ANZ economists say interest rate hikes will be tough - but ongoing high inflation would be worse

Higher interest rates are going to be tough - but ongoing high inflation would be much tougher, economists at the country's largest bank say.

ANZ economist Finn Robinson and chief economist Sharon Zollner have compiled a comprehensive crunch of the interest rate and inflation picture in a new NZ Insight publication.

Inflation hit a 10-year high annual rate of 4.9% for the September quarter and is set to go higher yet, with the Reserve Bank picking a peak of 5.7% for the December 2021 quarter. Interest rates are on the up in response, with the RBNZ having lifted the Official Cash Rate over the past two months from 0.25% to 0.75% and with more to come. But wholesale interest rates have lifted much more and this has seen banks aggressively pushing up mortgage rates.

Robinson and Zollner say the path to low inflation isn’t easy.

"Unfortunately, the tonic for overly high underlying inflation is higher interest rates, which isn’t a barrel of laughs in a net-debtor economy either. We’re forecasting that the RBNZ will continue to lift the OCR in 25bp increments to a peak of 2% in August 2022 – and we think that will be enough to bring CPI inflation back to a more-manageable level."

One reason they think the OCR will ‘only’ need to go to 2% (the RBNZ is itself suggesting a peak of 2.6%) is that the New Zealand economy - in particular the housing market - is very sensitive to higher interest rates right now.

They say, for some context, that the one-year special mortgage rate dropped to a low of 2.21% in June 2021, and as of November, was about 130bps higher at 3.49%.

"If a hypothetical household with an $800,000 mortgage experienced the same increase in their mortgage rate, then all else equal their weekly payments would increase by roughly $115 (assuming a 25-year mortgage). That’s going to hurt – and when you multiply across hundreds of thousands of borrowers, it’s a lot of disposable income that’s suddenly taken up with increased mortgage payments."

So, how does this possibly make things better for households?

"It’ll be a rough adjustment for some for sure – especially those who have leveraged up to the hilt to jump into the frothy housing market over the past year."

But it’s worth noting, they say, that overall, interest payments are just 2.7% of expenditure for lower income households, and 6.2% for the highest earners.

"Debt servicing has gotten more expensive (and will likely continue to in coming quarters), but out-of-control inflation would deal a much more devastating blow to household purchasing power.

"And of course, some households are net savers, particularly older ones, and they stand to benefit from higher interest rates."

But overall, New Zealanders have a tendency to "spend beyond our means", as demonstrated in our persistent current account deficits, so higher interest rates "do suck income out" of the economy overall.

"High inflation is not just a theoretical problem. It’s a real problem, especially for low-income households. And while the medicine (higher interest rates) isn’t pleasant for borrowers, it’s far better than seeing living costs spiral out of control and real incomes collapse.

"We’ve spent a long time in New Zealand getting used to low and stable inflation, but it’s worth remembering that high inflation can be extremely damaging, and that’s why the RBNZ has acted (much faster than many of its international peers) to protect the value of money in New Zealand."

The two economists go into substantial detail of what Kiwis spend their money on. They say the Household Living Cost Price Indexes (HLPI) published by Statistics New Zealand show how living costs are rising for different types of households – including by differing income, and other social indicators.

"Because households have very different spending patterns, the HLPI for each type of household is weighted to reflect that. For example, the 2021 expenditure weights calculated by Statistics NZ show that 16.4% of expenditure of the lowest-income households went towards rent payments, versus just 6.7% for those on higher incomes. So when the price of renting goes up, that will have a larger impact on the cost of living (and HLPI) of lower-income households than for higher-earnings ones."

They say what’s immediately clear from the data is that households have historically had varied experiences of inflation. Over most of the last decade, beneficiaries and superannuitants saw their living costs rise at a faster rate than average.

"And that matches up with what you’d expect if we look at the data by household income – the 20% of households with the lowest incomes have tended to see the largest living cost increases, while the richest 20% have seen the smallest increases."

The cumulative impact of higher cost increases for some households is actually "quite significant", the economists say.

"If we plot the level of the HLPIs across income quintiles, it’s clearer how much more costs have increased for low-earning households. Since [the second quarter of] 2008, living costs for the top 20% of earners have risen 20%, but for the lowest 20%, the increase has been 30%. Superannuitants have had it the worst in terms of the rising cost of living, with costs up 34% over the same period."

However, in recent quarters, and in a break from historical patterns, cost increases have been of about the same magnitude for all households.

The economists say this likely reflects the fact that inflation has been very broad-based – the only component of the Consumers Price Index that didn’t rise in the September quarter was communication (just under 3% of the total basket).

"On average, households saw living costs rise 4.0% in the year to September 2021 , and we don’t expect cost pressures to moderate on an annual basis until the June quarter of 2022.

"On paper it looks like everyone’s hurting from the same strong inflation currently. But when we dig into the details, it’s clear that for poorer households, high inflation is particularly hard to deal with."

Robinson and Zollner say the biggest drivers of strong inflation in recent quarters have been housing, transport, and food. Of the 2.2% increase in consumer prices in the September quarter 2021, 0.7ppts came from housing (eg rents, building costs, council rates), 0.5ppts came from food, and transport added 0.5ppts (60% of that from petrol alone).

"These are all essential items - and that makes absorbing price rises more difficult for poorer households, since a larger share of their expenditure goes towards essential goods and services. It’s easier for higher-income households to cope with price rises because they can simply cut back on more discretionary spending (eg not eating out as much).

"But for a poor household whose budget can barely cover the essentials even when inflation is low, the choice quickly becomes: do I have lunch this week or pay the rent?"

Looking at the composition of household spending across different income groups, it can be seen that for the bottom 20% of households in New Zealand, housing, food, and transport make up a much bigger share of their expenditure than for the top 20%.

"It’s also interesting to note that for wealthier households, interest payments make up a larger share of their expenditure – because they’ll be much more likely to have a mortgage on an owner-occupied home (and/or investment property)."

So, adding up the numbers, 63.5% of expenditure goes towards food, housing, and transport for lower-income households, compared with 51.2% for the highest earners.

"And that underweights the importance of ‘essential’ spending for poor households, since they also have to fork out for essential clothing and footwear, insurance, health, education, and other items – which have all gone up in price.

"Plus, within groups like food expenditure, higher-income households tend to spend more on more ‘optional’ items, like restaurant meals and takeaways."

They say that the share of expenditure going on restaurant meals and ready-to-eat meals has increased in recent years over all income quintiles, but that it has remained broadly true that the top-income group spends roughly twice the proportion of their income on this category as the lowest-income group does. That means they have considerably more flexibility in their spending choices.

"...Even though the HLPI does a better job of showing how households are differently affected by inflation, income quintiles can still mask extreme outcomes. As an example, the New Zealand Food Network reported that the August to October 2021 period saw a 504% increase in food being given to communities compared with the same time in 2020.

"Clearly, for the very poorest people in New Zealand, life is even tougher than official data captures.

"The bottom line is that for poorer households who spend a lot more of their constrained budgets on essential goods and services, the current composition of strong inflation is particularly hard to bear. Higher-income households may be able to more easily absorb price rises by simply cutting back on non-essential spending, but for poorer households, there’s simply not much fat to trim."

The economists say that "unfortunately", hourly wage growth is now languishing behind CPI inflation, with real wages falling the most in the third quarter since GST was increased in 2010.

They say that this is to be expected, since wage adjustments are often indexed to previous outturns, and usually occur annually, "and forecasters (including us) have seriously underestimated the speed at which consumer prices would rise in the wake of Covid".

"Normally, indexing wages to inflation once a year works pretty well, since inflation is usually low and stable, meaning last year’s CPI inflation isn’t a bad forecast of the next year. But when prices are rising so quickly, such backward-looking and infrequent adjustments can actually have big impacts on household purchasing power.

Though rising living costs mean many households are doing it tougher currently, there is reason to be optimistic about household incomes in the medium term, the economists say.

"It may take some time, but wages will adjust, and the tight labour market will give workers more bargaining power to lock in cost of living adjustments. Our forecasts for inflation and wages imply respectable real wage growth from around the second half of 2022.

"But our expectation of stronger real wage growth over H2 2022 won’t make it any easier for households who need to meet those higher prices here and now. While there are many reasons why consumer confidence may be weak right now (including higher mortgage rates and the ever-mutating variants of Covid), it’s very possible a contributing factor is that households are having to work harder just to maintain the same standard of living as inflation surges.

"Sagging confidence is a downside risk to the economy if it sees consumers pull back on spending.

"Some reduction in demand is needed for the RBNZ to bring us back to a more sustainable growth path, but it’s a delicate balance between putting a lid on a bubbly economy and pouring cold water over everything.

"High inflation is an unpleasant thing to go through – it’s eroding purchasing power, stretching the budgets of poor households, and possibly contributing to a deterioration in consumer sentiment that could weigh on economic momentum, even as Covid restrictions continue to be relaxed."