Consumer spending is less likely to blow out on the back of the current housing upturn than it did during previous housing booms, according to the Reserve Bank.
Assistant Governor John McDermott, in a speech to the Financial Services Institute of Australasia today said that household spending was constrained by high debt levels and the experience from the global financial crisis, "which has implications for the degree to which the strengthening housing market will feed into private consumption".
"Our current judgements are that the household debt position means consumption is likely to follow less of a pronounced upswing as a result of the housing market upturn than has historically been the case."
Another issue that the RBNZ is occupied with at the moment is the effects of the Canterbury rebuild. McDermott said the bank believed the concentrated character of the rebuild meant its spillover effects
to housing markets in the rest of the country would be "muted".
"However, since there is little recent experience against which to benchmark these events, we will have to monitor the evidence carefully to ensure that our judgements in this area remain reasonable."
McDermott's speech focused on the important to the RBNZ of its forecasting. . He said forecasting could be difficult, because the economy was never static and monetary policy actions took time to influence inflation. But forecasting was an important element of the Bank’s communication of policy and risks.
McDermott said there was no single “correct” way to look at the economy, and the bank drew on a range of official data, statistical models, surveys, business visits and market monitoring to shape its view of the economy.
“The forecasting framework includes some fundamental economic principles to anchor our analysis and dialogue. These include the big lesson from the 1970s experience, that you can’t sustainably get higher growth by tolerating a bit more inflation, and that to try to do so will eventually cause high and variable inflation, and damage the economy.”
The current environment also confronted the bank with trade-offs across policy objectives.
"Near-term inflation is low and is forecast to gradually increase back to the midpoint of the target range. An interest rate cut might help inflation return to target sooner. But such a cut would also probably exacerbate the current strength in house prices, risking further increases in private debt levels, potentially raising financial stability issues.
"On the other hand, while an interest rate hike might limit housing market risks, it could also place further upward pressure on the exchange rate."
McDermott said there was often concern that increases to the policy interest rate would adversely affect growth by causing exchange rate appreciation.
"But we do not hike the interest rate for no reason. While higher interest rates are normally associated with a higher exchange rate, this usually reflects strengthening of the economy due to other forces on spending, such as a pickup in foreign demand, rising terms of trade, or an increase in government spending.
"It therefore does not follow that keeping interest rates lower than otherwise in order to prevent exchange rate appreciation would necessarily be successful. Assuming the inflation target is credible, strength in the domestic economy will generally cause the exchange rate to appreciate even without immediate policy tightening, as people will anticipate eventual monetary tightening in order to limit rising inflation pressure.
"The sustained economic expansion in New Zealand prior to the global financial crisis illustrates these trade-offs well. The OCR was steadily raised 200 basis points from 2003 to 2006 and the New Zealand dollar exchange rate moved from 55 US cents to 75 US cents. Even a tightening of monetary conditions of this magnitude was not sufficient to prevent CPI inflation from reaching more than three percent by the end of 2006 . We could perhaps have leaned harder against this expansion at the time, but this would probably have exaggerated the exchange rate cycle on both the upswing and the downswing.
"We draw several lessons from this experience. One is that when there are strong forces on the New Zealand economy, policy settings may need to lean quite hard against them. A second is that financial cycles can be surprisingly large and long-lasting. A third is that such forces in a small open economy can cause large exchange rate swings. Difficult judgements must be made about the balance across the trade-offs."