Interest rates in NZ are on their way back up, as the world grapples with rapidly rising inflation. By Grant Spencer.
Over the past couple of weeks, both savers and borrowers will have noticed an unusual phenomenon – after many years of ultra-low interest rates, they have started rising again.
In fact, it has been seven years since the Reserve Bank of New Zealand last raised its official cash rate (OCR), which has a significant effect on mortgage and term deposit rates. While the OCR is still extremely low in historical terms (it is now 0.5 per cent), it is unlikely to stay that low for long.
Many central banks all around the world are planning similar moves amid global fears about rising inflation. So, what will be the consequences?
Interest rates were slashed in March 2020 to help our economy cope with the impact of the Covid pandemic, taking them to their lowest level in living memory. But now the economy has bounced back strongly, inflation (4.9 per cent in the year to September) is running well above its 2% target, and employment is near its maximum sustainable level. It is no longer appropriate to have such drastic measures in place.
Over the next 12-18 months, it is likely that the OCR will be successively raised to somewhere near 2 per cent. In turn, mortgage rates are likely to return to a more normal 4 per cent or 5 per cent. If inflation keeps rising, and gets baked in to the expectations of firms and employees, interest rates could go even higher.
The temptation for central banks around the world will be to allow inflation to run at higher-than-normal levels for the next two to three years. But if the higher inflation starts to become permanent, central banks will need to hike interest rates even more, increasing the risk of a painful correction in house prices, share prices and the real economy.
Before Covid came along, interest rates had been trending down over many years, driven by persistently low inflation and a glut of global savings. The baby boomers have been putting aside cash for their retirement. Also, the Chinese are big savers and they have become an increasingly important influence on the global economy.
When the pandemic arrived in early 2020, the Government and the Reserve Bank tried to make sure people and businesses still had plenty of money to spend and invest, to ensure the economy didn't grind to a halt. Funding of $60 billion was set aside to help subsidise wages and enable other forms of support. The amount of money the Government was spending, over and above what it was getting back in revenue, was expected to increase to 8.7 per cent of GDP this year.
One way of encouraging spending and investing is to lower interest rates. The OCR was already at 1 per cent at that point, so the Reserve Bank wasn't able to drop it much further. However, it was quickly reduced to 0.25 per cent
The bank also began quantitative easing. In essence, this meant it lent money to the Government and funded it by issuing new deposits to the commercial banks (in other words, by issuing new money). If the Reserve Bank had not been there to purchase a portion of the increasing amount of government debt on issue, borrowing rates would have had to rise to attract the extra funds from private and foreign investors.
This tool has been used commonly by the major overseas central banks since the Global Financial Crisis, and took considerable pressure off the Government's finances. It also helped ensure businesses and households could get finance at low interest rates.
Of all the money the Government now owes, over 40 per cent of it ($57 billion) is owed to the Reserve Bank. This is sensible in a crisis, but unwise and potentially dangerous as an ongoing policy. It could encourage the Government to spend persistently beyond its means, and give banks excessive amounts of cash to lend out. This was a key reason for making the Reserve Bank independent of the Government in 1989.
New Zealand's initial success in controlling Covid last year, coupled with plenty of cash flowing through the economy and strong export prices, led to a strong economic recovery towards the end of last year and early this year. Unemployment fell back to 4 per cent after peaking at just 5.3 per cent.
As Covid hit last year, real GDP fell by 8.9 per cent in the three months to the end of June 2020. Over the following 12 months, however, it grew by 17 per cent. It became increasingly apparent that emergency policy settings were no longer appropriate.
The clearest sign of that was the roaring housing market. In May last year, the Reserve Bank forecast a 10 per cent fall in house prices due to a post-Covid recession. However, it got more than it bargained for, as buyers took advantage of easy credit, the supply of new properties was limited and cashed-up overseas New Zealanders returned home just prior to the lockdown.
Instead of falling, house prices rose 29 per cent in the year to June. This helped the economy to recover, but also made houses less affordable, and increased the risk of a housing market reversal.
A major shift occurred in the Reserve Bank's view of the world between May and August this year. It became concerned that an overheated economy and an outbreak of inflation might become its biggest regret, instead of its least regret (as it previously thought). It stopped buying government debt and gave a strong signal that it would soon start increasing interest rates.
After the August 18 lockdown, the draining of the punch bowl was delayed until October 6. By then, the Reserve Bank was no longer so concerned about ongoing Covid restrictions slowing down the economy. It now believes that although some sectors, such as tourism, will continue to face problems, the overall rebound in the economy will continue into next year.
The Government's books reinforce this view. On October 12, the Government revealed that in the year to June, it collected significantly more tax than expected and spent significantly less than expected.
Governments and central banks around the world are now having to decide when they should stop pumping their economies with cash. New Zealand's Reserve Bank has been one of the first out of the blocks to make that call, thanks to our economic recovery being one of the strongest in the OECD.
The Federal Reserve in the US is taking a very cautious approach and is unlikely to start raising its cash rate until late next year. It's anxious not to repeat the "taper tantrum" of 2013, when financial markets went into a tailspin after the Fed hiked rates five years after the Global Financial Crisis saw them plunge.
The European Central Bank is also unlikely to move quickly, although some member countries are becoming concerned about inflation. And the Reserve Bank of Australia has a similar stance, because Covid is still restricting economic activity there.
The big question being debated in central banks and the financial markets is whether inflation will keep rising. Energy prices are high globally, with the price of oil now over US$80 a barrel, pushing up the cost of energy-intensive goods and services.
Weather conditions in Europe and China have contributed to reduced renewable energy supply, and backup energy sources have become less responsive due to restrictions on fossil-fuel generation, in particular the retirement of coal-fired power plants.
Is this another short-term oil price shock that will self-correct? Or will price pressures persist as the transition to renewable energy struggles to keep up with growing demand?
The disruption of global supply chains is also pushing up prices. Transportation costs have skyrocketed. The cost of shipping a 40-foot container from Shanghai to Los Angeles has increased from US$4000 to US$12,000 over the past year. Shortages of raw materials and components are widespread.
Deliveries of silicon chips now take 22 weeks, compared to 13 weeks in late 2020. Labour shortages are also holding back production, particularly in specialised occupations where employers have come to rely on overseas candidates to fill vacancies.
Some of these constraints and price pressures may be short-lived as Covid restrictions are reduced and new sources of supply emerge. However, we know that some Covid restrictions will be with us for years. This is particularly true of international travel.
Changes in human behaviour will also have a lasting effect on the international job market. These economic disruptions are causing a global shock to supplies of goods and labour, which, in turn, is causing economies to slow down and prices and wages to rise.
Unfortunately, central banks can only control demand, not supply. They generally avoid reacting to short-term problems, such as rises in oil prices and the effects of natural disasters, because attempts to offset such shocks will usually do more harm than good. However, they cannot afford to ignore long-lasting problems, as this could lead to inflation getting out of control. We know from the experience of the 1970s to the early 1990s that getting rid of chronic inflation is difficult and damaging to the economy.
Financial markets are concerned that major central banks are underestimating the growing inflation risk. If central banks find they have to play catch-up and make early hikes to interest rates next year, we could see markets tumble.
The International Monetary Fund, in its October World Economic Outlook, is clearly worried about higher inflation. It talks about "prolonged supply disruptions, commodity and housing price shocks, longer-term expenditure commitments, and a de-anchoring of inflation expectations" potentially leading to "significantly higher inflation than predicted".
The aim of central banks for the next two to three years is to achieve a soft landing, bringing inflation back to around 2 per cent without slowing the economy too much. They will try to avoid a collapse of the housing and equity markets that could quickly erode household and business confidence.
But the very cautious approach being taken by the major central banks does not bode well. They do not have a great record on soft landings, particularly from starting positions when asset markets are at record levels, as is the case right now.
Monetary policy is a blunt instrument, and its impact varies depending on market psychology. High interest rates are never popular and central banks can come under huge pressure to ease up from businesses, the media, the markets and governments.
There are other reasons, too, why governments might prefer central banks to keep interest rates low and inflation high for an extended period. They want to avoid pressure on sectors of the economy that are suffering the most from the ongoing Covid restrictions. A high-inflation policy would also reduce the real value of public and private debt that has reached record levels since Covid came along.
The Federal Reserve and European Central Bank have already positioned themselves to accept significantly higher inflation than their 2% target. The Fed has adopted a new "Average Inflation Targeting" regime that will allow it much more leeway, and both these central banks say they will wait for hard evidence of persistent high inflation before hiking rates. The Reserve Bank of Australia appears to be in the same camp.
In contrast, the Reserve Bank of New Zealand recognises the risk of keeping rates so low. It has started raising them with the intention of bringing inflation back within its 1-3 per cent target band by the middle of next year, and it should have its foot completely off the accelerator by the end of 2022.
The recent spike in inflation underlines the need for it to follow through on its plan, even if other countries are slow to act.
Grant Spencer is adjunct professor in the School of Economics and Finance at Victoria University of Wellington. He was the Deputy Governor of the Reserve Bank of New Zealand from 2007 to 2017.