Christina Leung, Principal Economist and Head of the Auckland Office, NZIER
Over the past year, the recovery in the New Zealand economy has underpinned a build-up in capacity pressures, reflecting the effects of supply chain disruptions globally and border restrictions exacerbating labour shortages. Strengthening demand against a backdrop of supply constraints has boosted inflation pressures in New Zealand and driven speculation of interest rate increases over the coming year.
The latest July Monetary Policy Review added to this speculation, as the Reserve Bank explicitly ceased any additional asset purchases under its Large Scale Asset Purchase (LSAP) programme by 23 July. This, along with an acknowledgement that “the level of monetary stimulus could now be reduced to minimise the risk of not meeting its [medium-term inflation and employment] mandate”, was seen as paving the way for interest rate increases over the coming year.
Major banks increased their fixed-term mortgage rates by around 25 to 40 basis points in the wake of the announcement, reflecting the rise in wholesale interest rates due to higher interest rate expectations.
These latest moves follow a period since mid-2015 where New Zealand interest rates have fallen to historically low levels. At one point in 2020, the Reserve Bank asked banks to prepare their systems to operate in a negative interest rate environment following its cut in the Official Cash Rate to 0.25%. The introduction of the LSAP and Funding for Lending (FLP) programmes in the wake of the COVID-19 outbreak provided additional monetary policy support, with market interest rates falling sharply.
A recent Reserve Bank Analytical Note assessing the cash flow effects of lower interest rates in New Zealand[1] found that, based on the composition of household expenditure in 2016, a decline in mortgage and term deposit rates to 2020 levels resulted in a net income gain of 0.1% for New Zealand households as a whole.
However, there were distributional impacts from the decline in interest rates. Households with mortgages benefited the most, reflecting the reduced interest expense from lower mortgage rates. In contrast, households without mortgages and renting saw a reduction in income as a result of lower term deposit rates. This deterioration in income was concentrated in the lower-income households and the 65+ age group.
With capacity pressures becoming more acute in recent months, inflation pressures have increased. Wage pressures are rising as firms struggle to hire workers in a tight labour market, and costs are accelerating as firms try to source materials amidst supply chain disruptions.
Annual CPI inflation jumped up to 3.3 percent for the year to June 2021 – above the Reserve Bank’s 1 to 3 percent inflation target band. This lift in inflation would be of concern to the central bank if the increase were to materially change longer-term inflation expectations, such that the transitory boost to prices becomes embedded into wage and price-setting behaviour. This would mean a more persistent increase in inflation.
Increasing interest rates should reduce inflation pressures as it dampens demand in the New Zealand economy.
Lower interest rates since 2016 have encouraged borrowing and spending, with household debt rising from 155.5 percent of nominal disposable income in June 2015 to 165.6 percent in December 2020.
This increased indebtedness of the household sector means that the New Zealand economy would be more sensitive to higher interest rates, as the increased cost of servicing debt leads households to rein in borrowing and spending.
[1] https://www.rbnz.govt.nz/news/2021/07/incomes-rise-for-mortgage-holders-as-interest-rates-fall