Brian Fallow on the economy

Brian Fallow is the Herald's Economics Editor

Brian Fallow: Rate rise will be less than in past

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Having more floating and short-term fixed mortgages than seven years ago gives monetary policy more traction.

Some expect Graeme Wheeler to take a more pre-emptive approach to adjusting the official cash rate. Photo / Mark Mitchell
Some expect Graeme Wheeler to take a more pre-emptive approach to adjusting the official cash rate. Photo / Mark Mitchell

Interest rates should not have to go as high this time around as they did in the last cycle.

For one thing the starting point is a lot lower. The last tightening cycle which began exactly 10 years ago kicked off from an official cash rate of 5 per cent, compared with 2.5 per cent this time.

Over the next two years the Reserve Bank pushed rates 2.25 percentage points higher, coincidentally the same cumulative increase over the same timeframe as it foreshadowed in last month's monetary policy statement.

But it was not enough. Over the first half of 2007 the bank tightened the screws four more times, raising the OCR to an eye-watering 8.25 per cent, pushing mortgage rates into double digits, inflicting a lot of collateral damage on the traded goods sector via the exchange rate and tipping the economy into recession by the start of 2008 even before the global financial crisis hit.

From that unhappy experience Labour and the Greens appear to have learned exactly the wrong lesson.

They think the problem lies with the Reserve Bank's mandate.

They want to change it so that the bank worries less about the internal value of the dollar (price stability) and more about its international value (the exchange rate) - as if the two could be easily decoupled and as if the latter was not to a large extent driven by what happens in the other 99.8 per cent of the global economy.

So we have David Cunliffe in his state of the nation speech on Monday deploring that people are struggling with a rising cost of living while their wages stay still and then talking about "reforming" the Reserve Bank Act to assist exporters.

It is one of the ironies of our political discourse that the parties of the left are the most casual about inflation when it is the poor and economically powerless who suffer most when inflation gets out of hand and as it is brought under control again. Perhaps they are too young to remember. But we digress.

The lesson the Reserve Bank itself has taken from the last cycle is that during the boom years it took too optimistic a view of the economy's potential or sustainable growth rate (the rate at which its productive capacity expands) and thus underestimated how much excess demand and inflation pressure there was.

The bank's forecasters were also surprised by the strength and persistence of the housing boom - the largest increase in real house prices in modern times and among the largest in the developed world. It spilled over into general inflation as homeowners withdrew some of the increase in their equity, boosting consumption at a rate exceeding growth in productivity and incomes.

A dairy-driven surge in the terms of trade from late 2006 also boosted incomes and spending power "just at a point in the cycle when we might otherwise have got on top of the growth in demand and checked the accumulation of inflation pressures", the Reserve Bank said.

Right now, of course, we face another outbreak of house price inflation and the most favourable terms of trade for 40 years. But each cycle is different and in important respects the situation now is quite unlike the last boom.

The recession saw the unemployment rate climb from below 4 per cent to over 7 per cent. When combined with the legacy of debt from the last boom, the result seems to have been to make households more wary of debt and more inclined to save.

For a while they even collectively spent slightly less than their incomes - a pathetically low saving rate by international standards but an improvement by recent historical standards.

ASB chief economist Nick Tuffley says we have been in a period where households appear to be a lot more sensitive to taking on debt.

"As interest rates rise there is the potential for people to respond a bit more noticeably than they used to. Interest rates have been very low for quite a long time but we still have very modest credit growth."

Nearly three-quarters of the mortgage debt is at floating rates or fixed for less than a year. That gives monetary policy more traction.

Households will feel the effects of a higher OCR faster than they would have seven years ago, say, when only a third of the mortgage book was at floating rates or fixed for less than a year.

The average household is carrying a lot more debt than it used to, relative to its income.

The ratio of debt to disposable (or after-tax) income was about 100 per cent in 2000. It peaked at 153 per cent in 2009, fell modestly after the global financial crisis but has since increased to about 146 per cent as mortgage debt has outpaced income growth.

Debt-servicing costs as a share of income, while down on their pre-crisis peaks as you would expect with mortgage rates falling to multi-decade lows, remain high by historical standards.

"Over the next couple of years the combination of higher house prices and higher mortgage rates will make a really substantial difference to affordability in Auckland," Tuffley says.

The Reserve Bank has lowered its estimate of where the neutral short-term wholesale interest rate lies - the level at which it flips from stimulating activity to restraining it and curbing inflation pressure.

It used to think that was around 6 per cent; it now thinks 4.5 per cent, give or take half a percentage point. It is about 2.9 per cent now. But the main reason the bank thinks it's 4.5 per cent should give us pause. It is weaker productivity growth.

Explaining the shift in thinking last October, the bank's assistant governor and chief economist John McDermott said a sustained fall in the pace of productivity growth would lower returns to investment, making it less desirable to invest.

"If the desire to invest falls and the desire to save remains unchanged, a lower neutral interest rate will be required [to] reconcile savings and investment plans," McDermott said.

So the good news is that the bank thinks interest rates will not have to go as high to rein in inflation.

The bad news is that the main reason - weaker productivity growth - means that we will reach that point sooner, at a lower rate of actual economic growth.

Another key change since the last cycle is that we have a new governor, Graeme Wheeler, and he has an amended policy targets agreement - the agreement with the Government which spells out how his statutory obligations are to be interpreted.

The inflation target band remains the same, 1 to 3 per cent , but there is now an explicit focus on aiming for the mid-point rather than merely remaining within the band on average over the medium term.

Some market economists interpret that as suggesting Wheeler will take a more pre-emptive, stitch-in-time-saves-nine approach.

Time will tell.

- NZ Herald

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