Don’t downplay the inflation boogeyman

Inflation has spiked to its highest annual level in over a decade, after recording its biggest quarterly lift in almost 35 years. Annual inflation is now running at 4.9% and the momentum in these pricing pressures is building.

The inflation boogeyman has raised his ugly head and left policymakers scrambling to explain and react. Even if inflation proves short-lived, the effects of these pricing pressures are real and are set to have a big impact on households’ discretionary spending.

The government has tried to downplay the situation, with the PM in one of her 1pm Q&As, dismissing the inflation result as being driven by temporary global supply-side factors.

Such comments are frustrating, as they neglect to consider that pricing pressures are occurring across all different types of goods and services. It’s not just things which rely on international supply chains where we have rising prices. Statistics New Zealand data has shown that inflationary pressures are apparent for both tradeables (eg. imported goods) and non-tradeables (eg. a haircut).

Businesses are lifting prices for consumers in industries that have no direct relationship to the border. They are doing so because capacity challenges exist across many parts of the economy and consumer demand has remained strong enough to reassure businesspeople that they can protect their margin by lifting prices.

The real cost of living isn’t even measured by inflation

We don’t know how long inflation will persist for, but we do know that there is enough momentum to keep prices increasing strongly well into 2022 at the very least.

This higher inflation is squeezing the budgets of households across the country and is going to raise the stakes for wage bargaining over the year ahead. What’s more, the headline inflation in Statistics New Zealand’s traditional measures of consumer pricing downplay just how much household budgets are getting squeezed.

Of most concern to me are the effects of rising mortgage rates, which don’t even come into inflationary data because they relate to financial rather than consumer prices. There is a bit of circularity here, because mortgage rates are rising as markets anticipate that the Reserve Bank will try and take the heat out of inflation by continuing to lift its target interest rate.

Over the past two months, mortgage rates have risen by around 1.5 percentage points on average across any duration of fixed term. Commentators are suggesting that those average increases could end up rising to as much as 2.5% over the months ahead.

Many are downplaying these increases, saying that they would still leave mortgage rates at no more than 4% to 5%, which is well below historical averages. From a financial stability perspective, I agree there aren’t concerns, as stress testing of households when they apply for a mortgage usually tests a household’s ability to pay a mortgage for rates of up to around the 6% to 7%pa mark.

However, what is neglected in everyone’s discussions are not the financial stability concerns, rather it is the economic fallout which higher mortgage rates are having on households’ discretionary budgets. To paint you a picture, if we take a household with a $500,000 mortgage, then a 2% increase in mortgage rates represents an additional $10,000 of interest payments each year ($200 per week). For the average household, this would represent a sudden 12% decline in their budget, given that the average household had an after-tax annual income of $85,853 (according to Statistics New Zealand as at June 2020).

Not many households have had to refix their mortgage since rates began to rise, but most will over the year ahead given that one-year fixed rates have been the most popular fixed duration to choose. As more and more households are forced to refix their mortgage, the burden of higher mortgage rates will be felt more broadly through the economy.

In response to these higher mortgage expenses, many households will need to tighten their belts in other parts of their budget. The burden of this adjustment will be unevenly spread across the economy and fall on sectors which rely on discretionary expenditure. Sadly, these sectors include things like hospitality and entertainment, which have been some of the most affected by the fallout from Covid-19.

So before you are too quick to dismiss the inflationary boogeyman, spare a thought for what it has already meant for the real cost of living for people in your local area.