Thursday, October 20, 2016

Why 'mortgage tilt' means you might never pay off your home

What can you do when your dreams come true,
and it's not quite like you planned?

- Don Henley, Glenn Frey

Anyone would have thought Philip Lowe had it made. The new Reserve Bank governor has taken the helm at a time when the Bank's traditional enemy, high inflation, is dead. He says he is the first to have done so. Yet he is worried by the fruits of that success.

If you're wondering what could possibly be worse than high inflation, the answer is "very low inflation". It may not destroy savings or spiral upwards, as inflation did when it soared to 18 per cent in the middle of the 1970s, but it can do things that are worse.

It can leave sellers – be they workers, manufacturers, retailers, importers or whoever – without power. And without power, without the hope of extracting higher prices, businesses have little reason to invest. Japan has been lumbered with extremely low inflation for most of the past two decades. They are called the "lost decades" because businesses and consumers have kept their wallets shut.

It's not like that here, not yet. But the household saving ratio, which was close to zero when inflation was high before the global financial crisis, has shot up to 8 to 10 per cent. Like low inflation, high saving is good – we've forever been exhorted to do it – but too much of a good thing can stop the economy turning.

On Tuesday, in his first speech as governor, Lowe explained that headline inflation had fallen to just 1 per cent – the lowest, with two brief exceptions, since the recession at the start of the 1960s. So-called underlying inflation is the lowest in records dating back to the start of the century, at 1.5 per cent.

It's fallen because producers and workers worldwide lack pricing power, in part because globalisation has exposed them to competition from producers and workers from elsewhere who will do the job for less. Information technology means that these days service industry workers such as academics, journalists, accountants and financial planners are no longer safe.

The Bureau of Statistics wage price index grew by just 2.1 per cent over the past year, the least since it began in the late 1990s. Lowe says when the Bank and the Bureau examined the individual records for each of the 18,000 jobs that make up the index they discovered that wage rises were happening less often, and that in most industries were smaller.

"The decline in the average size of increases is largely due to a very sharp drop in the share of jobs where wages are increasing at what, by today's standards, would be considered a rapid rate," he explained. "Six years ago, almost 40 per cent of jobs received a wage increase in excess of 4 per cent. Over the past year, less than 10 per cent have got that type of increase."

You might be thinking that low wage rises aren't a problem so long as prices are increasing by less. But that ignores a little-recognised phenomenon known as "mortgage tilt".

When you take out a mortgage in a world of high inflation, your payments are "front-end loaded". That's a technical term used by the former governor Glenn Stevens and the head of his financial stability department Luci Ellis to describe the phenomenon where payments used to start high, but then fall as a proportion of income with each wage rise.

In a world of low inflation the "tilt" becomes much less severe. If repayments consume a large proportion of your wage at the start, they'll keep doing it for decades. Ellis says the banks either haven't caught on to this, or don't want to own up to it. They use the same formulas to assess how much they'll lend as before. They link repayments to income. And because low inflation means low interest rates, repayments are lower than they used to be for any given loan, meaning they can lend more. The result is higher house prices, and harder-to-repay loans.

Even the head of the treasury complained on Wednesday that houses were becoming impossible to afford (and he could have added, impossible to pay off).

If anything the "tilt" matters more for businesses. They are not as easily fooled as homebuyers. Knowing there's little chance of their repayment burden shrinking if they can't push up prices, and believing they won't be able to push up prices, they become much less keen to borrow, however low the interest rate.

They become less keen to invest and to take on more workers.

In May the budget forecast a rebound in non-mining investment of 3.5 per cent this financial year. The latest investment intentions survey shows non-mining businesses expect instead to cut investment 14 per cent.

To the extent that "tilt" is one of the reasons, deeper cuts in interest rates won't much help.

We've a problem, one born of success. Low inflation looks good, until you're in it.

In The Age and Sydney Morning Herald