Macro-Prudential Decision Framework

From the latest Reserve Bank Bulletin. There are many subjective assessments of the factual situation at hand in this diagram. I think 2013 marked the beginning of the end for inflation targeting in New Zealand. Even if Labour/Greens don’t win the election, the median voter first home buyer now thinks of the Reserve Bank as the government agency that stopped them from buying their first home with LVR restrictions.

The precious snowflakes of my generation don’t like being told no, and will now be ripe for the picking as the election looms – promises of affordable housing would have nothing on any major party campaigning on “forcing the Reserve Bank to consider ordinary Kiwis” or other nebulous feel good nonsense.

Despite the success of inflation targeting and the low levels of inflation we see now, I’m worried that we’ll look back to this year and mark it as the start of a new chapter in independent monetary policy that ends up looking like a complete rollback to the 1970’s.

Diminishing Marginal Returns To LVR Restrictions

This paper from the RBNZ on the potential impact of LVR restrictions is interesting.

The net effect of this is that credit growth is expected to be about $3.2 billion lower over the first year that LVR restrictions are in place. This would lower annual housing credit growth by 1.7 percentage points in the first year. The longer LVR restrictions are in place, the more likely it is that borrowers would be able to find alternative sources of funding and alternative buyers would enter the market. As a result, we expect that LVR restrictions would have a diminishing effect on credit growth after the first year.

While I think that loan to value restrictions are basically saving young dreamers from negative equity and restricted options in the labour market (can’t move for higher wages if you’re stuck with a mortgage), the Reserve Bank is putting its independence at risk.

Nothing is more sacred in New Zealand than the home ownership cow. It’s even more sacred than dairy cows themselves, and that’s saying something considering the handouts dairy farmers get to help their capital gains farming.

Thus, as the election comes closer, I would not be surprised if there was a bipartisan consensus on a raft of further exemptions for “struggling young first home buyers” without any consideration of how stupid the obsession with home ownership is.

It’s almost as if politicians didn’t learn anything from the Global Financial Crisis, the sub-prime mortgage market and what happens when you start giving exemptions and subsidies and special treatment to facilitate a policy outcome that has fuzzy outcomes attached.

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?

Citi’s William Buiter On Central Bank Forward Guidance

Here is a long note from Citi’s William Buiter on central bank forward guidance. It is a good overview of how forward guidance can be “cheap talk” and in order for markets to take central banks seriously, contingent changes to monetary policy (like inflation or unemployment at certain thresholds) are the only serious option.

The best approach to signaling longer-term policy intentions in an operational manner typically has three components.

First, commit to the regular publication and updating of longer-term forecasts of the target variables, of any additional nominal or real thresholds, knockouts or triggers that define the central bank’s reaction function for each of its instruments, and of the instruments themselves.

Second, reach an agreement that at most one member of the monetary policy making committee, presumably its chair, speaks or writes publicly about the likely future paths of the policy instruments – rates, QE, or whatever. The other members can of course still discourse in public about the principles of monetary policy and the history of central banking.

Third, give the central bank skin in the game by requiring it to issue or purchase material amounts of financial instruments on which it will lose money if interest rates depart from the forward guidance-consistent levels – financial hostage instruments. If possible, link the pay of the monetary policy makers at least in part to the performance of these instruments.

Hat tip to FT Alphaville who wrote about this yesterday.

It is interesting that despite Buiter thinking that policy rate changes by committee is a good idea, he still thinks that only one person – the chair or governor should be communicating this stuff.

The US Federal Reserve has a whole lot of people making public comments – all of the regional governors for example – and I’m not sure that’s optimal.

Different Federal Reserve Banks have different ways of looking at the world, and if market participants can cherry pick forward guidance from who they like on the Board of Governors that’s problematic.

With respect to the hostage instruments he talks about, I don’t think that’s appropriate. The people best equipped to deal with these sorts of strategies are on trading desks, not on the capped salaries of the public sector.

It would be far too much to expect there to not be significant losses on the learning curve of those sorts of policies, in the vein of massive foreign exchange market intervention losses that have occurred in the past when countries tried to defend fixed exchange rates and went broke.

I think New Zealand is doing OCR changes the right way – the buck stops with the Governor and he is also the person who fronts the press conferences. It’s a shame they’re anointing themselves as arbiters of what loans are good and what loans are bad though.


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.

Leave The Reserve Bank Act Alone David Cunliffe

Now that David Cunliffe is leader of the Labour Party, a defence of the Reserve Bank Act has to be mounted.

Inflation targeting has worked, price stability is a whole order of magnitude better than it was pre-inflation targeting and our central bank is remarkably transparent.

I am skeptical over the introduction of macro-prudential tools. They require Reserve Bank officials to make judgments about where we are in a business cycle. That’s risky business.

But I am definitely against a rewrite of the Reserve Bank Act. When you make wholesale changes to something that has been working exactly as intended, there will be unforeseeable consequences.

David Cunliffe has been a key driver of the left wing derp on monetary policy, he is almost as bad as Russel Norman and that’s saying something.

Leave the Reserve Bank Act out of your policy proposals Mr Cunliffe. Monetary policy is not some plaything with which to achieve objectives better left to fiscal and regulatory policy if you so choose and the electorate votes you in.

Reserve Bank Responds To Submissions On LVR Speed Limits

Today the Reserve Bank released their response to submissions on the LVR speed limit “macroprudential tool” they intend to implement to curb what they see as risky lending.

If you want to know the full story read the long document over at the RBNZ.

Key Points:

  • There were only 20 submissions, mainly from banks. Interestingly, small banks with an average of $100M / month in residential mortgage lending over a rolling 3 month won’t face speed limit
  • The RBNZ will restrict the proportion of high LVR lending as opposed to high LVR lending itself – presumably in recognition of the reality that many high LVR mortgages will be to very high earning couples
  • There will be a transition period because some banks think they’d breach the rules even if they stopped all high LVR mortgage approvals tomorrow
  • There will be an anti-avoidance rule so banks can’t get around the speed limit – the detail can be found in section 7 of the updated BS19 document (Framework for restrictions on high-LVR residential mortgage lending)
  • It will take time for banks to process their backlog of pre-approvals if the speed limit is applied and time for them to forecast high LVR loan flow to stay under the limit
  •  Disintermediation risk is acknowledged – people topping up deposits with credit cards or using multiple second tier loans to resemble a traditional residential mortgage – banks could be hit by anti-avoidance provisions if they try to get around restrictions

There is a lot of stuff that still needs to be worked out by the Reserve Bank and the banking sector. If we think about what the Reserve Bank is trying to achieve – dampening what it sees as risky lending in the housing sector – and then we think about what the government is trying to achieve – every special snowflake moaner being able to afford a house – I have to wonder why, in the light of how Basel III has already impacted the lending that actually matters to growing the economy i.e. commercial and agricultural lending – why they don’t save the expense and complications of this scheme with something simpler?

Reserve Bank On Exchange Rate Volatility And Real Exchange Rate Drivers

This came out a month ago, but this analytical note “New Zealand’s short- and medium-term real exchange rate volatility: drivers and policy implications” is worth a read if you want a solid overview of how the Reserve Bank is thinking about exchange rate volatility.



The macroeconomic balance view of the exchange rate offers a way to interpret exchange rate developments, by identifying a level of the exchange rate that would be consistent with definitions of internal balance (for example, output being at potential or unemployment at its equilibrium rate) and external balance (the current account balance being consistent with convergence to a sustainable long run net foreign debt position).

And that is the hard stuff right there. Intervening without consideration of the trade-off the RBNZ is imposing on the entire economy could be quite horrible. High real exchange rates are a reasonable indicator of healthy investment opportunities in the home country and the ability to obtain goods from overseas at a cheaper price.

This graph is an interesting result of some econometrics work:



As an interesting reminder of why real exchange rates matter, I’d point you to a good IMF article. While real exchange rates do matter, it has to be said that as long as New Zealand government and New Zealand firms can borrow overseas, we’re all good.

Real Estate Agent John Key Tells Local Government They Suck (If Only)

Prominent real estate agent John Key said the central government has to manage its finances carefully. He didn’t point out that local government can’t manage its finances carefully. If only he’d told them local governments around the country suck.

Sensible government is being destroyed. By turning KiwiSaver into HouseSaver and undermining the independence of the Reserve Bank through soundbite sparring, John Key is putting the economic recovery at risk.

Our economy grew 2.4% last year and is on track for similar growth, he told attendees. We know DSGE models are dangerous territory. We have no idea what economic growth will be, despite Treasury projecting out public finances for decades.

He didn’t talk about how GDP rising because of the Christchurch rebuild isn’t really economic growth, but simply replacing what was already there before. The broken window fallacy is a key driver of the economic recovery plan.

He was talking to a bunch of town clerks who’ve rebranded as “Chief Executives” and bumped their compensation packages to include comparison with NZX executives.

At no point was there any discussion of how town clerks are underperforming relative to NZX executives and how their supervisors – hapless councillors all round – are just as powerless as MPs.

There was an opportunity for John Key to point out how councils are spending way too much money on pet projects and over-inflated salaries for “make work” roles. But he didn’t bring it up because he already knows that the grey ones have the power.

“Better Local Government” is an oxymoron. All the reforms are for nothing if a town clerk can make $550,000 a year while spending more on wages than it earns in rates.

The RMA will be reformed, but not in a way that will change the billing opportunities for RMA consultants and lawyers. John Key didn’t discuss how some property developers have exited the market – a negative supply side shock – because of the RMA and decimation of lenders who had some gumption to lend.

The Productivity Symposium recently included a good presentation on construction productivity. Booking inspections is one of the biggest problems. It’s a bottleneck around the country, one of the real culprits for housing affordability.

Home buyers don’t want pre-fab anything and we’re a decade behind on trades training so most of the productivity improvements have to come from local and central government.

The need for special housing areas where the government agrees with a local council to make consents easier is an indication of how far gone local government is.

Simply inform councils that consent processing times have to drop lest they get a “Local Government Manager” installed like Environment Canterbury. They’ve had a decade to sort it out since the Local Government Act reforms.

It’s not like democracy in local government matters anyway – just look at how few people vote in Local Body elections! You made the best case against democracy in local government in your speech Prime Minister.

The “39,000 new homes over the next 3 years” target for Auckland house construction is pathetic. If you read the recent NZ Initiative report on housing affordability, you’d realise that hundreds of thousands of houses will need to be built over the next decade to make up for lower construction levels and population growth.

It is disappointing that in his discussion of the Reserve Bank having to raise interest rates, he seems to think the consequences of a rising Kiwi dollar and hurt exporters are bad. Is John Key really an NZ Inc evangelist when he had a career in the foreign exchange markets? Does he think “exporting stuff” is better than exporting services?

He also ignores the idea that demand for housing can come from better job opportunities, immigration and a completely different way that couples form households in 21st century New Zealand. A rapid price rise is a signal most of the time. Bubbles are rare, but bubble stories make more sense and get more reader attention.

He does support the independence of the Reserve Bank, but his Housing Minister is undermining the loan-to-value restrictions with potential changes to Kiwisaver first home subsidy rules and he’s having an effect on markets.

He dedicates more time in his speech to discussing the cycle trail. If there was ever an example of how local government can “get stuff done” on pet projects like that, whilst ignoring rising wage bills, rates and permission fees, the cycle trail is a sad reminder of what happens when you don’t take a blade to the permanent government every so often.

Local government sucks really bad at almost everything it does with respect to making it easier to build houses. Real estate agent John Key missed the opportunity to call them out at their “we’re so wonderful, pat me on the back please” conference.


Why The Reserve Bank Should Hire The Mentalist

Over the weekend I’ve decided that the Reserve Bank should hire The Mentalist.

They are currently not taking into account the unique psychological problems that home buyers are burdened with.

In fact, their plans to implement LVR restrictions highlight a clear misunderstanding of how inelastic demand for “houses” is here.

The central assumption of my mental model is that the median home buying couple will do anything to get a house.

They will beg, borrow and steal in order to “get on the housing ladder” or some other reason that highlights their inability to think like an economist.

Real estate agents know how emotional home buyers can be. They even refurnish open homes to include children’s toys in nurseries to tug the heart strings and enhance the idea that “this is where we can build a family”.

What we know from the addiction literature is that addicts are quite price-insensitive.

I posit that the majority of New Zealand house buyers are housing addicts.

Therefore, raising the price of houses through making it harder to borrow with a low deposit will have 3 effects on the market for “houses”:

  1. Borrowing from finance companies will rise to top-up deposits.
  2. Parents and grandparents will give their kids way more money than necessary.
  3. Nothing will change the supply (it’s restricted) and demand (it’s growing) story in Auckland so restrictions could actually increase house prices even more than before the policy is implemented.

The Reserve Bank, if it really wanted to do something around making people jump through more hoops in order to obtain mortgage financing for an asset that shifts household consumption onto a whole other level of assorted expenses (rates, insurance, maintenance, kitchen remodelling etc) should hire The Mentalist.

The Mentalist would be tasked with building a clear psychological profile of “house” addicts and figuring out trigger words that could be used to reframe the stupidity of buying a house with a 5% deposit.

Through conducting focus groups and surveys that highlight the similarities between drug addicts and couples desperate to get on the housing ladder “no matter what”, bank risk management and credit control teams will receive a signal that they’re dealing with a very special type of client.

Sadly, The Mentalist is currently doing advertisements for ANZ. And that’s why the public sector regulators will always lose out to the private sector. They pay their experts more.