How will inflation controls impact the housing market?

Recently lifting the Official Cash Rate (OCR) from historically-low levels, the Reserve Bank of New Zealand (RBNZ) has signalled more rate rises loom large on the horizon, leaving many pondering the impact of inflation controls.

For Kiwis across the country, inflation not only spells higher costs for everyday items such as food and petrol but the price of servicing debt has grown from record-low levels to something shy of the double-digit interest rates circa 1990.

While much of the country’s inflationary pressures are beyond our domestic control – think oil prices, shipping costs, the shock of a global pandemic and worsening geopolitical tensions, it’s nonetheless up to the central bank to mitigate the effects of these influences and bring quarterly inflation numbers back down from the recently recorded multi-decade high of 5.9 percent.

Independent economist Cameron Bagrie says there is no shortage of spectator sports on the economic horizon, but the central bank will be paying close attention to one indicator in particular – inflation expectations.

“Policymakers can look through a temporary spike in inflation but if this doesn’t budge and the headline seeps into pricing measures two-to-three years down the track, the RBNZ will have to go harder to manage it upfront.”

Bagrie says government expansionist and ultra-low interest rate policies have worked well to temper some of the worst economic effects of the pandemic, but the situation has turned into a boom no one expected.

“The follow-up to a boom is inflation and containing this is neither growth nor asset-price friendly so the central bank has a hell of a job in front of them trying to get the genie back in the bottle,” he says.

Considering the careful balancing act ahead for the RBNZ, Bagrie notes the risks associated with a perpetually increasing OCR.

“We are in unchartered waters grappling with a health shock, the shock of overheated markets and now intensifying geopolitical tensions in Europe – while not the central scenario, it’s a recipe for 10-percent inflation.”

Bagrie says the real issue, however, is where Kiwis will be in three years’ time.

“Accelerating wage demands over the next 12 months will undoubtedly occur as businesses keep up with the cost-of-living adjustments, though policymakers will be careful we don’t get locked into an inflation wage spiral where prices including wages keep moving up in response to inflation.”

“There’s an element of taking the medicine upfront so the central bank doesn’t have to keep coming out with the stick.”

“If the housing market rebounds or we receive a big surge of migrants to push property prices upward, the RBNZ will likely continue to lift interest rates which will prolong household pain,” he adds.

Looking ahead, Bagrie says we are about three months away from a critical period where conclusive evidence could show a lift in interest rates has impacted the economy and dampened some consumer demand.

Which side of the leger economic data falls will likely determine where interest rates end up, but financial markets have fully priced in the expectation of a 3.25-percent OCR by 2024.

“At the moment we still have steam in the economy which requires continued contraction of monetary policy but weaker pockets of the property market may cause a rethink,” he adds.

The chief economist at ANZ, New Zealand’s biggest bank, Sharon Zollner echoes the sentiment that market expectations play a crucial role when looking to pricing movements ahead.

“The market is now on board with raising interest rates aggressively, anticipating 50 basis point hikes which have not been seen for two decades.”

“Inflation will not go away unless the RBNZ clobbers it – and this expectation has led to a sharp rise in swap rates which are the key determinant of mortgage lending rates.”

“Thus far it isn’t the RBNZ’s actual interest rate decisions so much as expectations of future movements that are influencing the mortgage rates we have today.”

“Headline inflation is too high and forecast to go even higher, while core inflation and inflation expectations are also way above where they should be - this current burst is broad-based and much more than just a flash in the pan.”

Zollner says while rising mortgage lending rates only hurt about one-third of the population, and actually benefit savers, the higher cost of living will impact everyone, with ANZ’s forecast of inflation to peak around 7.4 percent by mid-2022 akin to a blanket tax increase in relation to its impact on spending power.

Over the last year, highly stimulatory monetary policy (a global phenomenon) has seen house prices and equities grow in value, contributing to a perceived feeling of wealth amongst those fortunate enough to own assets. Both of these things have made households more willing to take on debt and spend – an outcome of functional monetary policy.

But now, with interest rates rising sharply and inflation eating into disposable incomes, households will have strong incentive to be a little more cautious with their spending, which will slow the economy.

Zollner says that while low unemployment puts a floor underneath the residential property sector insofar as it puts fewer people in a ‘must sell’ situation, it could equally see the RBNZ up the ante on interest rates to avoid a wage spiral.

“The central bank’s language has changed; the ‘least regrets’ strategy has flipped around. Until now, near-term unemployment was the biggest concern. But now it has to be about a bigger-picture/long-term approach which prioritises the avoidance of structural damage to the economy through embedded inflation,” she says.

Stopping short of forecasting a recession, Zollner says the RBNZ will do well to avoid one with its efforts to manage inflation a daunting task.

“Our recent business survey results show every sector of the economy is reporting much higher costs and pricing intentions – inflation pressures are incredibly broad-based and its not clear a gentle slowdown will be sufficient to root them out.”

To an unusually high degree across the OECD, Kiwi household wealth is inseparably tied to residential assets. This means the housing market is a major channel through which monetary policy operates – as evidenced by annual house price inflation peaking over 30 percent.

Unfortunately, the corollary of the massive upswing is that house prices are now vulnerable as policy tightens.

Uncertainty persists not only about how high interest rates will go, but how quickly and also the outlook for net migration – another key driver of the housing market alongside unemployment.

All things considered, higher interest rates, tighter credit conditions and stretched affordability have changed the tone of the market appreciably which will be a welcome reprieve for affordability metrics and buyers playing catch up on previous market movements.

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