One of the risks for the Reserve Bank is that people will see LVR curbs as a substitute for higher interest rates

Now that we know what the Reserve Bank is doing by way of curbs on low-deposit mortgage lending the question is whether it will work.

The answer depends on what the policy is intended to achieve and how we are supposed to tell whether it is doing the trick.

"Our main concern is the rate at which house prices are increasing and the potential risks this poses to the financial system and the broader economy," governor Graeme Wheeler said when announcing the policy on Tuesday.

"Rapidly increasing house prices increase the likelihood and the potential impact of a significant fall in house prices at some point in the future. This is particularly the case in a market that is already widely considered to be overvalued."


But does that mean the object of the exercise is to strengthen the resilience of bank balance sheets so that they are less vulnerable to some future shock to the incomes out of which mortgages have to be paid?

It is not hard to imagine such a shock. What if, God forbid, babies were dying from consuming New Zealand milk powder, or last week's earthquake was on the same scale as Christchurch's? The economic outlook would be a lot darker than the relatively cheerful one we currently have.

Or is it about protecting households from debt-peddling bankers and the risk of finding themselves with mortgage debt that exceeds the value of their homes and needing to slash their spending to pay down debt?

In other words is it about protecting banks from the economy, or vice versa, or both?

Wheeler's comments suggest the test of success should be moderation in the rate of house price inflation.

There are some tentative signs of that already.

Jonno Ingerson, research director of PropertyIQ, which crunches the numbers for Quotable Value, says that over the past three months in a majority (15) of the 27 suburbs they divide the Auckland market into house prices either fell or went sideways. However, he also points out that on an annual basis most of the Super City has double-digit house price inflation, listings are low (between 1 and 2 per cent of the housing stock), building consents while rising are low by historical standards and the net migration flow has turned positive and is climbing.

In the two previous cycles annual house price inflation in the greater Auckland area hit 25 per cent, Ingerson says. "Auckland may have much further to go."


The restrictions on high loan-to-value ratio (LVR) lending represent a significant tightening of the availability of credit to the housing market, reducing such loans from around 30 per cent of new lending recently to less than 15 per cent.

But that begs the question of whether credit growth has been driving house price inflation or the other way around.

Bank of New Zealand head of research Stephen Toplis believes it is the latter.

In the year ended June 2013 the stock of residential mortgage debt rose 5.4 per cent.

"This was the strongest rate of increase since October 2008 but miles away from the pace of growth seen in previous housing booms," he says.

But credit growth is slower than growth in sales activity and house prices at the moment, Toplis says, reflecting the fact that much of the activity is being funded by past increases in savings or by insurance payments in the case of Christchurch.

If he is right, then the risk is that the Reserve Bank is applying the brakes only to the axle that is not connected to the engine. Westpac economist Michael Gordon argues that beyond an initial "sticker shock", the long-term effect on the housing cycle will be limited.

Restricting the number of high-LVR loans will shut some potential buyers out of the market, unless they can put together a larger deposit.

"This means that less-leveraged buyers are more likely to be the successful bidders and they will set the benchmark as to where house prices will gravitate."

But banks are likely to compete more vigorously for the pool of low-LVR borrowers, those with deposits of 20 per cent or more, which could keep borrowing costs for that group lower than they would otherwise be.

"This means that for those who can stump up a deposit of 20 per cent or more, their willingness to pay [for a house] may actually increase as a result of LVR restrictions," Gordon says.

ANZ's chief economist, Cameron Bagrie, says the international evidence on LVR restrictions is mixed but generally points to success in slowing credit growth and house price appreciation.

But he reminds us that the Reserve Bank has already increased the amount of capital banks are required to hold for high-LVR mortgage lending, with effect from the end of next month.

This mean that banks are more likely to add an interest rate margin to low-equity loans. "So not only is credit being rationed, but the price of it is also moving up, in the high-LVR space."

And Bagrie agrees that one of the side-effects could be that banks become more aggressive in competing for high-equity borrowers.

One of the biggest risks the Reserve Bank is running is that people will see the LVR restrictions as a substitute for higher interest rates.

The risk is that home buyers will discount or underestimate the extent to which interest rates are going to rise and the impact that will have on their mortgage payments.

Market pricing implies an official cash rate around 125 basis points higher by the end of next year, which would increase the mortgage bill of someone with a floating mortgage by at least a fifth.

By saying that the LVR restrictions will give him more flexibility about the timing and magnitude of any future increases in the OCR, Wheeler may be signalling to the financial markets that they are being too aggressive in pushing up wholesale interest rates. But he risks reinforcing a false sense of security among home buyers, born of several years now of mortgage rates at multi-decade lows.

After all, headline inflation is only low because the dollar is high. It will only stay so low if the exchange rate continues to climb.

Non-tradable or domestic inflation is running at around 2.5 per cent and inflation expectations two years out have just jumped 30 points to 2.36 per cent.

We may not know how to judge the effectiveness of the LVR policy but we do know how to judge monetary policy.

And figures like those herald higher interest rates ahead.