RBNZ warns on housing risks

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By Leith van Onselen

The Reserve Bank of New Zealand (RBNZ) today released its June Statement of Monetary Policy (SoMP) following its decision to leave the official cash rate (OCR) on hold at 2.5% (see next chart).

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The SoMP contains quite a lot of discussion on the New Zealand housing market and the likelihood of the OCR rising in the event that home prices continue rising strongly.

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Below are key extracts pertaining to the current state of play in the New Zealand housing market and the RBNZ’s central projections:

House price inflation continues to increase. Nationally, prices rose by 9 percent over the past year (April quarter 2013 over April quarter 2012), with prices rising by 14 percent in Auckland and 11 percent in Christchurch. Outside these areas, prices rose by an average of around 4 percent, although there is considerable variation among districts. House price increases are being driven by a combination of supply shortages (especially in Auckland and Christchurch), pent-up demand for housing, and the lowest mortgage rates since the mid-1960s.

The central projection is for the rate of house price inflation to moderate soon. House prices are very high relative to rents and household income. Household debt relative to disposable income, while reduced somewhat since before the 2008/09 recession, is also very high. House price inflation is projected to rise modestly over the coming half year, before tracking lower thereafter. This projection assumes unchanged prudential policy settings. A key risk is that house price inflation is stronger than forecast. The Bank is concerned that the current escalation of house prices is increasing the probability and potential harm of a significant downwards correction in house prices. Furthermore, stronger house price inflation could boost the inflation outlook through its positive effect on domestic demand…

The housing market and the exchange rate present difficult challenges for monetary policy at the current juncture. Both house prices and the currency appear overvalued. The central projection assumes both annual house price inflation and the New Zealand dollar TWI moderate from early next year…

The RBNZ then considers a scenario where house prices rise more strongly than anticipated, forcing interest rates to be around 1% higher than would otherwise be the case. Such an outcome would badly damage the tradeable goods sector and worsen New Zealand’s already poor external balance:

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Annual house price inflation is assumed to peak at 14 percent, approximately 3 percentage points higher than in the central forecast, and remain higher throughout the projection (figure B1). This results in a house price inflation cycle reasonably similar to that seen in the mid-1990s. Private consumption expenditure and residential investment increase to shares of the economy last seen in the mid-2000s.

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The resultant increase in domestic demand places more pressure on domestic resources, boosting non-tradables inflation. To contain headline inflation, the 90-day interest rate rises sooner and to a greater extent than in the central projection (figure B2).

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A higher path for the 90-day interest rate causes the New Zealand dollar to appreciate, dampening tradables inflation. The higher New Zealand dollar also constrains activity in the tradables sector, through lower export receipts and volumes, as well as higher import volumes – providing some offset to stronger domestic demand.

Stronger domestic demand, along with a stronger New Zealand dollar, results in further deterioration in New Zealand’s external balances. In particular, the current account deficit widens by more than in the central projection.

It’s important to note that these forecasts do not include any use of its macro-prudential policy tools, which would likely act to dampen credit demand and house price growth independently of the OCR, allowing lower interest rates than would otherwise be the case.

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About the author
Leith van Onselen is Chief Economist at the MB Fund and MB Super. He is also a co-founder of MacroBusiness. Leith has previously worked at the Australian Treasury, Victorian Treasury and Goldman Sachs.