By Ryan Greenaway-McGrevy*
The RBNZ is widely expected to cut the OCR on Thursday. And although it has erected many macroprudential barriers to try and stop them, I imagine many Kiwis will feel the urge to buy property, should the banks pass on the cut to borrowers.
Many will take the plunge, if they can.
But should they? Do we overreact to interest rate cuts?
Unlike some other countries in the world, here in New Zealand we cannot lock in an interest rate for the duration of a long-term mortgage (usually thirty years). This means that if you want the cheapest rates you will be renegotiating your mortgage with the bank every couple of years or so.
There is always the risk that interest rates will be higher when it comes time to renegotiate. That is a risk – and a substantial one if you are already forking over more than half of your after-tax pay check to the bank. I suspect that if interest rates climb back up to the historical averages seen in the 2000s, a lot of households will be put under financial strain, especially in Auckland. If you are paying sixty percent of your after-tax income to the bank at five percent interest, how much will you be paying if mortgage rates are back up to seven or eight percent five years from now?
On the other hand, perhaps low interest rates are here to stay for the foreseeable future. That is a distinct possibility. Inflation rates worldwide have remained stubbornly low, and many point to the deflationary effects of global overcapacity in production (see: China).
Deflation – or at least lower rates of inflation – matter if you are borrowing money. Deflationary pressures mean that the incomes that ultimately service a mortgage – be it your own or those of your tenants – are not going to be growing as fast as they have in the past.
Handing over massive mortgage repayments to the bank every month may appear palatable right now if you expect your income to grow over time. But these lower interest rates are reflective of those deflationary pressures – meaning that it would be wrong to expect incomes to grow all that much over the foreseeable future.
Inflation-adjusted (or real) interest rates are what matter over the long term. Prior to the economic reforms of the 1980s, the government gave cheap loans to many home buyers at rates of interest below the rate of inflation. That turned out to be a free lunch for those who could borrow, because inflation simply eroded their debt over time.
But the days of the free lunch are long-gone.
In this era of inflation-targeting and liberalised financial markets, real interest rates do not move around all that much. Nominal interest rates are low when expected inflation is low, and they are high when expected inflation is high.
There is, however, another possibility. Perhaps nominal interest rates are lower because real interest rates are permanently lower.
Economists Bob Gordon and Tyler Cowen tell us that the “average is over” – meaning that there are not many technological innovations left to be discovered that will generate the same amount of economic growth that we experienced last century. In such a world, the returns to investing in capital could be lower – and hence we may expect permanently lower real interest rates.
A world in which real interest rates are permanently lower is perhaps a much more frightening prospect – because lower real interest rates are part of a permanent reduction in economic growth.
Again, this should matter if you are borrowing money. If the rate of technological progress has slowed down, wages and salaries are not going to be growing as fast as they have in the past.
There are not many ways out for heavily-indebted households. Some breadwinners will earn those promotions and make it easier for the household to service its debt. But not everyone can get promoted.
The only quick-fix that I can see would be for the government to abolish inflation targeting and unleash a tidal wave of inflation to shrink household debt. While that may rescue those who have borrowed beyond their means, it would come at a massive cost. The economic fallout of such a policy would be disastrous, to put it mildly, and would punish households that have chosen not to ride the exuberance of the property market. Let’s hope it never comes to that.
Rock-bottom mortgage rates make it tempting to borrow huge sums of cash from the bank. But households should consider much more than the current level of interest rates when making that decision. Low interest rates are not manna from heaven – they are a consequence of the economic climate and tell us something about where the economy is headed. Take heed of all the information before taking the plunge.
*Ryan Greenaway-McGrevy is a senior lecturer in economics at the University of Auckland. Prior to that he was a research economist in the Office of the Chief Statistician at the Bureau of Economic Analysis (BEA) in Washington DC.