House prices and New Zealand monetary policy: the debate so far
As central banks around the world have cut interest rates to historically low levels, the potential impact on asset prices has become a major topic of discussion. Nowhere is this more apparent than in the housing market, wherein many countries access to affordable housing is seen as a social necessity. It is this dynamic which is behind the New Zealand government’s recent moves to have house prices included as an explicit target in the setting of policy by the Reserve Bank of New Zealand (RBNZ). This raises the question of whether adding such an objective presents a ‘win-win’ situation?
The current state of monetary policy objectives
The current objectives of the RBNZ are set out in the Reserve Bank Act (1989). More specifically, the Monetary Policy Committee primary operational objectives (Section 2a of the remit) states:
- Future annual Consumer Price Index (CPI) inflation between 1-3 percent over the medium term, with a focus on 2 percent.
- Support maximum sustainable employment.
As can be seen from Section 2a within the RBNZ’s current remit, there is no explicit objective around house prices. This is not to say, however, that house prices, albeit indirectly, do not have an impact on RBNZ policy settings. Like many other central banks, the RBNZ considers changes in house prices through their impact on economic activity and/or inflation. With respect to inflation, housing costs such as rent, insurance, utilities and construction are included in the calculation of the CPI.
The inclusion of house prices via the indirect impact on CPIs has some limitations. Firstly, the issue facing central banks is often that the weight of these indirect housing costs in the CPI may be materially lower than the ‘political/social sensitivity of housing affordability. Secondly, the measures included in the CPI are often ‘second best’ proxies for housing costs arising from the issues associated with directly measuring house prices in a timely manner. These limitations often result in calls for housing affordability to be included as an explicit policy objective by central banks. This is currently the situation in New Zealand where, in a letter to RBNZ Governor Adrian Orr published on 24 November 2020, Deputy Prime Minister and Minister of Finance & Infrastructure Grant Robertson proposed changing a clause in the RBNZ’s remit so that the Monetary Policy Committee be required to “seek to avoid unnecessary instability in output, interest rates, the exchange rate and house prices.”
Implications for RBNZ policy setting
The potential implications for policy setting from the proposed changes in the RBNZ’s remit will depend upon which arm of policy the objective of house price stability falls. This distinction arises as most developed market central banks have twin mandates of economic/inflation stability and regulation/stability of the financial system. For the RBNZ, this second arm of policy objectives is captured under Section 2b of the remit which states that:
"In pursuing operational objectives, the MPC shall:
- Have regard to the efficiency and soundness of the financial system; …"
The result is that the RBNZ has two levers available to manage house prices. These two levers can be best summed up as:
- Cost of credit (interest rates)
- Availability of credit (macroprudential)
Accordingly, despite most of the focus being on interest rates (cost of credit) as the RBNZ’s main policy tool, monetary policy and macroprudential policies (availability of credit) are interconnected parts of the twin mandate of many central banks.
Implications for managing house prices
A key factor with respect to central banks achieving objectives is that they cannot have more independent objectives than they have tools to achieve them. This doesn’t mean that central banks cannot have multiple objectives, just that the ability to achieve the objectives is assisted if they are interrelated. For this reason, using interest rates to manage economic growth, employment and inflation are seen as a set of interrelated/consistent policy objectives even though only one policy tool is available. If a further, less interrelated objective like house prices is added, then this can make it more difficult for the one policy tool to achieve an appropriate balance between the objectives. Accordingly, quite apart from the issue of central bank independence, if politically-driven objectives are included within its remit, the result may also be the ‘worst of all worlds’ whereby the RBNZ is unable to satisfactorily achieve any of its objectives.
There is, however, another option available, which is to assign a separate policy tool to achieve stability in house prices. It is for this reason the RBNZ views that such an objective is best incorporated as part of the ‘financial stability’ remit. As Adrian Orr wrote, “There are considerably fewer trade-offs between the Reserve Bank’s financial policy objective, of a sound and efficient financial system, and stable house prices. It would also enable the Reserve Bank to use financial policies that can be specifically targeted at key drivers of the housing market.” Such a policy bias is already reflected in the RBNZ’s move to reinstate loan to valuation restrictions from early 2021. This greater focus on such measures going forward suggests that having been the poor cousin of interest rate policy, macroprudential measures have a greater role to play in a low interest rate environment.
Is this a ‘win-win’?
It is tempting to view this as a ‘win-win’ situation, as now the RBNZ can use non-interest rate levers to control house prices. But is this really the case? The answers are ‘yes’ and ‘maybe’. At the macro level, such a move is a positive outcome due to one of the potential impacts of low interest rates. Longer-term evidence suggests that extended periods of ultra-low interest rates have the potential to materially increase financial stability risks due to higher and riskier lending by financial institutions. This is because low interest rates make it easier for borrowers to service higher levels of debt. This is fine while interest rates remain low, however issues start to arise once interest rates begin to normalise, i.e. rise. In this context, an increase in house prices may be a symptom of a more general risk to financial stability arising from increased indebtedness. To manage such risks, while still using low interest rates to encourage growth and employment, central banks need to make greater use of macroprudential tools to restrain excessive borrowing. When looked at in terms of maintaining the stability of the financial system, the utilisation of additional policy tools to restrain house prices and the higher debt levels associated with abnormally low interests is a positive outcome.
That said, the concept of housing affordability goes beyond purely financial considerations to encompass a ‘social’ dimension. The social dimension arises as to the concept of ‘housing affordability’ also implies the notion of equality, whereby a greater proportion of the population has access to housing. Put another way, society wants to ensure that all its members have equal access to private housing with public housing providing a safety net for the poorest. This is where the outcome becomes more nuanced, as the utilisation of macroprudential measures aims to restrict the access of certain types of borrowers to credit. These macroprudential measures can take many forms, such as maximum loan to value ratios, provisioning, reserve requirements, etc. Irrespective of the form taken, the aim of macroprudential measures is to limit how much credit banks can physically extend. Unfortunately, it is those individuals who are unable to enter the housing market due to high prices are most likely to be excluded from borrowing under more conservative lending practices resulting from the introduction of macroprudential measures. Therefore, whether the introduction of macroprudential measures to contain house prices achieves the desired social outcome is less clear cut.
Central banks around the world have had to progressively lower interest rates to offset a series of deflationary shocks and maintain growth and employment. A by-product of this has been a boom in house prices as the ability to service higher debt levels increased. The recent debate in New Zealand over the impact of ultra-low interest rates on housing affordability has highlighted the need for macroprudential measures to be utilised to offset the risks associated with excessive borrowing. Though such moves will assist financial stability, the question remains whether limiting the availability of credit provides a ‘fairer’ outcome than pricing signals.
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Clive Smith is the Senior Portfolio Manager on Russell Investments’ Australian fixed income team. Responsibilities span management of Russell Investments’ Australasian fixed income funds as well as conducting capital market and manager research...