Debt lag

Take the tight labour market. Most of us will have personal evidence of how hard it is to hire at the moment (this is certainly the case at KangaNews, just in case you happen to know any qualified candidates). Data back up these experiences, and there has clearly been a radical shift in the vacancy to jobseeker ratio. This is not in and of itself anomalous, though it does seem a little strange that labour would be so tight in an environment of such moderate growth.

What is odd is the universality of the phenomenon. At the recent KangaNews New Zealand Debt Capital Market Summit, BNZ’s head of research, Stephen Toplis, pointed out that every country in the world seems to think it will cure its labour shortage with net immigration – and the obvious fallacy of this idea at system level.

I subsequently had the opportunity to ask another leading New Zealand economist how it is apparently possible for there suddenly to be a global shortage of workers. He had some ideas but few convictions. His primary hypothesis was that somehow the pandemic has caused a quiet but immensely significant erosion of productivity. Are more of us off sick more of the time on an ongoing basis? Is flexible working less productive than we thought? Has supply chain disruption effectively de-automated work processes?

Meanwhile – in Australia at least – the labour shortage has yet to feed through into a spike in wage inflation. WPI data show annual wage growth of 2.2 per cent for the second quarter, compared with CPI of 6.1 per cent for the same period. Wages have lagged for years, but a tight labour market should be increasing collective and individual bargaining power.

One perspective on the wages issue is simply that it is taking time for wage growth to catch up with inflation. Speaking at the Westpac-KangaNews Corporate Debt Summit in Sydney in October, Westpac’s chief economist, Bill Evans, argued that there is “nothing magical” about the Australian economy and assuming local wages will not follow the accelerating path seen in the US – where wage inflation was an annualised 5.7 per cent in Q2, just 0.4 per cent less than CPI – would be “complacent”.

There is also a possibility that the low headline WPI number conceals a more complex underlying story. ANZ research published in the wake of the Q2 print notes that nonfarm average earnings per hour increased by 5 per cent in the same period – a consequence of a sharp increase in the proportion of workers in higher-paying occupations.

Something must be going on, because otherwise it is hard to conceive of how dramatically higher interest rates and cost of living could combine with sluggish wage growth to produce so little apparent impact on household behaviour.

It is true that indicators of consumer confidence are starting to ease. Commonwealth Bank of Australia (CBA)’s Household Spending Intentions Index fell by 0.5 per cent in September, which the bank’s economists say “show[s] the effects on the household sector  of the RBA [Reserve Bank of Australia]’s aggressive interest-rate hiking cycle – with further impact expected in the months ahead”.

But this is the first monthly decline since April and the index remains relatively strong, at 114.9. The RBA began hiking rates in May; even households that are still on fixed-rate mortgages – a number that must be falling by the week – are surely aware of the impending consequences of the new interest-rate cycle. Holders of an average-sized Australian mortgage, of around A$600,000 (US$376,000), will be having to find an extra A$600 or more a month as they move from pandemic-era fixed rates to typical variable rate. Is no-one preparing?

Perhaps this is just a lag effect. Another piece of CBA research found that it takes 2-3 months for cash rate increases to feed through even to floating-rate mortgage holders. Households also built up substantial savings buffers during the pandemic. Perhaps the story of the middle part of 2022 is simply one of people having one last hurrah between the social constraints of the pandemic and the looming financial constraints of the tightening cycle.

This seems to be the view being taken by policymakers and the major lenders. In late October, I heard CBA’s chief executive, Matt Comyn, express surprise at how well household spending has held up so far. He noted that perhaps half the rate hikes of 2022 have filtered through to mortgage holders but also said he would still have expected to see a greater pullback in spending.

His puzzlement is easy to understand. Even if the full bill from rate hikes has not come due yet there cannot be many mortgage holders who are not aware that it is looming. Maintaining discretionary spend while rates are rising as fast as they are is not so much a case of making hay while the sun shines as burning all the hay on the first cold night of the year.

It does not help that some trailing data are still only reporting up to the end of Q2, which – adding the 2-3 month lag – would only include the real world impact of the very first RBA hikes. But the data that are available seem to show a gap between consumer sentiment – which is at near-recessionary levels – and consumer behaviour, where spending has barely begun to flicker. In other words, households know things are bad but are acting as if they aren’t – so far.

To put it another way, it really does seem that Australian households are enjoying their last dinner at the captain’s table in full awareness that the ship hit an iceberg several hours previously. The RBA’s job now seems to be to bail out enough water that the after dinner dance doesn’t have to be interrupted – a task Chris Kent, the RBA’s assistant governor, financial markets, acknowledges with perhaps a degree of understatement represents a “narrow path”.

This is why the record rate at which this tale has unfolded is so critical. Kent notes that the last time rates increased by as much as they have in the past year it took four times as long. This afforded central banks the luxury of watching and interpreting the impact of each marginal increase. The RBA and its peers are essentially flying blind in 2022 and will have to decide whether to ease off the throttle before seeing definitive evidence that it is safe to do so.

In years past, whenever the prospect of a steep correction in the Australian housing market was raised by concerned global investors – which it often was – the response from Australian lenders would typically follow a set path. Yes, they would admit, the Australian household is among the most indebted in the world. But while housing affordability is a concern, loan serviceability is relatively benign. On this basis, Australians can be expected to keep paying their –  full recourse – mortgages provided there is no outbreak of unemployment.

We now seem to be down to the last of these traditional failsafes. Household debt has increased despite an increased savings rate during the pandemic and the oft-repeated mantra that most mortgage holders are well ahead of their payments. House prices are falling but are still in a different stratosphere from what could reasonably be considered ‘affordable’ to most Australians. And, as discussed, serviceability either has or will soon ratchet up significantly. This looks like a pretty sheer drop on either side of the RBA’s narrow path.

On one side lie the consequences of failing to get on top of inflation before an uncontrollable wage-price spiral breaks out. On the other, the risk of overshooting with policy tightening is a collapse in demand, recession, unemployment and potentially significant risk in the financial system.

The combination of a lag in policy transmission that may be greater than many had accounted for and the sheer pace of rate rises in 2022 means the last months of 2022 are one of the most interesting and fraught periods in recent economic and market history – even though the die may already be cast.

CPI prints – the single most-watched data point at the moment – are yet to show convincing signs that inflation has slowed, let alone gone into reverse, anywhere in the world. Central bank approaches are starting to differ, nonetheless.

The US Federal Reserve’s smoke signals have always been that it will keep swinging the demand hammer until it is convinced inflation is under control, even if – as most now seem to think is all-but inevitable – doing so triggers a recession. The Reserve Bank of New Zealand has kept up its run of big hikes apparently more in sorrow than in anger. The RBA slowed its hiking pace in October, going for a 25 basis point increase after four consecutive 50 basis point increments. The Bank of England has to clear up the mess made by an incompetent government.

Some of this is clearly the product of different national circumstances. But calibrating the optimal response has rarely been so important.