Air goes out of the asset bubble

ANALYSIS: Inflation is on the rise, share prices are taking a tumble and house prices may be next.

Rubbish assets – such as cryptocurrencies – have taken a bigger knock, and there are a lot of investors and wage earners in New Zealand and worldwide who might be feeling a fair bit worse off than they did six months ago. But, so far, the sky is not falling.

For sure, the 5.9 per cent annual rise in the consumer price index (CPI) reported by Stats NZ yesterday is not as high as it is going to get. ANZ and ASB are forecasting the inflation rate will rise above 6 per cent early this year, if it hasn’t already.

Economists might need to add an extra 1 percentage point to that, perhaps, if Russia invades Ukraine and sanctions push up the global price of petrol, wheat and metals.

But there is little evidence at the moment that inflation is going to completely run away on us. The rise in the CPI in the December quarter itself was 1.4 per cent, down from the 2.2 per cent quarterly rise in the September quarter, so could have been worse.

In fact, this was one of the few occasions since the outbreak of Covid when the inflation or employment numbers released by Stats NZ didn’t really surprise.

Remarkably, just over 41 per cent of the entire 5.9 per cent increase in prices over the year was caused by increases in the price of new housing and petrol, neither of which look likely to be sustained over the medium term.

That is even though they make up less than 13 per cent of the overall basket of goods and services measured by the CPI.

The rate of house building could fall quite sharply amid signs that the number of new homes being built is outstripping demand growth from population growth and immigration.

Fuel price rises should also be to a large extent self-limiting, with shale oil production in North America forecast to ramp up to a new record next year.

As Council of Trade Unions economist Craig Renney pointed out yesterday, there is surprisingly little sign of higher inflation becoming strongly baked into wage claims, despite low unemployment, with labour costs over the year to the September quarter up a modest 2.4 per cent.

It may be some time before inflation drops to anywhere close to the Reserve Bank’s mid-point target of 2 per cent, but a spell of somewhat higher inflation may be best viewed as a necessary evil.

To cushion the blow of Covid, governments and central banks around the world fooled us into thinking we were more wealthy than we were by pumping liquidity into the economy through quantitative easing and fiscal stimulus. The inevitable consequence was an asset bubble that has resulted in a huge increase in wealth inequality that would greatly disadvantage people who receive most of their incomes from wages, including the young, were it to be locked in long-term.

Modestly higher inflation is one way of letting a bit of air out of that bubble in a reasonably controlled way. For example, house prices were up 20.5 per cent over the year, rather than 27.6 per cent, if adjusted for consumer price inflation, potentially making them slightly less unaffordable.

Higher inflation and falls in the nominal price of assets such as shares – which we are starting to see – and in house prices, which we can expect to follow over the next two years, should go further to bring wealth and income streams back into alignment.

A further 7.5 per cent rise in the CPI over the next 18 months or so (that is, a 5 per cent annual rate), combined with a 10 per cent drop in house prices forecast by Capital Economics over that period, would bring house prices back in real terms to more or less where they were at the start of last year.

Wages will also have to adjust upwards some time down the track, for the intergenerational wealth rebalancing to occur.

Higher inflation may be best viewed as a necessary evil.