Inflation numbers for the June quarter are out. The Consumer Price Index (CPI) rose by 3.3% in the year to June. That is much higher than forecast, overshooting the Reserve Bank’s 1-3% target range.
Inflation is a big problem. It erodes the purchasing power of money and distorts many savings and investment decisions.
Perhaps worst of all, if you do not get pay rises to match, you will see your pay packet fall in real terms.
Even if the RBNZ acts swiftly, it may be too late. Monetary policy takes time to work on inflation and the Government is not exactly making the job easier – showing no signs of easing up on spending any time soon. Expect a few more high inflation numbers yet.
To be safe, maybe we should prepare for a world with persistent inflation. We could start by lending a hand to prospective homeowners. They have suffered enough with 30% house price growth this year.
Inflation can have a substantial negative effect on housing affordability. It results in ‘front-loading’ of mortgage repayments. In real terms, principal repayments are higher during the early stages of home ownership – $100 today is worth more than $100 in 30 years. The issue is known as mortgage-tilt.
Price level adjusted mortgages (PLAMs) can help – a debt contract that links dollar repayments to a price index, usually the CPI. Compared to a conventional mortgage, repayments are lower during the early years of the mortgage and higher during later years. This difference is important as incomes typically increase over time.
PLAMs have been widely available in countries such as Iceland and Chile and were even introduced in Denmark during a period of high inflation.
With a real interest rate of 4% and inflation of 3%, for example, initial monthly repayments are around 25% less for a PLAM than a conventional mortgage. The difference is more pronounced the higher the inflation rate.
A few years back when analysing housing affordability using the Survey of Family Income and Employment (SoFIE) I built a model of affordability based on people’s incomes, assets, and the type of mortgage available. More people could afford to buy a home with PLAMs than conventional mortgages, without initial repayments exceeding a certain percentage of income.
There could be value in further investigating the implementation of price level adjusted mortgages.
However, I find myself reminded of a quote by German economist and former President of the Bundesbank Karl Otto Pöhl: “Inflation is like toothpaste. Once it is out, you can hardly get it back in again. So the best thing is not to squeeze too hard on the tube.”