Brian Fallow: Reserve Bank revs up house prices

In much of the country house prices are already so high they are practically snow-capped. Photo / File

COMMENT:

So the Reserve Bank is happy to reignite house price inflation because the cost of living is not rising fast enough for it.

What is wrong with this picture?

In one sense, nothing. One of the standard mechanisms by which lowering the policy interest rate boosts economic activity and ultimately prices is through the wealth effect.

Lower mortgage rates mean home buyers feel able to bid a higher amount for a property, pushing up prices. Existing homeowners then feel richer and are willing to spend some of that increased wealth, boosting consumption over and above what their disposable incomes would cover.

The wealth effect might only amount to about 3c in the dollar of the increase in wealth, but when the housing stock is worth something like $900 billion, half as much again as it was five years ago, the effect on consumption is not to be sneezed at.

But it has waned. The Real Estate Institute's house price index for the country as a whole has recorded a compound annual growth rate of 8.2 per cent a year over the past five years but only 3.9 per cent in the past year, reflecting a flattening of house prices in Auckland.

The Reserve Bank's monetary policy statement (MPS) last week says low house price inflation over the past two years has slowed housing wealth accumulation, dampening consumption growth. "However a recent lift in house price inflation is expected to support household spending in coming quarters."

Indeed, it is explicit that one of the ways it expects the 75 basis points of official cash rate cuts it has dispensed since May to boost household spending — and help lift inflation towards the 2 per cent mid-point of its target band — is through a pick-up in house price inflation.

The problem with this is that in much of the country house prices are already so high they are practically snow-capped.

For households with a mortgage, average debt is 3.22 times disposable income, at least it was back in May. We will get an updated number in next week's financial stability report from the Reserve Bank. Twenty years ago it was 1.88 times income.

Reserve Bank Governor Adrian Orr. Photo / File

Relative to the size of the economy, household debt is also high by international standards. It is equivalent to 94 per cent of gross domestic product when the average for advanced economies is 72 per cent, according to the Bank for International Settlements which compiles such data.

We are also internationally conspicuous in having a chronically negative household saving rate. Households collectively consume more than their disposable income — $566 million more in the year ended March. The saving rate has been negative for the past five years and 19 of the past 25 years.

But while it may be normal for us, it is distinctly abnormal for a developed country. We languish in the low end of the OECD's league table on this measure, along with Greece, Latvia, Lithuania and Portugal — not perhaps the peer group we aspire to.

So the question arises, how does the Reserve Bank reconcile its reliance on house price inflation and the wealth effect to rev up consumption and ultimately consumer price inflation, with its other main responsibility as the guardian of financial stability?

The monetary policy committee's remit requires it to "have regard to" the soundness of the financial system when pursuing its objectives of price stability and maximum sustainable employment.

Asked about this last week, governor Adrian Orr acknowledged that house prices and the wealth effect are an important channel for delivering stimulus to the economy — but not the only one.

"This is not a one-pony show," he said, citing in particular the stimulatory level of the exchange rate and a low hurdle rate for investment by businesses and the Government.

As for the negative side effects of monetary easing on household debt levels and saving rates, the bank has other tools at its disposal, Orr said, in particular macro-prudential instruments like loan-to-value ratio (LVR) curbs, and the capital requirements for banks. We will hear more about the former next Wednesday and the latter on December 5.

The bank also argues that using the official cash rate to lean against a slowdown in economic activity is itself helpful for financial stability.

The OCR is a blunt tool, Orr said, but he is confident a lower OCR will provide an impetus to spending and investment. After all, there are more borrowers than savers and debt levels are higher than the level of savings.

Lower mortgage rates mean home buyers feel able to bid a higher amount for a property, pushing up prices. Photo / File

The bank in its MPS argues that the neutral level of the OCR (one that is neither stimulatory nor contractionary) has trended lower since the global financial crisis, from around 5 per cent to around 3 per cent (albeit with a wide error margin around such estimates). Given that decline in the neutral rate, not to have lowered the OCR would have had detrimental consequences for the real economy and threatened financial stability, it says.

"However, sustained low interest rates have contributed to vulnerabilities in the financial system building up over time," it says.

"The right level of the OCR depends on a number of factors including how we expect OCR changes to transmit to the economy and how hard we push to return inflation back to its target."

The bank interprets the requirement to take account of financial system soundness when setting monetary policy "to mean that we can adjust how much we pursue our primary objectives [inflation and employment] if there would be material consequences for financial stability."

But it is wary of setting a higher OCR to lean against financial stability risks if that were to make it more likely to undershoot its inflation and employment targets and that in turn caused inflation expectations to fall. "This would make it even harder to achieve our primary objectives, and at a greater cost to financial stability." So okay, it is a tricky balance to get right.

But as the central bankers wrestle with this dilemma, how much sympathy can they expect, from mortgagors up to their nostrils in debt, from young couples despairing of ever owning a home of their own, or from depositors looking at nil or negative returns after tax and inflation?

Not too much, I think.