But buyers are vulnerable to income shifts
Exuberance, if it continues, could contribute to a more pronounced housing cycle, adding to risks that the housing market has further to fall if it eventually turns. This risk is accentuated to the extent that buyers who are entering the market have high debt-to-income ratios, making them more vulnerable to income strains.
Income strains are a typical pressure point for the housing market in a recession. Good equity positions (low LVRs) make it less likely that homeowners will go into negative equity if house prices fall.
But if someone’s income dries up, then they may not be able to service their mortgage, no matter how low mortgage rates might seem right now. In the extreme, this can lead to significant financial hardship, fire sales and nasty feedback loops between house prices, spending and credit supply.
House prices and household debt levels are already very high in New Zealand, making the market vulnerable to a disorderly correction at some point. This isn’t a new risk by any means, but an outright housing boom in a recession would certainly up the ante.
Housing affordability is a serious social and economic problem in New Zealand that requires some mix of lower prices and/or enormously higher incomes to resolve.
Seeing prices drift lower as a result of more supply, weaker population pressures or adjusting regulation would be socially desirable, even if it would come at a cost to existing homeowners. But triggering a demand-choking painful correction in house prices would most certainly not be a win.
To be clear, it is not our expectation that such a painful correction in house prices will occur, but the risk is there, and increased speculative behaviour that could expose borrowers to income strains adds to it.
We question the sustainability of the upturn
Unemployment looks set to rise, even if by less than previously expected, and some households will face more challenging times ahead. As such, we are becoming concerned that the housing market appears to be increasingly moving out of step with fundamentals, like rents and incomes – particularly given our expectations for where those fundamentals are headed.
Looking forward, we expect that the economic recovery will stagnate, that closed border impacts will become more evident, and that income strains will increase – and ripple well beyond low-income earners. It is our view that these effects will see some wobbles emerging in the housing market as we enter 2021, even as mortgage rates move lower. Our current assumption is that we see another strong quarter to finish the year, but that house prices will fall 4% next year, before recovering. This is a smaller, later fall than our previous forecasts.
Of course, the outlook is highly uncertain and the strength in the housing market to date has surprised us. It is possible that further declines in mortgage rates have a more potent effect than we assume and the housing party goes on longer. But there is also the possibility that increased income strains, reduced population pressures, and a shift in expectations lead to a more abrupt adjustment in house prices than incorporated in our central forecast. Policymakers will be cognisant of the risks on both sides.
Financial stability in the spotlight
Recent signs that financial stability risks might be creeping higher will see macro-prudential and broader housing policy increasingly in the spotlight, if those trends continue.
Interest rates are not the right tool to address financial stability risks; prudential tools are. “Leaning against the wind” (keeping interest rates a little higher than otherwise on financial stability grounds) has been shown to lead to suboptimal societal outcomes. The housing market is one of the (many) channels that monetary policy works through, but longer-term trends in house prices tend to be largely outside the control of central banks.
That’s not the same thing as saying there is nothing to worry about, though. Increasingly, we are moving to a world where “big bang” monetary stimulus at the onset of the crisis needs to be replaced by a more nuanced approach, with the case for ever-increasing stimulus becoming less clear, especially with impacts and risks associated with new unconventional tools unknown.
We think more stimulus will be deemed necessary by the RBNZ, in the form of an FLP and then negative OCR. But at some point, adding more stimulus could boost the housing market more than is necessary for monetary policy objectives to be achieved. A considered, gradual approach is likely to be increasingly required as the recovery progresses, with scope to pause and see how the economy is tracking.
The best policy at the RBNZ’s disposal for addressing financial stability concerns is prudential policy. Micro-prudential policy relates to the solvency and liquidity requirements faced by banks to ensure they can cope with unexpected shocks. On this score, New Zealand banks have excellent buffers to weather any storm and protect the interests of both shareholders and depositors.
RBNZ’s proposals to increase capital requirements still further in July next year would mean the banks would have even more “skin in the game”, but it could come at a cost by increasing the price of credit, or curbing its availability, at a time when a fragile recovery is still in infancy. In that respect, it’s not the case that bigger system buffers are always better, and timing broad changes carefully is very important.
Macro-prudential policy provides an extra overlay to the micro-prudential framework by responding to financial stability risks in a more cyclical or targeted fashion, such as responding to an increase in risky lending that might lead to an unhelpfully pronounced house price cycle. The RBNZ has a number of these tools currently at its disposal, including LVR restrictions, countercyclical capital tools, and adjustments to the core funding ratio.
At the start of the COVID-19 crisis the RBNZ relaxed some of its counter-cyclical tools, loosening the core funding ratio and suspending LVR restrictions for a year. The aim was to protect against a tightening in credit supply and that appears to have been successfully avoided. But at the time the RBNZ was anticipating marked falls in house prices and activity. Now with signs of a “frothy” dynamic emerging in the market, albeit in its infancy, the RBNZ will be alert to evolving risks and may respond with a macro-prudential overlay.
If wobbles in the housing market emerge next year as we expect, then the RBNZ would be more likely keep LVR settings as they are to ensure that credit keeps flowing, since downturns in the market are typically accompanied by increased caution on the part of both lenders and borrowers.
But if the market continues to run hot and macro-prudential policy is deemed necessary, the obvious response would be to reinstate LVR restrictions. Responding with broader tools, like the counter-cyclical capital buffer, could risk choking non-housing lending though, so not all macro-prudential policy options would be deemed appropriate.
The RBNZ plans to review whether to reinstate LVR restrictions in March next year. The case would be particularly clear if there was a surge in low-deposit lending between now and then.
But implementing LVRs isn’t the only option, and it may not be effective or indeed the best response. High debt-to-income ratios (like high LVRs) can be a significant source of vulnerability in a downturn, and risks tentatively appear to be building in this area.
The RBNZ does not currently have a mandate to implement debt-to-income (DTI) restrictions, but its macro-prudential policy powers are currently under review as part of The Reserve Bank Act Review.
A case could be made for expanding the RBNZ’s powers to include these sorts of tools should they be required in the future, even if they are not needed any time soon. But it’s political, because DTIs make it harder for first home buyers to get on the ladder.
Broader policies are also needed to address our long-term housing affordability challenge, like adjustments to regulations limiting land supply and building, and ensuring that population flows are sustainable (once the border opens) given limited home building capacity and infrastructure. Such policies can help from a financial stability perspective too.
Lack of responsiveness of housing supply and huge swings in population can lead to house prices becoming unaffordable, but can also lead to more exaggerated house price cycles overall. There are no easy answers, but doing nothing isn’t a solution either.