The Reserve Bank's expected move to place "speed limits" on high loan to value lending (LVRs) is a gamble and "the biggest central bank experiment seen in New Zealand in decades", according to BNZ's head of research Stephen Toplis.
In the BNZ's latest "Economy Watch", Toplis said the LVR move was a "gamble" designed to slow down the pace of house price inflation in order to reduce the banking sector’s vulnerability to a future house price correction. He also talks about the RBNZ being in "panic mode" about house price inflation. And he argues that the bank is sending conflicting signals and says its credibility is on the line.
The RBNZ gave more details of its plans this week, though it has yet to reveal when the so-called speed limits might be applied.
In the meantime, the Government has been attempting to ease the path of first home buyers into the housing market, having earlier failed in attempts to get first-timers exempted from the RBNZ moves. See here for articles about LVRs.
Toplis said RBNZ was hoping to both help curtail the appreciation in house prices by reducing demand, therefore limiting the extent of future price falls and to directly protect bank balance sheets by reducing exposure to the housing market relative to what might be the case otherwise.
He said, however, there were "a couple of flies in the ointment".
He noted that the RBNZ had said the LVR limits could help dampen excessive credit growth - but questioned whether credit growth was indeed excessive in this country at the moment.
"Total borrowing for housing rose 5.4% between June 2013 and June 2012. This was the strongest rate of increase since October 2008 but is miles away from the pace of growth seen in previous housing booms.
"Moreover, there is a question of what is leading what? If you have strong house price growth then credit growth would be expected to rise even if the volume of activity did not.
"But volume and price growth is well in excess of credit growth at the moment reflecting the fact that much of the activity in the market is being funded by past increases in savings and/or insurance payments (in the case of Christchurch). The credit channel might thus be the wrong one to attack."
Lack of supply
Toplis said BNZ economists were convinced the biggest problem confronting the New Zealand residential property market was the lack of supply accompanied by the rising cost of construction.
"It is a moot point as to whether a reduction in credit availability will reduce these problems. It may even exacerbate them."
Toplis said the RBNZ had often said in the past that rising house prices by themselves were no worry to them, from an inflation perspective, provided that households did not start spending unsustainably off the back of the house price inflation and, in turn, spreading that inflation through the wider economy.
"At this stage there is clear evidence of a pick-up in household demand but not, yet, an accompanying increase in overall retail and consumer price inflation."
Toplis said there was "substantial evidence" the economy would soon be running hot enough to create upward pressure on inflation.
"This pressure will be exacerbated if the generally upward trend in the [New Zealand dollar], which we have seen for some time now, dissipates," he said.
"It is these factors that have us forecasting annual CPI inflation heading to the top edge of the RBNZ’s target band in 2015 which will necessitate pre-emptive action by the central bank early in 2014."
The sheer pace of the momentum that is building now might argue for earlier bank action "but you can see why they [RBNZ] are reluctant to move", Toplis said.
Inflation was below the RBNZ's 1% to 3% targeted range and had been for a year, while the central bank's own inflation forecasts had over-estimated the rate of inflation for the past six quarters, suggesting to them at least future "downside risk" to projections.
"As if that’s not enough, the RBNZ is petrified that any increase in interest rates might push the currency higher working against the rebalancing of the economy that New Zealand so badly needs.
"Frankly, we believe the [central] bank should worry less about this than it does. To start with, financial markets are already pricing 170 basis points of tightening over the next two years, with the first hike fully priced by March. Theoretically, the RBNZ would only create further upward pressure on the currency if it was to suggest that the market was underestimating the likely extent of the tightening cycle. This would seem unlikely given that the RBNZ’s own published forecasts are currently miles behind the market’s expectations."
Toplis said the RBNZ was "in panic mode" about the pace of house price appreciation but didn't want to raise interest rates as it saw no immediate inflation problem.
"The bank has a veritable dilemma and you can see why prudential policy is centre-stage and why the Bank feels inclined to experiment."
But it was "absolutely critical" that the RBNZ clearly identified its objectives, so leaving no confusion over what it was trying to do.
"If it does not do this effectively then its transparency will be called into question as will its credibility. We believe that it is teetering on the brink of doing this now by appearing to confuse its objectives."
Toplis said the RBNZ need to communicate a clear separation between the objectives of prudential and monetary policy.
"Prudential policy is exclusively for the purpose of ensuring the integrity of the New Zealand banking system while monetary policy is directed at maintaining inflation within a one to three percent target band. The two must not be confused."
Toplis said the market was being told that the proposed LVR adjustments are a prudential tool only. Therefore success or failure must be judged against the protection that their imposition provides for bank balance sheets, not whether they control generalised inflation.
There were, however, "far too many folk wandering around" believing the main target of the LVR changes is inflation, which in turn is designed specifically to enable the Reserve Bank to maintain interest rates lower than would otherwise be the case.
"The RBNZ has been accused of giving mixed messages on this front. If our interpretation is incorrect and the Bank is instead using LVR’s to target CPI inflation it must come clean and say so and admit that it is using these tools as a monetary policy add on. Otherwise its denial must be vigorous."
Toplis said irrespective of what happened with the LVR moves, official interest rates would need to return to "normal" in reaction to the economic recovery.
"Any suggestion that [they] will not in this environment will lead to increased spending and heightened leverage. The fear of rising interest rates, even if that fear is never realised, is a potent weapon. Any suggestion now, without a corresponding dip in aggregate demand, that interest rates will stay on hold for longer would be like pouring petrol on a fire. It is thus imperative that the Reserve Bank does not engender a significant rally in fixed interest markets when it makes its LVR announcement.
"If all this sounds very confusing, that’s because it is. We’re not strong advocates of the macro-prudential process generally, and the proposed LVR changes specifically, but that’s by-the-by as the changes are upon us whatever we think.
"What matters now is that the Reserve Bank provides absolute clarity as to what it is doing and why it is doing it.
"It will tell you that it already is but the number of questions we are getting from both offshore and onshore is testament to the fact that its current communications strategy is less than optimal.
"Moreover, with all the hype over LVRs and the current intense concentration on regulatory matters at the Bank, it is equally imperative that the importance of monetary policy and orthodox responses to economic cycles does not play second fiddle," Toplis said.