an era of oil shocks, strikes, cost-plus pricing and across-theboard wage increases.
Policymakers, including the likes of Don Brash and Sir Rod Deane in New Zealand, became desperate to shift those expectations and make it easier for businesses to invest and safer for savers to avoid being destroyed by inflation.
They had to fight hard against the orthodoxy of the day about prioritising low unemployment over all else to break those expectations, but it paid off in the end.
One of the heroes of this time in modern macroeconomics was Paul Volcker, appointed United States Federal Reserve chairman in 1979.
He chose to break the inflationary cycle by putting up America’s version of the official cash rate, the discount rate, from an already punishingly high 11 per cent in August 1979, when inflation was also 11 per cent, to an unthinkable 20 per cent in March 1980.
That rate hike shock shattered expectations and generated a recession that drove down inflation once and for all.
That same shift took a while to get to New Zealand, but when it did, our macroeconomic heroes of the day took it to a new level. Brash and Deane oversaw a complete reworking of the economy and how the Reserve Bank operated, giving it full independence and tasking it with getting inflation down to 2 per cent permanently.
Brash became our own version of Volcker, lifting cash rates from closer to 10 per cent to over 20 per cent at various points in the late 1980s.
It also worked, cranking up unemployment to over 11 per cent and driving down inflation and inflation expectations to around 2 per cent.
And that’s where they’ve stayed until the last decade or so. Then something weird started happening.
Core inflation, which strips out the blips and dips associated with tax changes and oil prices, started sagging towards 1 per cent. The advent of globalisation of both goods and services, along with surges in the gig and app economies saw consumers, savers and investors start to expect lower inflation than the 2 per cent the Reserve Bank was tasked with achieving.
This was and is dangerous because falling inflation expectations are not just awkward and difficult to turn around, but they’re toxic for the economy and worsen imbalances, favouring already-wealthy asset owners at the expense of lowwage workers living in rental properties who are scrambling to keep multiple and insecure jobs.
This problem of low and falling inflation expectations happened all over the developed world for much of the last decade, forcing central bankers into ever more extreme actions to try to generate inflation. This phenomenon was wellknown to those who had studied Japan since the early 1990s.
It has been grappling with deflation and deflationary expectations for almost 20 years. Japan was never quite able to stimulate its economy enough to escape this deflationary trap. It becomes a vicious cycle when an economy with falling expectations of inflation is left to its own devices for long enough.
Consumers prefer to wait to buy things because they know they’ll get a better deal in future once prices fall.
Employers stop giving pay increases and employing new staff, given they expect they will have to cut their prices and profits. Savers don’t like low interest rates on their savings accounts, but they’re also nervous about investing in new products or companies when prices are depressed or falling. They also fall prey to the idea that money left in the bank will be able to buy more in future once prices have fallen.
Investors, especially the older ones more focused on protecting wealth than growing wealth, also cotton on to how central banks and governments respond to this very low and falling inflation. They pile their money into these risk-free existing assets such as bonds and dividendyielding shares in the expectations of capital gains.
In New Zealand terms, that means pouring more money into existing rental property.
There’s also the reassurance that politicians and the Reserve Bank, which is also tasked with keeping the banking system stable, will act to prevent the main security of banks, residential property, from falling. The end result is not much investment in real businesses or extra businesses.
It’s much easier just to bet on interest rates staying low and house prices staying high.
This fear about inflation expectations setting in and investors becoming used to low interest rates for a very long time is very real for central banks. That’s why Volcker’s heirs at the US Federal Reserve, the Reserve Bank of Australia and the European Central Bank have been talking for most of the last year about how they can ‘‘overrev’’ the economy to get inflation well clear of 2 per cent and for the economy to reach ‘‘escape velocity’’.
The way they talk about it is to say they have changed their targets somewhat from getting inflation down to 2 per cent or below, to saying they are targeting 2 per cent on average.
Given inflation has been between 1 per cent and 2 per cent for most of the last decade, that means running the economy ‘‘hotter’’ than they normally would to get inflation well above 2 per cent and closer to 3 per cent for years to come.
US Federal Reserve chairman Jay Powell set this out in his most recent speech, using the dry language of a central banker. Audience members who didn’t fall asleep went out to buy more bitcoin and bet on more central bank stimulus.
This week the European Central Bank also recommitted to pumping €1.85 trillion (NZ$3.1t) into its economy to push up inflation from closer to 1 per cent to around 2 per cent.
The Reserve Bank of Australia is also trying to pump the accelerator. It confirmed this week it would buy another A$100b (NZ$107b) worth of bonds and pledged to keep its main interest rate at 0.1 per cent until 2024.
Now it’s the Reserve Bank of New Zealand’s turn and it is taking a more conventional view on what it should be targeting and how much it should pump the accelerator. It will release its next Monetary Policy Statement next Wednesday and is widely expected to signal it won’t cut rates any further, it won’t increase its bond buying any further and may even signal rate hikes next year.
That’s despite core inflation remaining below 2 per cent and few signs the economy is headed for escape velocity and inflation closer to 3 per cent. Governor Adrian Orr rejected suggestions last year of adopting the American, Australian and European approaches to targeting ‘‘average’’ inflation of around 2 per cent and ‘‘overrevving’’ the economy to clean it out.
The risk, though, if he doesn’t gun the engine even harder, is that mortgage rates get embedded around 2 per cent, house prices keep rising and investors begin to expect that interest rates will stay low for multiple years. That raises the risk that too many rental property investors will gear up too much in the expectation of never being burnt by a sharp rise in rates.
The longer interest rates stay low, the higher the risk of euthanising the real economy and entrenching a low-wage and low productivity economy where the obvious investment is a lowrisk one in existing rental property, rather than a higher-risk and higher-return one in a real business that employs extra people.
Many savers lament the low returns from their term deposits, but the only way the economy can generate higher returns in the long run is for the cobwebs to be blown out with a burst of growth and inflation that cleans out all the soot and carbon clogging up the cylinders and exhaust valves of the economy.
Audience members who didn’t fall asleep went out to buy more bitcoin and bet on more central bank stimulus.
Hamilton has seen strong price growth, frantic buyer activity and increasingly low levels of housing stock. But while a three-bedroom, two-bathroom unit in Hillcrest in Auckland recently sold for $1 million, according to Trade Me Property, for that money you could have bought a five-bedroom, two-bathroom standalone house on a large section in Rototuna in Hamilton – it sold for $980,000.
Another sale was a fivebedroom, one-bathroom standalone house, but with limited land, in Beerescourt for $954,500.
Ray White Hamilton City managing director Fraser Coombes says you can get more for your money in Hamilton than you can in Auckland or Tauranga.
‘‘People are very attracted by that. It’s just a lot more achievable to get on the property ladder here, whatever type of buyer you are.’’
According to the latest CoreLogic House Price Index, the city’s average value came in at $693,826 last month. That reflects quarterly value growth of 6.9 per cent and annual value growth of 12.6 per cent.
The Real Estate Institute’s latest data, released this week, put Hamilton’s median price at $695,000 last month. While that is a 4.8 per cent decrease on December’s median price of $730,000, it does represent growth of 14.9 per cent on the city’s median price of $605,000 in January last year.
Despite real estate agent reports of a busier January market than usual, the Real Estate Institute’s data showed sales at 151 last month. As well as being a big decrease (61 per cent) on the 387 sales seen in December, it’s down 13.2 per cent on the 174 sales seen in January last year.
One reason for this could be the limited number of properties. Realestate.co.nz recorded 228 new listings last month, compared to 237 in December.
Lodge Real Estate managing director Jeremy O’Rourke says the lack of stock is a major feature of the market.
‘‘It means house prices are under upward pressure,’’ O’Rourke says. ‘‘There’s lots of competition and we are seeing some surprising results at auctions.
‘‘Listings started to pick up in
‘‘Listings started to pick up in late January as people returned from holiday, but we are still finding there is simply not enough stock to meet huge buyer demand.’’ Jeremy O’Rourke Lodge Real Estate managing director, left
late January as people returned from holiday, but we are still finding there is simply not enough stock to meet huge buyer demand.’’
However, while Hamilton prices have increased significantly in recent months, the city remains comparatively affordable, compared to prices in other major cities.
CoreLogic’s data puts Hamilton median value as the lowest of all the big North Island cities. At $693,826, it compares favourably to Auckland’s median of $1,164,440, or Tauranga’s median of $888,930. It’s also below the national median of $806,151.
Hamilton’s comparative affordability has made it popular with investors and first-home buyers. CoreLogic’s latest Buyer Classification data shows firsthome buyers represented a
27 per cent share of Hamilton purchases in the last quarter of 2020 and a 25 per cent share last month.
But it also shows that mortgaged investors have the dominant market share in Hamilton, with 36 per cent of purchases in the last quarter of 2020, and 39 per cent in January.
These are the highest levels since mid-2016 and well above the national average of 30 per cent in January and 27 per cent in the last quarter for 2020.
CoreLogic senior property economist Kelvin Davidson says it’s easy to see why the city appeals to investors. ‘‘Prices are lower in Hamilton and hence deposits are lower, so it’s easier to raise that 30 per cent or 40 per cent which is now required,’’ Davidson says. ‘‘Yields at about 3.5 per cent are 1 percentage point higher than in Auckland too.’’
Hamilton’s prospects for the future also make it attractive as a city to buy and live in. There’s a lot of change and development already in motion, and more is planned for the coming years.
Current residential and mixed-use developments underway include the Peacocke development in the south, the GreenHill Park development in the east which is close to the Ruakura Inland Port, and the Ra¯ whiti Village redevelopment in Frankton.
This is supported by Hamilton’s robust economy, which has as its backbone the primary sector and associated industries – all of which have seen limited impact from Covid-19.
Improved transport connections, such as the new expressway, have enhanced the city’s proximity to Auckland, and that’s another appealing feature for many, O’Rourke says.
‘‘We are seeing good economic growth, so there’s solid employment prospects, alongside the lifestyle options that living in Hamilton offers.
‘‘It all means there’s confidence in developers about where the city is going and what the future looks like, so they are pushing for more housing development.’’
More much-needed housing supply is in everybody’s sights but, as with many other cities, the big challenge is unlocking land for further development and unblocking building material supply chains to ensure that.
Coombes says one development on the supply front is increasing infill development and redevelopment of older, sometimes former commercial, stock which is relatively new for Hamilton.
‘‘It is a growing trend for a growing city and it’s great because it makes home ownership more affordable for people,’’ Coombes says. ‘‘As such, we are seeing a fair bit of off-the-plan buying but that’s investors mainly. First-home buyers tend to be more cautious about going down that path.’’
Hamilton – which Coombes notes was voted New Zealand’s most beautiful big city last year – does offer possibilities to property buyers. But with the city’s housing stock at record low levels, all the experts Stuff spoke to anticipate the heat in the market will continue.
Short of a huge change in the trends prompted by a Covidinfected world or a sudden rise in interest rates, neither Coombes nor O’Rourke see any easing of the market in the near future.
But Davidson says that, in common with most other areas, affordability pressures are building. In the third quarter of last year, Hamilton’s house price to income ratio hit 6.5, the highest since 2016, while the typical years required to save a deposit had risen to 8.7, again the highest since 2016.
‘‘Combined with tighter LVRs, it seems likely to me that these affordability issues will be a natural handbrake on the Hamilton market later this year.’’