Savings figures understated due to inflation, report says

New Zealand borrowers are saving more than they think because of the effects of higher inflation, a working paper released by Motu Economic and Public Policy Research argues. The research indicates that savings are understated by NZ$4.5 billion in real terms, meaning that housing is more affordable than what models suggest and that New Zealand's current account deficit is overstated. Motu's Andrew Coleman suggests that inflation distorts the measurement of savings, and that these distortions are not included in New Zealand government documents on savings rates. When inflation is positive, interest payments are divided into two components. The first is to compensate creditors for inflation, leaving the second being the 'real' interest rate - what the creditor actually earns after taking inflation into account.

Coleman argues that the component of the interest rate that covers for inflation should be considered as savings by the borrower. The same component should also be taken away from the lender's earnings. This is because the loan that the borrower has to repay remains the same, regardless of inflation. If the inflation rate were 3% per annum, $100,000 now would have the same purchasing power as $103,000 a year later. Yet if a borrower recieves a loan of $100,000, the amount they would have to repay a year later remains the same, given that they have not made any repayments on the loan, only interest payments. For interest payments, the inflation-covering component is labeled as a 'capital transfer' from the lender to the borrower. This indicates the compensation for inflation made by the lender. With a 3% inflation rate, the lender's loan of $100,000 will have the purchasing power of $97,000 a year later . The borrower is therefore effectively credited $3,000. Coleman gives an example of the saving process:

Suppose the inflation rate is 3% and a debtor borrows $100,000 at 9% interest. A year later he pays the lender $9,000 and the outstanding loan remains at $100,000. In nominal terms the creditor has earned $9,000 interest, but in real terms the assets she has - $9,000 cash and a $100,000 loan "“ are worth $106,000 so the real interest earnings are $6,000. As such, the $9,000 cash payment can be split into two parts: a $6,000 real interest payment and a $3,000 capital transfer that reduces the amount the debtor owes from $103,000 to $100,000 in nominal terms, or from $100,000 to $9,7000 in real terms. From the debtor's perspective, $3,000 of the cash payment is saving, as it reduces debt by $3,000.

He then applies this to the NZ$150 billion worth of New Zealand residential mortgage borrowing as at June 2008. Coleman indicated that with the average fixed mortgage being NZ$133,000 at June 2008, and an inflation rate of 4%, the inflation adjustment for a household would be NZ$5,300. This indicates that if the average borrower were to pay off their loan a year after receiving it, they would save $5,300. A year later, the amount of the loan would have 4% less purchasing power due to inflation. If inflation were to be added to the loan, it would cost 4% more to repay. As the amount to repay remains the same, the borrower is saving in relation to the new reduced purchasing power of money in relation to a year earlier. Coleman argues that by taking these savings into account, New Zealand mortgage borrowers are in fact saving an extra NZ$4.5 billion than what government figures suggest. This then would mean that New Zealand's current account deficit is overvalued, as it does not take this form of savings into consideration. He also suggests that the inflation-component of interest rates should not be included in calculations of housing affordability indexes, and that only real interest rates should be used when calculating the costs of buying a house. Even though a household would pay the full interest rate (inflation component plus real interest rate component), they are effectively paying the inflation component as savings on future inflation and purchasing power. * Andrew Coleman's paper is titled "A note on inflation and the measurement of saving and housing affordability." It can be found by clicking on this link to Motu's working papers. ** Motu's disclaimer states: "Motu Economic and Public Policy Research is a non-profit research institute that carries out long-term, socially beneficial research programmes. We aim to promote well-informed debate on public policy issues, placing special emphasis on issues relevant to New Zealand policy. We are committed to disseminating our work and facilitating discussion with others through workshops, dialogue groups, teaching, publications and sponsorship of overseas visitors. We are wholly independent and never advocate an expressed ideology or political position in our research."