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 hire 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.

Go to www.tonyalexander.nz to subscribe to my free weekly “Tony’s View” for easy-to-understand discussion of wider developments in the NZ economy, plus more on housing markets.

By Tony Alexander

It would be good to be able to say that things are settling down now in the world economy and our own, and that we can make some reasonably robust predictions as to where interest rates might go and therefore perhaps the housing market. But with Covid-19 spreading in India, Taiwan and Singapore and causing new problems in Victoria, we remain in a world of high uncertainty.

However, just because there are some clear negatives still around does not mean one has to adopt a negative outlook for growth if there are other factors which are strongly positive. In the case of our economy there are, and this has some strong implications for interest rate risk management and eventually the housing market.

When we economists consider the outlook for the New Zealand economy our starting point will almost always be the prospects for growth in our export markets. That is because about one-quarter of expenditure in the NZ economy derives from export sales and we can often see some big changes in income for our export sector.

Clearly, in the tourism sector the level of income is miniscule and unlikely to become robust again until our borders open up – perhaps from the middle of next year. But for our primary sector exports such as red meat, dairy products, seafood, horticultural products, forest products and so on, conditions for most currently are good and look set to get better, our export prices are sitting about 16% higher than they were on average at the end of 2019, and Fonterra have recently announced their highest ever starting payout projection for the coming season. The positive outlook for our export receipts and therefore the likes of the farm servicing sector and the regions stems from accelerating growth in countries such as the United States, Australia, the United Kingdom, and China.

The driving forces vary from one country to the other. In the US and UK successful vaccination campaigns are a key positive and in the US a huge fiscal stimulus is underway. In China factories are running flat out making the many consumer goods the rest of the world is demanding in place of spending on international travel.

In Australia there is strong growth underway in sectors like house building, infrastructure, mining, farming, and various care sectors such as health, early childhood, and the aged.

The second thing we economists look at when assessing our growth outlook is household spending. This typically makes up about 65% of our economy and although it is bigger than exporting the direction of influence tends to run from exports to households and not always the other way around.

There is very strong demand for staff across virtually all sectors and all parts of the country both now and anticipated for the future. That means not just increased household incomes from more people in work, but higher willingness to spend from good job security as well as eventual faster wages growth.

People will also feel happy to spend from the average 26% increase in NZ house prices over the past year. Plus, there is about an extra $10bn sitting in our bank accounts at the moment than what would otherwise have been the case without Covid-19. This will help keep spending up even as we eventually start pulling back from buying more spas and adding more rooms to put money aside for overseas travel again one day. The third thing to look at is what we generally call capital expenditure. This covers things like house building, purchases of machinery and computer systems by businesses, infrastructure development, and commercial construction.

In all of these areas prospects for growth are strong, especially for house building where construction is almost running at the highest level compared with our population since 1975. There is clearly a lot of spending to occur on infrastructure, and businesses are looking to build more warehouses and distribution centres to handle the need for higher inventories and more online retailing.

The interesting factor here is business spending on labour-saving machinery and technology. This has tended to be an area of weakness in New Zealand over the long term and one of the likely reasons the government is cutting back on working visas is the observed tendency for businesses to facilitate their growth more by bringing in migrant labour than investing in better systems etc.

The lower average level of productivity and therefore income per capita in New Zealand than the OECD average can be explained to a large degree by too small a capital stock. The next few years then for many businesses will be very challenging because while labour availability is bad now, it is going to get a lot worse.

It is not just that the government is changing the working visa rules. A surge of growth in Australia always drags Kiwis across the Tasman to earn more and build nest eggs of savings which they may or may not return with. The upturns in other countries like the United Kingdom, and United States will have a similar effect of not just encouraging some Kiwis to go offshore, but to dissuade a great number of Kiwis from coming back.

Overall, prospects for growth in our economy look good, the labour market is tightening up rapidly, and that is why the Reserve Bank recently signalled that they anticipate raising their cash rate from 0.25% to 1.75% starting in the middle of 2022. They anticipate rising inflationary pressures and eventually central banks overseas are likely to see things the same way.

But because a tightening of monetary policy in NZ is likely to occur before other countries move, the NZ dollar is likely to generally move higher over the next couple of years.

What impact will rising interest rates have on the housing market? Keeping in mind that a strong economy with sturdy job security tends to naturally push up house prices, rising floating rates from mid-2022 and rising fixed mortgage rates well before then will slow down the pace of increase in prices.

Extra slowing will come from the new tax rules announced on March 23, plus the introduction of a 40% minimum deposit requirement for investors from May 1. There is also strong growth in house supply underway, and the pace of growth in our population risks being a bit less than people have been thinking these past 15 months, once the borders reopen.

The upshot is not that average house prices are likely to fall because that generally only happens when we have a recession. But the pace of growth will slow to perhaps 5%+ in the coming year then slightly less for the 2-3 years after that.

Can we see signs of slowing already? Yes, in that the pace of growth in average house prices nationwide has already eased from 5.3% in February to 2.7% in March then 0.6% in April. The various surveys I run also show that investors have stepped back from the market to wait and see how things develop. First home buyers, taking their cue from these investors, have also stepped back though not to the same degree.

Both the Treasury and the Reserve Bank have recently predicted that house prices will barely rise in the coming year. But they may have an excessive degree of faith in the effectiveness of their recent policy change. Until the second half of next year the floating and one-year fixed rates which people largely still borrow at will remain near their record lows. And although there are plenty of other things which people can invest in, none of them will be done with a bank lending an investor 3-4 times their capital in order to do so. Housing is the only investment banks will willingly help someone gear into.

Go to www.tonyalexander.nz to subscribe to my free weekly “Tony’s View” for easy-to-understand discussion of wider developments in the NZ economy, plus more on housing markets.

By Tony Alexander