By Simon Louisson
Is Reserve Bank Governor Graeme Wheeler so concerned about the bogey of Auckland’s housing bubble that he is underestimating an equally nasty bogey – deflation?
With annual inflation at 0.1 percent, it seems the scourge of inflation that dogged New Zealand for decades has been licked, but the danger of what NZ Herald economic editor Brian Fallow called “inflation’s ugly sister” – deflation – is threatening.
At the start of the Global Financial Crisis in 2008, Fallow quoted economics Nobel laureate, Paul Krugman, as saying it is deflation, not inflation that was the greatest concern for the world economy.
Deflation is an extended period of falls in the general level of prices. It occurs when demand is so weak for so long that firms keep cutting their prices to attract buyers. If it becomes embedded in expectations, people put off buying things in the belief they will be cheaper later in what becomes a vicious circle.
Japan experienced deflation in its “lost decade” of the 1990s (that extended into the 2000s), when its property bubble burst, causing GDP to shrink 19 percent, banks to collapse and real wages to fall.
Deflation can lead to depression as it did in the 1930s when a trend developed simultaneously in large parts of the world economy.
New Zealand’s consumer price inflation rate in 2015 was 0.1 percent and, contrary to what most people imagine, food prices fell 1.3 percent last year. The inflation rate has now been below the 0-3 percent target the RBNZ has been mandated to keep, for over a year.
And it is set to go negative next quarter due to a sharp fall in oil and petrol prices with consequent second-round effects – Air New Zealand already signalling a steep fall in air fares.
World oil prices are going down for the same reason dairy prices are – over supply and slack demand mainly spurred by China’s economic slowdown.
It is ironic that minutes before Wheeler today decided to leave the Official Cash Rate unchanged in his six weekly review, Fonterra announced it had cut its farmgate milk price forecast for the 2015/6 season to $4.15/kg of milksolids from a previous forecast of $4.60 in response to weak international prices.
Federated Farmers dairy director Andrew Hoggard commented that most farmers are in the red at any price below $5 and ,while one year was survivable, 2015/16 will be the second year and “the outlook was not that flash”, so a third year of losses was likely.
Had Wheeler been aware of Fonterra’s decision, he may have been more inclined to take out a little more “insurance” and cut today rather than wait until mid-March by which time the cow might have bolted.
Wheeler’s worry is debt – both dairy farmers’ debt and those exposed to that industry (a fair chunk of the economy), and the property market debt.
If he cuts interest rates, the exchange rate will likely drop and that will help farmers and other exporters, but it will also encourage Aucklanders to jump deeper into an already over-inflated property market that is already well out of kilter to household incomes.
The Auckland property market has in the last couple of months shown a few speed wobbles, classic signs that a bubble is about to burst.
In November, Wheeler warned a sharp “correction” in Auckland’s housing market could threaten New Zealand’s financial stability and the risk was growing because prices were increasingly stretched relative to household incomes. “A correction could be triggered by a range of demand-side factors, such as a deterioration in labour incomes, an unexpected rise in mortgage rates, a reversal in migration flows, or a sudden reduction in investor appetite.”
He reiterated today that house price inflation in Auckland remains a financial stability risk
Fonterra’s latest price forecast downgrade may be just such a trigger that results in a lot of dairy industry incomes being cut that may flow through to investors getting cold feet.
New Zealand’s banks are highly exposed to Auckland’s property market, hence Wheeler’s worries about cutting rates further and pouring petrol on that market.
But by not cutting rates and encouraging the inflation rate to fall into negative territory, Wheeler may have an uglier problem to deal with, because once people hold off buying today what may be cheaper tomorrow, the economy could slide into a deflation tail-spin that will be very difficult to pull out from.
Unlike Europe and the US, where interest rates have been near zero for over five years (despite the US Fed’s 0.25 percent hike last month) the RBNZ still has some stimulus it can lend the economy with its cash rate at 2.5 percent.
There is no question it is a devilishly delicate path Wheeler has to tread, especially as curbs to the Auckland property market will undercut spending that flows from the “wealth effect” of inflated property prices.
However, he needs to cut now while simultaneously introducing new measures to curb investment in the Auckland property market, such as household income lending ratios or regional property lending limits for banks.
He must act while there is still life in the economy because if he leaves it too late, cutting the cash rate will have little effect. Deflation will certainly cure the problem of the property bubble, but that cure will be at a terrible cost.
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