Will a 'lolly scramble' lead to higher mortgages rates and is that bad thing for all?

Treasury paper from 2011

For the convenience of email subscribers, here's my Herald on Sunday column on whether a budget 'lolly scramble' would have the same impact on interest rates as the one in 2005, and even if it did, whether it would be seen as a bad thing by everyone.

Prime Minister John Key cut to the heart of his political and economic strategy this week when he posed this question to voters: "If a political party tells you they are going to spend a lot of money, ask them how much it is going to cost your mortgage?"

He was announcing the Government would stick to its discretionary spending limit of NZ$1 billion per year in the May 15 Budget and use surpluses from next year to repay debt, rather than promise a pre-election "lolly scramble".

"There won't be a big spend-up either in the Budget or closer to the election, because anything more than a modest increase in spending will mean higher interest rates over the economic cycle than would otherwise have been the case," Key told the North Harbour Club.

"In turn, that helps to keep the exchange rate lower than it would be, which is important for the overall competitiveness of the economy," he said.

New Zealand's experience between 2005 and 2008 looms large in Mr Key's thinking and perhaps coincidentally comes at a similar point in the electoral cycle as National bids for a third term. Back before the September 2005 election when Labour was striving for a third term, New Zealand's economy was straining at the leash. It was generating
inflation pressures that had already forced the Reserve Bank to hike the Official Cash Rate from 5% to 6.75% through 2004 and early 2005.

Opinion polls in mid-2005 suggested Labour might lose and then Prime Minister Helen Clark unleashed a turbo-charged Working For Families package and interest-free student loans to win over poorer families and students. The extra spending worked to win the election, but pushed the capacity-constrained economy even harder, generating more
inflation over the next two years.

That forced the Reserve Bank to start hiking interest rates again less than six weeks after the election and to eventually raise the OCR to a peak of 8.25% by mid 2007. Floating mortgage rates rose over 10.7% by August 2008 and two year fixed rates hit 9.6%. The pain of the high interest rates helped drive the economy into recession by late 2008, even before the Global Financial Crisis hit.

Now the economy is beginning to hit its straps again, although not as much as it was in 2005. The Reserve Bank says it is growing faster than its potential growth rate and has an 'output gap' of about 1% of GDP, which is increasing inflation pressures. The OCR is expected to be a full 1% higher by the September 20 election.

Mr Key is in a more electorally comfortable position than Ms Clark was back in early 2005, but not that much more comfortable. So it's
somewhat surprising that Mr Key is swearing off the use of the fiscal lolly jar.

But only somewhat surprising. He knows that a large swathe of home owners and landlords through the electorally-crucial mortgage belts of Auckland are nervous about rising mortgage rates, which are likely to be around 6.5% by election day. They are expected to rise to 8% within two years. Households have around NZ$205 billion of debt so every 1% increase in interest rates cost about NZ$2 billion in increased interest costs.

Somewhat surprisingly, there has never been a direct study of how much the increased Government spending from 2005 to 2008 drove up interest rates. There isn't a simple relationship, despite what Mr Key might suggest. A Treasury paper published in June 2011 found the fiscal stimulus had reached about 1% of GDP by 2008 and happened at the same time the economy was running about 3% faster than potential output.

This happened at a time when the Reserve Bank increased the OCR by 1%. The suggestion therefore is that Government stimulus of 1% of GDP increased interest rates by 1% when the economy was running hot with an output gap of 3%.

The Reserve Bank itself issued a mild warning to the then Labour Government in 2007 that its fiscal stimulus was forcing interest rates and the exchange rate higher than would otherwise be the case, but didn't specify just how sensitive the relationship was.

Any Government could, for example, promise increased spending or deliver tax cuts worth NZ$2 billion or about 1% of GDP, but then see those gains whittled away by a 1% rise in interest rates that cost NZ$2 billion in increased interest costs.

This is where the tradeoffs become interesting. The big question for voters is who would get the benefits and who would suffer the consequences? And are they the same people? Increased government payments for poorer renters would not necessarily generate higher costs for them immediately, given they don't directly pay the mortgage, although landlords might argue they would pass on the higher mortgage costs in higher rents. As an aside, landlords were not able to pass on the higher mortgage rates from 2004 to 2008. Rental inflation nationally barely budged over that time.

Tax cuts for wealthier income earners who had big mortgages on their own homes may see money go in one pocket and out the other. Tax cuts for older home owners with low or no mortgages may not over-stimulate the economy because they are more likely to save their windfalls than spend it. Or they may even benefit twice through higher interest rates on their term deposits.

So the question posed by Mr Key this week about how much a lolly scramble would put up "your mortgage" is not as simple as it first appears and neither is the answer. It all depends on how the lollies are scrambled, who gets them and how crowded the lolly scramble is.

For example, not everything is the same in 2014 as it was in 2005. The output gap was between 3% to 4% between 2005 and 2008. The Reserve Bank says the output gap will range between 1.5% and 0.4% over the next three years. The higher the output gap, the higher the sensitivity of the OCR to fiscal stimulus.

Back in 2005 household debt was about NZ$115 billion, but rising at 16% per annum, again suggesting an economy already over-heating. By election time this year mortgage debt will be around NZ$205 billion and growing at a much slower (and falling) annual rate of about 6%.

Also, term deposits back in 2005 were worth just NZ$59 billion. Now deposits are NZ$125 billion and rising at a rate of 9% so there would be plenty of voters actually cheering FOR higher interest rates.

Perhaps the questions a voter should ask a politician promising higher spending or tax cuts is this: what type of spending and tax cuts are you planning and who would get them? And then the politician should ask the voter if they are a renter, a borrower, a pensioner or a saver. There'll be different answers for different people.

Ultimately, perhaps a conversation and some research into each parties policies and the economic context around those policies would be better than the assumed answer to a rhetorical question.