I Don’t Think The Banks Realise What They’ve Just Acknowledged

New borrowers negotiating home loan terms over roughly two years are likely to pay more than 1.5 percentage points more for their mortgages annually if they have a deposit of less than 20 per cent, including a higher headline interest rate and an increased low-equity margin of 0.75 per cent.

They’ve told us that if your deposit is less than 20% they need to tack on 150 basis points to cover the risk of low equity mortgages.

When you add it to comments by Reserve Bank Governor Graeme Wheeler, who said last week floating mortgage rates could go to 8% by the end of next year, you have a problem for low equity buyers who aren’t fixing their interest rate.

Why? Because 800+150=950 or 9.5% per annum floating rate for low equity borrowers. That will change the affordability equation for a non-trivial proportion of low equity mortgage holders.

I hope all of these buyers are adjusting their Excel spreadsheets regularly to keep track of these things. Do home buying types even use Excel to model their personal finances over time? Bueller? Bueller?

Is The Reserve Bank On A Mission To Lose Its Independence?

The role of a central bank is to implement monetary policy. The role of a central bank is not to act as an arbiter of what credit allocation decisions are good and what credit allocation decisions are bad.

Matt Nolan has a very good overview of the issues around the level of discretion the Reserve Bank is claiming mandate for with respect to macro-prudential policy.

I’d point out that on top of the level of discretion the Reserve Bank is engaging in, the Basel III framework which includes provision for unexpected losses, is just as discretionary and distortionary when it comes to capital allocation decisions in the economy.

The idea that a bunch of officials can forecast market tops better than private industry is hilarious. If they could they’d be hired by hedge funds in the US straight out of graduate school and would never set foot in a central bank because the opportunity cost in terms of wealth accumulation would be too high.

Even though I’m still just an economics student, I follow the literature and blogosphere closely. I know that since the global financial crisis, a lot of the stuff the Reserve Bank talks about in its bulletins has been dealt to by private actors.

How so? Banks are only going to give large mortgages to large earners in stable careers. If you run a business or are self-employed, you are subject to credit rationing because banks have been burned so often. Although Rob Hosking is correct in saying that LVR restrictions will save some people from themselves, the unintended consequences of discretionary policy are where the real welfare losses lie.

At the heart of the housing affordability issue is that in 2008 a lot of banks prematurely pulled the plug on residential development funding that was plugging the supply and demand deficit in Auckland and other places around the country.

New Zealand is a poor country – someone on wages is unlikely to be able to save up enough capital to take a risk on a speculative property development so banks need to match up developers with loans. It’s risky – but it’s a societal benefit because without this activity, there would be no downwards pressure on house prices.

In the most cynical of analyses, I think the RBNZ could be pre-empting the possibility of a Labour / Greens / NZ First coalition government ripping up the already expanded memorandum of understanding and throwing in a whole lot of additional policy objectives for the RBNZ to achieve.

Are they on a mission to lose their independence? It sure seems that way. I’m not convinced that there is enough discussion about the trade-offs involved in making arbitrary decisions on what sort of lending is good and what sort of lending is bad.

In terms of efficiency, risk should be managed by those closest to the coalface. I think there has been a bit too much hysteria over the finance sector and not enough examination of how substantial changes in how they do business in light of their regulatory changes makes the Reserve Bank’s new clothes an awkward fit.

Tomorrow Graeme Wheeler Is Giving A Speech About Macro-Prudential Policy

Tomorrow Graeme Wheeler Is Giving A Speech About Macro-Prudential Policy.

Macro-prudential policy includes the high LVR speed limits I wrote about last week.

I wonder what Russel Norman will make of it? Apparently the release of the speech notes will be after 1400.

By the way, I think it’d be really cool if the Reserve Bank could upload more content to their YouTube channel.

Substituting reading a Reserve Bank document for watching a speech by a senior official would be lots of fun.

Monetary policy matters folks! We can’t let politicians like Russel Norman interfere with New Zealand’s Barro-Gordon compliant institutional arrangements by letting another government agency interfere in monetary policy decisions.


Why John Key Will Take Graeme Wheeler’s Independence Away

An independent central bank is better than a government micro-managed central bank.

If you disagree, have a read of the interesting things National Prime Minister Robert Muldoon did with wage and price controls.

Furthermore, the global financial crisis shows what happens when central bankers fold under pressure from politicians and big banks to “do something” in the form of quantitative easing.

Yes, many central bankers desperately wanted to bail out the global financial system, but a good number warned that no good would come of it, and they’ve been proven correct.

A jobless recovery around the world made easier because artificially low interest rates make borrowing for capital investment easier and thus replacing labour with robots is simply a profit maximising strategy for corporations.

Last year I was writing about how the Labour-Greens-NZ First troika could prove disastrous for the independence of the Reserve Bank of New Zealand.

But I clearly forgot that John Key is an interventionist just as much as Helen Clark ever was. It’s just that he intervenes in different areas of policy.

The issue of housing affordability is on track to become an election issue. If young couples can’t buy houses they are less likely to have kids, which means the demographic ponzi scheme paying for unproductive oldies to stay alive collapses forthwith.

They’re not special though, and don’t deserve special treatment like the first home subsidy – a perversion of Kiwisaver as a retirement savings scheme if there ever was one.

But on the other side of that same coin they don’t deserve another slap down in the form of higher loan-to-value restrictions.

This is because banks are unlikely to grant such loans – which run the risk of negative equity if house prices fall – to low income households.

In the aftermath of Basel III and other risk management changes in the banking sector, loan quality matters a lot more than it did before 2008.

If the Reserve Bank does want to put a speed limit on housing, they are completely ignoring the supply and demand story around housing services.

In fact, they are basically saying that static efficiency (one price for housing! no price changes! a price rise is not a signal but an indication of a bubble!) beats dynamic efficiency.

What they’re also doing is missing the wood from the trees – the reason house prices are going up so quickly is because it’s not only hard to build a house, it’s almost impossible to obtain financing for property development.

And what they’re also doing is forgetting that a lot of house deposits come from parents and grandparents.

Young people in aggregate suck at choosing profitable careers and saving – economic outpatient care is probably the key driver of the Auckland housing market.

How does this work? Well, if two sets of parents chip in tens of thousands of dollars each to the pittance scraped up by Jack & Jill then suddenly a mortgage can be approved.

John Key will foil the Reserve Bank Governor Graeme Wheeler on this issue because he knows that despite an independent central bank being an inherently good thing, his 3rd term in government is simply more important.


Graeme Wheeler, Currency Intervention And Mean Reversion

Reserve Bank governor Graeme Wheeler is giving a speech to the Institute of Directors in Auckland today. It is interesting to see how our central bank, which pioneered inflation targeting and has maintained a credible monetary policy for some time, rationalises its inability to successfully intervene in the foreign exchange market.

For example, the challenges faced by producers competing against foreign low-cost producers, or multinationals with global supply chains, increase when our exchange rate overshoots.  On the other hand, the high exchange rate makes imports of capital goods cheaper and may encourage the take up of capital intensive technologies.

How successfully have exporters “captured” the mind of the Reserve Bank? Remember, everyone benefits from imports, but the benefits from exports primarily accrue to asset rich farmers and closely held manufacturing firms that export high value products. Yes, they earn the foreign exchange we need, but it’s no different to working people turning up at the office to collect their salary – it’s essential but not where the value in the economy is added.

Among the developed market currencies, the Kiwi has been the third strongest performing currency against the US dollar (after the Mexican peso and Swedish krona) over the past 12 months.

There is a global reach for yield going on. The Reserve Bank can’t do anything about it through playing with the Official Cash Rate. Imposing loan-to-value restrictions in the housing market are unlikely to have much effect on housing demand and will funnily enough make increasing the housing supply more difficult for people wanting to build on greenfield subdivisions on the outskirts of Auckland.

Our past exchange rate cycles have exhibited substantial overshooting followed by a sharp and rapid exchange rate depreciation.  Such rapid exchange rate corrections reflect the drain in market liquidity that can occur when a small market like New Zealand begins to turn down.

This happened in 2008 after the global financial crisis began in earnest after the collapse of Lehman Brothers. Since quantitative easing began, volatility in risky assets like those denominated in NZD has increased alongside their price – there is a global reach for yield that necessitates investors who don’t want to earn 1% buying foreign bonds like those on offer in New Zealand where yields range from 3% to 6% on bonds and equities that pay dividends.

The Federal Reserve is currently buying USD85 billion per month in assets. They are on track to have a balance sheet that is 25% of US GDP by the end of 2014 at this rate. If they taper off, there is the risk that interest rates will rise fast and high losses will be imposed on bondholders and equity holders alike.

In assessing whether to intervene in the exchange market, we apply four criteria. These are whether the exchange rate is at an exceptional level, whether its level is justifiable, whether intervention would be consistent with monetary policy, and whether market conditions are conducive to intervention having an impact. This last factor is especially important given the volume of trading in the Kiwi.  (In the most recent survey – April 2010 – by the Bank for International Settlements, the Kiwi was the tenth most traded currency in the world with daily turnover of spot and forward exchange transactions totalling around USD $27 billion.)

How do you define justifiable? The Reserve Bank’s intervention justifications are ridiculously broad. 4.4 million people against 44,000 farmers. In terms of societal welfare, in the age of the Apple gadget, all that matters is the price of imports. Hardly anything we actually want to spend money on is made here so now that we’ve made our bed (through not supporting NZ manufacturing at the point of sale, revealed preference people) the RBNZ can’t suddenly “fix things” for the tradable sector through selective intervention.

But we are also realistic in respect of potential outcomes given the strength of the foreign demand for the New Zealand dollar relative to the scale of our intervention capacity.  We can only hope to smooth the peaks off the exchange rate and diminish investor perceptions that the New Zealand dollar is a one-way bet, rather than attempt to influence the trend level of the Kiwi.  But we are prepared to scale up our foreign exchange activities if we see opportunities to have greater influence.

Careful, here be dragons. The list of central bank failures in currency intervention are legion. We have to realise that there is nothing inherently wrong with currency speculation. It’s a free market in currencies for the most part and the NZD is extremely liquid.

The Reserve Bank is basically saying that spending hundreds of millions of dollars or even billions of dollars to give people the appearance that they are doing something is better and more welfare-enhancing than simply realising they are powerless and letting the market work its way to a “fairly valued” exchange rate.

There is some extremely risky thinking going on here. The Reserve Bank are thinking like Long Term Capital Management, you know, the US hedge fund that employed a trading strategy that used mathematics to prove that the market was wrong and through buying long/selling short they’d profit from the market price of whatever they were speculating in as it reverted to the mean.

This is hilarious stuff – just because a financial asset (the NZD) has an historical mean does not mean one iota that it will revert to it at all! Every day is a new day, and it the age of global central bank intervention driving financial markets, there is a high risk of the RBNZ being on the wrong side of the trade with taxpayer money at risk.

How did Long Term Capital Management work out? Oh, it got bailed out. But the guys behind it still rationalise their trades! To paraphrase Keynes, the market can remain irrational longer than you can remain solvent or take advantage of a central bank bailout to keep carrying a losing trade.

Our society has made a lot of collective decisions over the past 20 years that have led up to this point. We abandoned a compulsory super scheme that could have led to the NZ Super Fund being the size of Temasek, we spent more than we earned while simultaneously wasting money on unproductive housing investments and ignored the risks of betting the farm on the farm.

The Reserve Bank and the exporting community may not like the “high” NZD but that’s the price. That’s the price we pay for having a reasonably non-crazy fiscal response to the global financial crisis, reasonable institutions and tax policy and reasonable levels of regulation relative to other countries.

It’s not because New Zealand is amazing, it is because we suck less on a relative basis to other OECD countries where people could park their hot money capital. We might as well enjoy it while we can with cheap stuff from ASOS. The NZD will not revert to the mean – next week 10 billion barrels of oil might be found off the East Coast – we don’t know, therefore risking taxpayer money on the NZD short trade is bad business for “NZ Inc”.

Bernard Hickey Is Wrong About Market Reaction

In the Herald over the weekend, Bernard Hickey argued that because Labour, NZ First and the Greens have realised the importance of monetary policy and its relationship to key macroeconomic variables, they will undermine how the Reserve Bank conducts monetary policy.

The problem with our system is that we think that all opinions are equal. The intellectual deficits present in Labour, NZ First and the Greens have been truly exposed with their calls for kooky ideas that are completely unjustified and have been proven in the real world to cause terrible side effects. Arguing for exchange rate intervention is an example of the stupidity we could expect if politicians had more influence on how monetary policy operates.

I am pleased that Graeme Wheeler has made it clear what job goals as Reserve Bank governor is – using inflation targeting as the monetary policy tool of the day and eschewing calls to intervene in the exchange rate and monetise government debt. Complaining that the Reserve Bank doesn’t make decisions by committee is childish in the extreme. Almost every other central bank in the world is worse than the RBNZ. They are extremely credible and a central reason for that is their strict adherence to their statutory mandate in the Reserve Bank Act.

There is no doubt that monetary policy is linked to our housing bubble in the 2000’s and a resurgent housing market. But to adjust monetary policy now by adding slippery targets on unemployment numbers, what the exchange rate should be and how much house prices should be defeats the entire purpose of having a reasonably independent central bank. Gareth Morgan’s comments that they should all be fired for incompetence are so far off the mark it’s not even funny.

With respect to housing, while increased M3 has enabled banks to lend more on housing, that’s them simply responding to incentives. There is an enormous demand for housing loans, there are severe supply restrictions on housing and loan-to-value ratios are not regulated so poor people who have no business buying a house easily qualify for 95% mortgages.

Did we not learn anything from the sub-prime debacle in the United States? One of the key drivers behind lax regulation around new mortgage lending was the “housing affordability” and “owning a home makes you a real American” nonsense. Just because many people can’t afford to buy a house doesn’t mean that the OCR should be lowered to stimulate more investment in housing. A lot of that extra credit will sit on bank balance sheets for their own risk-free carry trades.

If the markets really were spooked about the possibility of Graeme Wheeler having the Policy Targets Agreement rewritten by a troika of populist politicians, they would be pricing that risk in now. The 3 year bond rate would have spiked some time after October 26 and the drama-filled select committee meeting. Using the data at Interest.co.nz we see that since the 26 October speech by Graeme Wheeler the change in bond rates has been negligible. And here’s a nicer chart from Westpac that fits out time frame just nicely:

The risk premium for New Zealand debt has barely changed either. So what gives? If there was any likelihood of economic kooks coming to power, that risk premium would have shot up. So would the price of NZ government debt CDS swaps. If expectations were that the exchange rate would be lower then that would be reflected in the March 2014 NZD/USD futures. They’ve barely dropped a cent over the past month.

Non-residents own about $28 billion of the $72 billion of government debt on issue. If what Bernard Hickey is saying was credible – the risk of lower yields in future – why was there no rapid capital flight? We have extremely free movement of capital these days and if overseas institutions wanted to they could drop billions of dollars in NZ government debt in an afternoon.

The truth is that if market participants were thinking like Bernard Hickey, there are about 4-5 different things they would have done to lower the risk of any changes in monetary policy impacting on the capital they have invested in New Zealand.

Bernard’s column is sadly unique in that no one actually thinks Labour, NZ First and the Greens will get anywhere near destroying the independence of the Reserve Bank. In not arguing that the policy changes Labour, NZ First and Greens are proposing fall into the category of kooky economics, he is ignoring the reality that quantitative easing reinforces inequality, makes housing affordability even worse and lowers real money balances.

If the market starts pricing in the possibility of kook monetary policy being implemented, I’ll revise my opinion. Needless to say I’ll be watching the yield curve and forward exchange rate numbers with interest.



Are Jobless Recoveries The New Norm?

This week at Vox EU an interesting piece by Henry Siu & Nir Jaimovich argues that jobless recoveries, at least in the United States, are the new norm. It’s called “Jobless recoveries and the disappearance of routine occupations“.

They talk about job polarisation where there is an increasing division between high skill and low skill jobs, with the “middle” jobs that are routine and can be automated or mechanised are no longer needed. The reduced reliance on labour-intensive production methods in manufacturing and increased reliance on software and robots to perform routine tasks is an example of this trend.

To examine this against they data they constructed a counterfactual scenario – if routine employment rebounded after a recession the same way as it did before job polarisation started happening, what would total employment look like?

In the 2001 recession:

For the global financial crisis:

They conclude:

The loss of routine jobs in recent recessions has given rise to jobless recoveries. Aggregate employment struggles to rebound following recessions since middle-wage, routine occupations no longer recover. Moreover, employment growth following recent recessions has been unevenly distributed across pay, concentrated in high- and low-wage occupations. A recent report by the National Employment Law Project (2012) indicates that the recovery from the Great Recession has been particularly lopsided, with the majority of jobs added being low-paying jobs.

What does this mean for New Zealand’s unemployment crisis? If the US situation applies to New Zealand then we should be very concerned indeed. We already suffer from low levels of labour productivity and rising labour costs. More flexible hiring practises including the 90 day trial period have not made any difference in net job creation.

It means that we need to think careful when thinking about who is unemployed. Are they unemployed for cyclical reasons – because their employers failed due to lower demand for the goods and services they produced? Or are they unemployed because their job is no longer needed or they no longer have the skills necessary to perform a similar job in the same industry?

If the structural changes in the labour market are not addressed promptly, hysteresis will set in and the long-term unemployed from the past few years will be permanently locked out of the labour market. The urgency of addressing this problem is clear – if workers aren’t supported through the retraining and adding skills process they will not be able to participate in any recovery in the labour market.