RBNZ 'taking a premature gamble with the housing market,' BNZ's Stephen Toplis argues

By Gareth Vaughan

BNZ head of research Stephen Toplis has accused the Reserve Bank of "pouring petrol" on the housing market fire through its latest review of the Official Cash Rate (OCR).

As expected the Reserve Bank left the OCR unchanged at 3.5%. But it opened the door to a potential rate cut by saying; "In the current circumstances, we expect to keep the OCR on hold for some time. Future interest rate adjustments, either up or down, will depend on the emerging flow of economic data."

Toplis says the first OCR review of 2015 was a test of the Reserve Bank's risk preferences in terms of whether it's more nervous about the potential of the strong New Zealand dollar undermining the economy, or whether it's more concerned about the housing market again threatening to get out of control.

"We are erring on the latter view. The RBNZ today showed it is leaning to the former," says Toplis.

He describes the OCR review statement as the Reserve Bank's most proactive attempt yet to get the currency down, with it including a whole paragraph dedicated to the NZ dollar's overvaluation and suggestion of further significant depreciation.

"We misjudged the RBNZ's risk preferences. But we also think that they have taken a premature gamble with the housing market," says Toplis.

There are clear signs that the housing market is again taking off with house sales up 8% in the December quarter 2014 when compared to year earlier levels. Traditionally this would be expected to result in an acceleration in house price inflation."

'Almost guaranteeing further falls in mortgage rates'

"The (Reserve) Bank is bargaining on the recent pick up as being simply a transitory development as sales bounce back from a weak period pre-election," adds Toplis.

"There may be some truth in this but, with excess demand clearly in evidence and very high migration inflows continuing unabated, it's hard to see much of a softening. Moreover banks are already competing aggressively in the mortgage market with fixed rates, in particular, on a trend decline. The RBNZ today poured petrol on the fire and has almost guaranteed further, potentially significant, declines in mortgage interest rates. A precursor to this is today's rally in the swap curve which has seen the two to five year part of the curve rally between six and nine basis points."

"It will be fascinating from here on in seeing how the RBNZ will confront an over-heating housing market when its own actions will have encouraged the very behaviour it doesn't want to see," Toplis says.

He goes on to say fixed interest rate markets are now almost fully pricing in a rate cut as the Reserve Bank's next move, with the swap rate curve suggesting the rate cycle has now peaked.

"We continue to beg to differ. While we don't rule out a rate cut as a possibility, we think the rationale for doing so, based on current economic evidence, is limited."

"Interestingly the market currently places a 30% probability on a rate cut at the RBNZ's next meeting in March. We think that, barring any near term disaster, this is way wrong," adds Toplis.

BNZ's economists still believe the RBNZ's next OCR move will be up and the increase will be in March 2016, Toplis says, noting the "precipitous drop" in the NZ dollar following the OCR review actually increases the probability of a tightening. The Kiwi fell to a fresh three year low of US73.75 cents.

For the Reserve Bank to cut the OCR Toplis argues this would require; a sudden and unexpected drop in global economic activity, a sudden and unexpected drop in domestic economic activity, further falls in dairy prices, or a drought.

"Of these perhaps the most likely is the prospect  that a widespread drought might knock the stuffing out of an already burdened dairy sector. Recent climatic developments are certainly worrying and we will be following soil moisture levels closely over the next few weeks," says Toplis.

The Reserve Bank, meanwhile, has "taken a gamble" that the benefits of hammering the NZ dollar will ultimately outweigh the cost of providing more stimulus to the housing market.

More macro-prudential tools?

Toplis made no mention of the Reserve Bank potentially moving to use an additional macro-prudential tool(s), alongside the restrictions on banks' low equity mortgage lending, to combat an overheating Auckland housing market. His counterparts at both ANZ and Westpac did, and ASB's economists said house price inflation risks increasingly becoming a financial stability, rather than a monetary policy, concern.

ANZ's economists said: "We would not rule out further macro-prudential actions against this (housing) sector to free up the OCR to respond to wider economic forces."

And Westpac's said: "One cannot overstate the importance of the RBNZ’s admission that the housing market is 'showing signs of picking up, particularly in Auckland.' Previously, the RBNZ was resolute in describing the housing market as having slowed in response to LVR restrictions. This serves as significant encouragement for our forecast that a tightening of macro-prudential policy will occur later this year. Our thinking has long been that falling mortgage rates, combined with a strong economy, booming population growth and cheap petrol, will create a renewed environment of rising house prices."

"With the OCR pinned down at 3.5% by low inflation, the RBNZ will be left with only one option – macro-prudential tightening. Late last year the RBNZ appeared to shoot down our forecast, explicitly saying that macro-prudential tightening was not currently under consideration. But now that the RBNZ has changed its assessment of the housing market, it must surely also be changing its assessment of the required policy response."

Here's Toplis' full note.