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Soaring inflation will eventually aggressively boost mortgage rates

I’ve spent the past year delivering some fairly upbeat forecasts for the housing market, yet at the same time warning about eventually rising interest rates. We already have evidence in hand that I wasn’t optimistic enough regarding the extent to which house prices would rise. We can even see that after the relative lull in April and May following the March 23 tax announcement affecting investors, the pace of price increase has gone back up again.

With the ongoing shortage of listings and rising construction costs, it looks like house prices will continue to rise at a pace well above the rate of inflation – which is where my interest rates comment becomes relevant.

Like all other economists I have been expecting a rise in the inflation rate in response to the strong recovery in our economy and accelerating growth in wages. But none of us expected that as of late-October, New Zealand’s inflation rate would be 4.9%.

Only five months ago the Reserve Bank were forecasting that inflation currently would be 2.5% and on that basis they have left monetary policy at record levels of looseness up until October 6 when the official cash rate was increased a small 0.25% to 0.5%.

But inflation is almost exactly double what they expected and this forecasting error of 2.4% in less than a six month period shows that they have a lot of catching up to do with regard to boosting interest rates. This sort of error is unprecedented.

Why has inflation risen by so much? A lot we can put down to shortages of goods and materials around the world as supply chains have been shattered. Some reflects labour shortages boosting business costs and thus business selling prices. Some also reflects higher energy costs, and of course housing-related costs have jumped up.

Looking ahead it seems reasonable to expect that the inflation rate will soon go appreciably above 5%. If your wages have not gone up by at least the 4.9% inflation rate of the past year, you have become poorer at the same time as you might have become richer on paper from your house price rising.

Labour shortages are worsening and wages growth is set to accelerate as employees and job candidates now enjoy their strongest bargaining position in over four decades. Higher wages and many other costs will boost business selling prices and as a result the situation currently is one in which the Reserve Bank is failing to achieve its primary objective of keeping inflation under control.

What will they do? The answer is reasonably clear – but before we get there it pays to note that the means by which they will seek to get inflation back down and locked near 2% is forcing households to cut back on spending. That is not going to be an easy task as we enjoy rising wages, rising job security, rising house prices and already the biggest boost in our housing wealth which we have ever seen.

At some stage the Reserve Bank is going to increase interest rates quite aggressively. That might not be in the short-term because of their continuing concerns about the economic impact of Covid-19. But eventually they will need to shock household spending and shock people back into accepting inflation will consolidate back at 2%.

This reinforces my warning that the likes of the ever popular one-year fixed mortgage rate will reach 5% from 2.19% just a few months ago. In fact rates above 5% now look increasingly likely given the soaring rate of inflation.

What does this mean for housing? Until the Reserve Bank has boosted its cash rate from the current 0.5% to above 2.0%, maybe not all that much. But once they get above 2% and talk grows of much higher rates, we will probably see a flattening in prices. When that happens however, that flattening could easily involve average prices still being another 10% - 20% above where they are at the moment.

So, summer is likely to involve still very strong residential real estate activity all around the country.

To sign-up to my free weekly Tony’s View publication go to www.tonyalexander.nz