RBNZ misstep on macroprudential policy

I was hesitant to write this post, until I realised I was writing it on a personal blog that only a few lovely people read and no-one will be too concerned with what I say :) .  Then I decided I may as well discuss how I actually feel about the speech from the RBNZ yesterday (where we discussed the summary here).

Not so long ago I wanted to note how to think about the causes of why we may move towards LVRs (maximum loan-to-value ratios on mortgage lending) in New Zealand.  I noted the following in terms of some quotes they had made:

Either these quotes miscommunicate the justification the Bank is using for such policies, I have completely misinterpreted the quotes, or they communicate it perfectly and I fundamentally disagree with the association they are using.

It is now clear that the RBNZ’s communication is crystal clear, and I fundamentally disagree with an element of their justification for LVRs.

Now I don’t come from this point of view because I am anti-RBNZ.  The RBNZ is one of the most transparent, effective, and dynamic central banks in the world.  RBNZ actions helped to prevent the full brunt of the financial crisis smashing into New Zealand – acting far more rapidly than I had recognised was necessary at the time.  RBNZ actions have ensured that our financial system is relatively secure.  RBNZ research is both incredibly good, and made to be very accessible.  Furthermore, their willingness to accept their role at regulator and to be conscious of regulation and risks given that relationship is both admirable and appropriate.

But to pretend I agreed about the way LVRs are being sold out in public would be a lie – as my boss said to me yesterday after reading my post it sounded like I was “sucking up to the Bank” given his knowledge of my views.

The “why” of macroprudential policy

Although the Bank seems unusually unclear on this point, they appear to be saying that they are unwilling to lift interest rates because the increase in house prices is not due to a generalised increase in demand – instead “for some reason” the relative price of housing is climbing.  Given the replacement cost of housing, the yield on housing, and income growth, the level house prices are rising too relative to other goods and services is high.

This is how I have to interpret what the Bank is saying – as it the lift in house price is due to a lift in general demand, they should simply be increasing interest rates.

Now given this the Bank notes the following:

Rapidly increasing house prices increase the likelihood and the potential impact of a significant fall in house prices at some point in the future

To which I have said, and will continue saying, who gives two hoots!

This isn’t to say we shouldn’t give two hoots – but just that we need to actually justify why hoots are given before reacting to this!

As we’ve noted in the past we need to think about the market failure involved.  In this way, we need to think about the inherent ‘externality’ that is involved.

Now the RBNZ has a point when they say:

“The Reserve Bank considers that LVR speed limits will be more effective than other macro-prudential tools in constraining private sector credit growth in the housing sector, and dampening housing demand. Other macro-prudential instruments, such as counter-cyclical capital buffers and capital overlays on sectoral capital requirements, are likely to have less effect on the demand for housing-related credit and on house price growth.”

Given that, during an “upswing” in the cycle, higher asset prices make it easier for banks to claim they have sufficient capital.  In this context, LVRs and the such are often justified as more direct.

But I also think this misses the point of what we are trying to achieve with macroprudential regulation.  We are fundamentally concerned about the stability of the banking system for two overarching reasons:

  1. The fact the banking system is implicitly backstopped by government.
  2. The idea that although banks take into account risk, they ignore systemic risks.  Furthermore, these risks can be exacerbated and changed through time by “complementary” behaviour – herd behaviour and irrational bubbles in this sense.

In this context LVRs are a bit unusual.  In this case, it should NOT up to the RBNZ to decide the “quality” of the lenders banks should be choosing – instead under their financial stability guise they are aiming to ensure that these heavily regulated and protected banks are holding sufficient capital to deal with the risk associated with a sharp drop in house prices.  Aiming our regulatory guns at borrowers misses the point, and is a poorly targeted way of trying to solve a macro-prudential concern stemming from asset price risk in a specific sector.

However, that was not my area of real disagreement – as I have previously accepted that LVRs are a “stop gap” measure as more appropriate schemes are designed in the background.  Stating that the concern is “house prices” is something I fundamentally disagree with.

Even if we ignore the points on communication I touch on later on there is something more fundamental.  The concern is not the asset prices, it is not a bubble, it is financial stability.  The RBNZ’s role it NOT to prevent people hurting themselves (transfers associated with volatility in house prices), it is to prevent their actions hurting other people (the financial instability due to banks holding insufficient capital given the risk of a systemic event)!!  I would note that I describe this more clearly in the earlier post here.

But how are we supposed to articulate risk without talking about house prices!

O.o … what

Discuss banks and borrowers taking on excessive leverage, and by all means roll out:

Rapidly increasing house prices increase the likelihood and the potential impact of a significant fall in house prices at some point in the future

But then state that the purpose of the policy is to ensure that banks are taking “risks into account appropriately” and that the RBNZ can’t control prices.  The Bank is completely and totally right that large increases in prices make declines more likely and that there is risk here – but the purpose of the policy IS NOT to bring house prices down or slow growth, it is just to ensure the stability of the financial system.

Never forget that if we are really responding to some “irrational bubble” it is unlikely policy can do anything to assuage it – instead appropriate policy (in my view) will try to protect the broader economy from a situation where the “bubble pops” and there is a transfer of resources between owners and non-owners, by making sure the financial system is appropriately regulated/taking into account these risks.

By explicitly stating that they are aiming to slow growth in house prices, and by not explicitly stating that it isn’t house prices that matter but the fact that banks are appropriately taking into account risk, the Bank is inherently saying something very different.  They are essentially stating that they have a concern about this transfer, and they are in part taking on a roll that belongs to government and private choice – not central bank management.

Wealth effects and stuff!

O.o who is writing these titles!

If the concern is wealth effects and not financial stability … then we are talking about rising domestic demand stemming from higher asset prices, and thereby higher future inflation.  Use monetary policy.  If our concern is that the house prices will rise then flash fall, we are again talking about an issue we should look past – it is not up to the Bank to “fine tune” the economy.

Also, be careful using “wealth effects” from housing.  Current evidence suggests that the wealth effect from housing is largely not a “traditional” one but is in fact due to a loosening in credit constraints for younger households (recent work here and here).  In this way, the volatility in consumption may be welfare improving – the actual impact of a rise and fall in house prices on welfare is ambiguous!

Confusing people on affordability

I was concerned when the RBNZ mentioned housing affordability in the past, given that this is 100% not their mandate.  I was as a result encouraged it did not turn up in this speech!

But I’m not sure what the RBNZ expects people to take from them constantly stating that its policy choices will bring down house prices.  What they should expect is a group of people in the public who now think the RBNZ in some way “controls house prices” and “controls housing affordability”.  You may well say that is not what the Bank meant, and I will be honest they were a lot more careful this time with their language – but this does not change the way some will interpret it!

Think about it a bit.  How would the man on the street interpret a central bank saying “house prices are too high” or “An important issue is how long LVR restrictions might be imposed. This largely depends on the effectiveness of the measures in restraining the growth in housing lending and house price inflation”.  I imagine a number of people hear from this that prices are wrong, and the RBNZ is going to fix em, good times!

Given the previous context of financial stability, there is no need to mention how house prices will change, or even state that a “relative price” is wrong.  The RBNZ’s role in terms of financial stability is to ensure that banking regulation is appropriate, as a form of insurance against the risk of failure, not to determine house and other asset prices.  UpdateOww my …. constraining people is now in their own interest.  Superb, this is not inappropriate ad hoc ex-post justification at all.

Mixing your instruments

This statement was incredibly unnecessary:

In this way, LVR restrictions will support monetary policy. While the primary purpose of the restrictions is financial stability, they will also provide the Reserve Bank with more degrees of freedom in conducting monetary policy. In particular, they will provide the Bank with greater flexibility in considering the timing and magnitude of any future increases in the OCR.

If the Bank believes that tighter monetary conditions are appropriate … tighten monetary conditions.

Yes the dollar is high, what exactly do you expect when NZ is going through a MASSIVE non-tradable investment binge (the Canterbury rebuild).  The rebuild involves significant activity, and will crowd out other forms of activity, this is undeniable.  No amount of “cute” central bank fiddling will change anything about this.

If the purpose of LVRs is to try to deal with concerns about systemic risk in the banking system … then make that case and don’t talk about monetary policy.  Yes the two are intertwined, just like fiscal and monetary policy are intertwined – but you still talk about them with reference to their actual targets.

Why say that we can avoid “trade-offs” by mixing together policies – as that is what is sounds like here.  In truth, all the Reserve Bank is doing is changing the trade-off, and they are doing it by explicitly shutting a bunch of people out of credit markets.  It will only have much of an impact in terms of monetary policy and the such if the LVR restrictions are incredibly good at keeping first home buyers out of the housing market … an interesting choice by our currently politically independent central bank.

Aren’t you splitting hairs – what is the difference between what the Bank’s said and what you are trying to say?

I see where you are coming from.  I can see an area of justification for LVR policy, I admit that macroprudential policy can have a role, I see increasing leverage and high house prices as offering an sector specific area for systemic risk.

But the difference between explicitly stating that changing house prices is a goal (RBNZ) and explicitly stating that changing house prices is a side product (me) is a fundamental difference in views.  My view is that it is not appropriate for a central bank to start further “managing” an economy by targeting a specific price outside of guiding broad macro variables (cash rate in relation to monetary conditions, inflation) and implementing specific regulation to internalise risk in the banking system.

The RBNZ made it clear that they are bringing in these regulations to lower house prices (note slowing growth is the same as fundamentally saying that you believe the policy will lower house price growth).  While lower price growth may be a result of policy, it should not be the aim, and that is where I’m strongly in disagreement.

I don’t see this as a small issue.  The decision about whether the goal is a price or whether it is to deal with some form of bank stability directly is core to the issue, the perception of success, the policies that seem appropriate, and the way these policies are communicated.  Hence why I view this difference as blog worthy :)

  • John Dickson

    reduce the uncertainty and flick the RB a OIA request for their analysis on the nature and quantum of risk the LVR restrictions are designed to “address”. Would be interesting…

    • http://tvhe.co.nz/ Matt Nolan

      I like your thinking – I am not sure if I’m able to use an OIA request. I am sure that I’d learn something from whatever is released though :)

      • John Dickson

        indeed. i’m quite interested in how one actually unpicks from price signal’s (and other data) the nature/size of this risk.

        • http://tvhe.co.nz/ Matt Nolan

          The price signal informs us about the risk – but the target is the risk, not the price itself. If banks are holding sufficient equity/capital to deal with a large fall in prices, then suddenly the RBNZ need not care about the prices!

  • Shamubeel Eaqub

    I took issue with something else as well. They described the Auckland and Canterbury markets in the same way – undersupplied. But that is wrong.

    In Canterbury there is a physical shortage of shelter. This is reflected in house prices and rents moving together. eg in Christchurch house prices are up 10% and rents are up 12%.

    In Auckland the shortage is in housing as an investment. eg Auckland city house prices are up 13% and rents are up 1%.

    The risks are different and the policy responses are too.

    • http://tvhe.co.nz/ Matt Nolan

      I agree – although I wouldn’t go quite as far with Auckland. The Auckland issue is a hard one, as we don’t have “quality adjusted” rents. We would suspect that people who are starting families are in better rental properties and can’t move out, as a result rental growth is negatively biasd at the moment.

      The rental figure can not, and should not, be ignored as questioning the idea of a “shortage”. But when we have vacancy rates and occupancy rates shooting around how they are, the idea that there is a “level” shortage is fair.

      Where I think your point is especially relevant though is related to “growth” in house prices – the growth occurring, even given the negative bias in rents, does indicate that there is some investment demand factor involved here. Of course, in this circumstance this is a relative price shift, and we need to go a step further and ask how this shift in investment demand influences the stability of banks balance sheets (asking questions such as where is the demand coming from etc) in order to do this.

      Now if we head this way, the Bank can come out and justify LVR limits as a means of targeting what they view as a specific shock that is creating instability – but as you say this is separate from the idea of a shortage, and as I’ve noted this is separate from the idea of talking about price growth and whether a price is right!

      • Shamubeel Eaqub

        We have stratified rents, they aren’t doing anything either. The Auckland situation is very tight (vacancy rate low), but the numbers being bandied about simply can’t be right (eg 30,000 shortfall). Where do these people live now and why aren’t they bidding up rents, because that would also be shortage in supply of that too…

        • http://tvhe.co.nz/ Matt Nolan

          Indeed – and Auckland construction is responding now. There may be concerns about the type of building, densification, and urban design – but not only are these not monetary policy issues, they are issues that are far beyond my own limited understanding of urban economics!

          I am looking forward to some posts on that turning up at some point ;)

  • Pingback: Reader mailbag: LVR edition | The Dismal Science

  • Blair

    This makes more sense in political terms than in economic terms. Let’s say Graeme Wheeler suspects banks don’t hold enough equity, that Basel III was probably wrong in its risk-weighted asset matrix, and that most of our banking system is owned by a more powerful neighbour with financial stability issues of its own. Would you want to come out and say such things, with Allan Bollard’s seat still warm, and keeping in mind the person who hired you? Or would you make a number of changes at the margin that throw sand in the gears of the next credit-housing cycle? Politicians don’t generally pick bold thinkers for their central bank governors, sadly.

    • http://tvhe.co.nz/ Matt Nolan

      I’d state that my posts wasn’t so much about whether LVRs can be justified (which is what I believe you are commenting on), but the justification they are using for doing it!

      In this context, I am looking it in more institutional and political terms rather than strict economics – I am worried that a perspective that tells people “Wheeler’s comments suggest the test of success should be moderation in the rate of house price inflation.” (http://www.nzherald.co.nz/business/news/article.cfm?c_id=3&objectid=11112231) tend to imply things about central bank policy that is inappropriate.

      At best this suggests that the RBNZ is putting its independence in harms way. At worst, it implies that there are elements within the central bank who are interested in control a greater element of the economy than their mandate allows them to.

      In these terms, this is quite an interesting situation!

  • VMC
    • http://tvhe.co.nz/ Matt Nolan

      I’d say the articles complement more than substitute – my issue wasn’t with intervention per se, it was with the discussion of house prices and their use in “justifying” the intervention :)