The Flightless Bird

FRI 27 MAY 2022

Something that caught our eye this week was the policy action by the Reserve Bank of New Zealand to hike the official cash rate by 50 basis points to 2%. The RBNZ noted higher global and domestic inflationary pressures and projected the cash target to increase to around 3.9% by the second quarter of 2023. Note to the US Federal Reserve; the MPC agreed that at present, with persistent cost pressures and rising inflation, the risk of moving too slowly and not far enough remained the most costly option. New Zealand is a small open economy and therefore sensitive to global factors driving inflation and trade. However, the broader implication is that trends are similar across other former British Colonies (including the United States).

The Reserve Bank of New Zealand has typically been one of the better managed and forward looking central banks. Interest rates and policy in New Zealand has often been a leading indicator of yields in Australia and other Anglo economies (chart 1). The observation noted above that the current asymmetry for policymakers is the risk of moving too slowly. While many financial market participants suggest that the US Federal Reserve is making a policy error today by hiking into a slowing growth environment, our assertion is that the policy error was already committed by leaving the funds rate too low for too long which has likely contributed to the overshoot in consumer price inflation and misallocation of capital in profitless assets.

The forward looing point for Australia, the United Kingdom, United States and Canada is that tighter monetary policy will probably lead to lower house prices or at the very least a moderation in the pace of growth. The median house price in New Zealand is already down by around 5% from peak. The good news for the United States and the United Kingdom is that household leverage (debt as a percent of disposable income) is much lower than it was during the 2008 episode. While Australia’s debt servicing ratio has also moderated since the last crisis, it remains much higher in relative terms (chart 2). Moreover, the moderation is mostly a function of lower interest rates. Put another way, a moderate rise in interest rates of around 2.5% would take debt servicing back near peak levels.

Australia’s housing market has experienced extraordinary gains over the past two decades. The national median house price has gained over 276% over that period, with the gains much greater in the major capital cities. On a price to rent or a price to income ratio Australian house prices are more overvalued relative to the United States. Moreover, median house price gains have outpaced wages over the period by around 2 percentage points per annum. The good news is that Australia’s inflation is lower than the United States and the other Commonwealth countries. However, if there is a meaningful acceleration in wage growth, the Reserve Bank of Australia will be forced to hike rates. Wage growth and inflation is critical to the central bank reaction function (chart 3).

In conclusion, house prices can essentially be thought of as the price of a long-term inflation protected bond, where the yield is determined by the inflation-adjusted long term mortgage rate and the ability to service the monthly coupon payments depends on the trajectory of households’ real wages. Global inflation pressure suggests that central banks need to hike rates further and the Reserve Bank of New Zealand is leading the way. For the potential impact on global house or asset prices, follow the leverage. Stated differently, the most vulnerable markets will be where liquidity has been most plentiful, leverage is greatest and asset prices are most overvalued. In that context the cost of protection is also still inexpensive in credit relative to the potential payoff.