NZ Reserve Bank Consults On DTI Restrictions

The NZ Reserve Bank has released its consultation paper on possible DTI restrictions. The 36+ page report is worth reading as it sets out the risks ensuring from high risk lending, leveraging experience from countries such as Ireland.

Interestingly they build a cost benefit analysis, trading off a reduction in the costs of a housing and financial crisis with a reduction in the near-term level of economic activity as a result of the DTI initiative and the cost to some potential homebuyers of having to delay their house purchase.

Submissions on this Consultation Paper are due by 18 August 2017.

In 2013, the Reserve Bank introduced macroprudential policy measures in the form of loan to-value ratio (LVR) restrictions to mitigate the risks to financial system stability posed by a growing proportion of residential mortgage loans with high LVRs (i.e. low deposit or low equity loans). This increase in borrower leverage had gone hand-in-hand with significant increases in house prices, particularly in Auckland. The Reserve Bank’s concern was the possibility of a sharp fall in house prices, in adverse economic circumstances where some borrowers had trouble servicing loans. Such an event had the potential to undermine bank asset quality given the limited equity held by some borrowers.

The Reserve Bank believes LVR restrictions have been effective in reducing the risk to financial system stability that can arise due to a build-up of highly-leveraged housing loans on bank balance sheets. However, LVRs relate mainly to one dimension of housing loan risk. The other key component of risk relates to the borrower’s capacity to service a loan, one measure of which is the debt-to-income ratio (DTI). All else equal, high DTI ratios increase the probability of loan defaults in the event of a sharp rise in interest rates or a negative shock to borrowers’ incomes. As a rule, borrowers with high DTIs will have less ability to deal with these events than those who borrow at more moderate DTIs. Even if they avoid default, their actions (e.g. selling properties because they are having difficulty servicing their mortgage) can increase the risk and potential severity of a housing related economic crisis.

While the full macroprudential framework will be reviewed in 2018, the Reserve Bank has elected to consult the public prior to the review. This consultation concerns the potential value of a policy instrument that could be used to limit the extent to which banks are able to provide loans to borrowers that are a high multiple of the borrower’s income (a DTI limit). A number of other countries have introduced DTI limits in recent years, often in association with LVR restrictions. In 2013, the Bank and the Minister of Finance agreed that direct, cyclical controls of this sort would not be imposed without the tool being listed in the Memorandum of Understanding on Macroprudential Policy (the MoU). Hence, cyclical DTI limits will only be possible in the future if an amended MoU is agreed.

The purpose of this consultation is for the Reserve Bank, Treasury and the Minister of Finance to gather feedback from the public on the prospect of including DTI limits in the Reserve Bank’s macroprudential toolkit.

Throughout the remainder of the document we have listed a number of questions, but feedback can cover other relevant issues. Information provided will be used by the Reserve Bank and Treasury in discussing the potential amendment of the MoU with the Minister of Finance. We present evidence that a DTI limit would reduce credit growth during the upswing and reduce the risk of a significant rise in mortgage defaults during a subsequent severe economic downturn. A DTI limit could also reduce the severity of the decline in house prices and economic growth in that severe downturn (since fewer households would be forced to sharply constrain their consumption or sell their house, even if they avoided actual default). The strongest evidence that these channels could materially worsen an economic downturn tends to come from countries that have experienced a housing crisis in recent history (including the UK and Ireland). The Reserve Bank believes that the use of DTI limits in appropriate circumstances would contribute to financial system resilience in several ways:

– By reducing household financial distress in adverse economic circumstances, including those involving a sharp fall in house prices;
– by reducing the magnitude of the economic downturn, which would otherwise serve to weaken bank loan portfolios (including in sectors broader than just housing); and
– by helping to constrain the credit-asset price cycle in a manner that most other macroprudential tools would not, thereby assisting in alleviating the build-up in risk accompanying such cycles.

The policy would not eliminate the need for lenders and borrowers to undertake their own due diligence in determining that the scale and terms of a mortgage are suitable for a particular borrower. The focus would be systemic: on reducing the risk of the overall mortgage and housing markets becoming dysfunctional in a severe downturn, rather than attempting to protect individual borrowers. The consultation paper notes that DTIs on loans to New Zealand borrowers have risen sharply over the past 30 or so years, with further increases evident since 2014. This partly
reflects the downward trend in interest rates over the period. However, interest rates may rise in the future. While the Reserve Bank is continuing to work with banks to improve this data, the available data also show that average DTIs in New Zealand are quite high on an international basis, as are New Zealand house prices relative to incomes.

Other policies (such as boosting required capital buffers for banks, or tightening LVR restrictions further) could be used to target the risks created by high-DTI lending. The Bank does not rule out these alternative policies (indeed, we are currently undertaking a broader review of capital requirements in New Zealand) but consider that they would not target our concerns around mortgage lending as directly or effectively. For example, while higher capital buffers would provide banks with more capacity to withstand elevated housing loan defaults, they would do little to mitigate the feedback effects between falling house prices, forced sales and economic stress.

The Reserve Bank has stated that it would not employ a DTI limit today if the tool was already in the MoU (especially given recent evidence of a cooling in the housing market and borrower activity), it believes a DTI instrument could be the best tool to employ if house prices prove resurgent and if the resurgence is accompanied by further substantial volumes of high DTI lending by the banking system. The Reserve Bank considers that the current global environment, with low interest rates expected in many countries over the next few years, tends to exacerbate the risk of asset price cycles arising from ‘search for yield’ behaviour, making the potential value of a DTI tool greater.

The exact nature of any limit applied would depend on the circumstances and further policy development. However, the Reserve Bank’s current thinking is that the policy would take a similar form to LVR restrictions. This would involve the use of a “speed limit”, under which banks would still be permitted to undertake a proportion of loans at DTIs above the chosen threshold. By adopting a speed limit approach, rather than imposing strict limits on DTI ratios, there would be less risk of moral hazard issues arising from a particular ratio being seen as “officially safe”. Exemptions similar to those available within the LVR restriction policy would also be likely to apply.


Measuring Home Price Trends Is Hard

Interesting note from the New Zealand Reserve Bank, “Evaluating alternative monthly house price measures for New Zealand” which highlights that whilst there are various methods which can be applied to measuring home prices, none is perfect. The data-intensive “Hedonic” approach as advocated by some in Australia, did not come out on top.

They also highlight the “quality-mix problem, which refers to the fact that the composition of houses sold will differ from period to period, making it difficult to discern whether observed price changes reflect genuine movements in underlying house prices or simply changes in the composition of houses sold. For example, prices may increase from one month to the next simply because of an increase in the average size of
houses sold. Larger homes tend to sell for higher prices, so it’s not clear whether the observed increases in prices represent genuine market movements or simply changes in sales composition. This quality-mix problem is of particular concern in the property market since
housing quality varies significantly along multiple dimensions.

This paper outlines the production of three monthly house price indices (HPIs) for New Zealand produced using data from the Real Estate Institute of New Zealand (REINZ) using three alternative methodologies. REINZ approached the Reserve Bank of New Zealand at the end of 2015 for technical guidance on possible improvements to their house price index methodology, in light of significant improvements to their dataset in recent years. The paper documents the guidance, providing an overview of the alternative methodologies and an empirical evaluation of the resulting indices.

The database provided by REINZ is a rich unit-record sales dataset with information on price, location, valuation, and property characteristics (such as the number of bedrooms and the floor area). We use the database to produce HPIs based on three well-established and widely adopted methodologies: 1) sales-price to appraisal ratio (SPAR); 2) hedonic regression; and 3) repeat sales. All three methods are found to produce credible-looking indices, which match the turning points and well-established cyclical properties of New Zealand’s existing house price statistics.

As a benchmarking exercise, the three candidate indices are evaluated alongside a simple median and a stratified median index (similar to the methodology currently used by REINZ). Applying a range of criteria to assess index performance, we find that all three alternative candidate methodologies out-perform the simple median and the stratified median methodologies.

The SPAR method is found to perform the best, due to lower month-to-month noise (especially for more disaggregated regional indices), greater stability as more data are added, robustness to sample changes, and higher accuracy in predicting sales prices.

NZ Official Cash Rate unchanged at 1.75 percent

The NZ Reserve Bank today left the Official Cash Rate (OCR) unchanged at 1.75 percent.

Core inflation is running 1.5-2%, and they believe they are on track to be within their 2-3% target range ahead. Wage growth remains sluggish, despite high participation rates.

The macroprudential policies (loan-to-value based) they have implemented have trimmed house price growth significantly, (nationwide monthly house price inflation has averaged 0.1 percent over the past five months, compared to 2.1 percent in the five months prior), although they said they also believe housing supply is important. The number of house sales nationwide has fallen by about 20 percent since its peak in April 2016. NZ regulators deserve recognition for their integrated and successfully implemented policies.

The steepening in wholesale rates has flowed through to rising fixed-term mortgage rates, with the 2-year mortgage rate rising by 45 basis points since their November Statement. They are also doing significant work on debt-to-income ratios, but have not yet implemented measures on this basis.  The NZ Government wants to see a cost benefit analysis of these measures before they are implemented.

The recovery in commodity prices and more positive business and consumer sentiment in advanced economies have improved the global outlook.  However, major challenges remain with on-going surplus capacity in the global economy and rising geo-political uncertainty.

Global headline inflation has increased, partly due to rising commodity prices.  Global long-term interest rates have increased.  Monetary policy is expected to remain stimulatory, but less so going forward, particularly in the US.

New Zealand’s financial conditions have firmed with long-term interest rates rising and continued upward pressure on the New Zealand dollar exchange rate.  The exchange rate remains higher than is sustainable for balanced growth and, together with low global inflation, continues to generate negative inflation in the tradables sector.  A decline in the exchange rate is needed.

Economic growth in New Zealand has increased as expected and is steadily drawing on spare resources.  The outlook remains positive, supported by ongoing accommodative monetary policy, strong population growth, increased household spending and rising construction activity. Dairy prices have recovered in recent months but uncertainty remains around future outcomes.

Recent moderation in house price inflation is welcome, and in part reflects loan-to-value ratio restrictions and higher mortgage rates.  It is uncertain whether this moderation will be sustained given the continued imbalance between supply and demand.

Headline inflation has returned to the target band as past declines in oil prices dropped out of the annual calculation.  Inflation is expected to return to the midpoint of the target band gradually, reflecting the strength of the domestic economy and despite persistent negative tradables inflation.  Longer-term inflation expectations remain well-anchored at around 2 percent.

Monetary policy will remain accommodative for a considerable period.  Numerous uncertainties remain, particularly in respect of the international outlook, and policy may need to adjust accordingly.

NZ Growth Looks Promising

The prospects look promising for New Zealand’s economic expansion to continue in the face of considerable international uncertainties, Reserve Bank Governor Graeme Wheeler said today.

Figure 1 - Summary Macro-economic Indicators relative to trend

Speaking to the Development West Coast Conference in Greymouth, Mr Wheeler said that in many respects the economy is performing well.

“Relative to the trends over the past two decades, New Zealand is experiencing stronger economic growth, lower inflation, and a lower unemployment rate – even with record levels of labour force participation.  The Achilles heel of many New Zealand expansions – a large current account deficit – has not eventuated.

“However, not everything is as positive.  The overall expansion, now entering its eighth year, is weaker than other post-WWII expansions.  GDP growth on a per capita basis has been slow and labour productivity growth has been disappointing.  House price inflation is much higher than desirable and poses concerns for financial stability, and the exchange rate is higher than the economic fundamentals would suggest is appropriate.”

Mr Wheeler said that, in the absence of major unanticipated shocks, prospects look good for continued strong growth over the next 18 months, driven by construction spending, continued migration, tourist flows, and accommodative monetary policy.  Supply disruptions associated with the Kaikoura earthquake are unlikely to have a major impact on overall economic growth, while some increase in freight costs and construction cost inflation is likely.

“Our November 2016 Monetary Policy Statement forecasts show annual real GDP growth of around 3¾  percent over the next 18 months, with inflation approaching the mid-point of the target band, the unemployment rate continuing to decline, and the current account deficit remaining within manageable levels.

“The low point for CPI inflation has probably passed and, supported by the improvement in global commodity prices in recent months, we expect the December quarter 2016 CPI data to confirm that annual CPI inflation is moving back within the 1 to 3 percent target band.

Mr Wheeler said that New Zealand will enter 2017 with considerable political and economic uncertainties.

“The greatest threat to the expansion lies in possible international political and economic developments and their implications for the global trading environment.  The main domestic risk – and one that could be triggered by developments offshore – is a significant correction in the housing market.  Numerous measures indicate that New Zealand house prices are significantly inflated relative to usual valuation indicators.”

“As has been the case in several other countries, monetary policy has been made more challenging in New Zealand by low global inflation and zero or negative policy rates in several major economies.  This has put downward pressure on our interest rate structure and contributed to asset price inflation and upward pressure on the New Zealand dollar.  This trend may finally be turning.

“At this stage, global and domestic developments do not cause us to change our view on the direction of monetary policy as outlined in the November MPS.  We expect monetary policy to continue to be accommodative, and that the projected policy settings will help generate sufficient growth to have inflation settle near the middle of the target range.”

NZ Financial system continues to face housing and dairy risks

New Zealand’s financial system is sound but continues to face risks, Reserve Bank Governor, Graeme Wheeler, said today when releasing the Bank’s November Financial Stability Report.

“Global GDP growth has been subdued, despite extremely accommodative monetary policy in a number of countries. Financial markets have remained volatile due to heightened political uncertainty.

“Dairy prices have recovered in recent months and the average dairy farm is now expected to return to profitability this season.  However, indebtedness in the sector has increased as farms have had to borrow to absorb losses over the past two seasons, leaving the sector vulnerable to future shocks.  Some farms remain under pressure and problem loans are likely to continue to increase for a time.

“House price inflation in Auckland has softened in recent months but it is uncertain whether this will be sustained.  House price to income ratios in the region remain among the highest in the world and prices are continuing to rise rapidly in the rest of the country.  There is a significant risk of further upward pressure on house prices so long as the imbalance between housing demand and supply remains.


“The Reserve Bank has asked the Minister of Finance to agree to add a Debt to Income (DTI) tool to the Memorandum of Understanding on macro-prudential policy.  While the Bank is not proposing use of such a tool at this time, financial stability risks can build up quickly and restrictions on high-DTI lending could be warranted if housing market imbalances were to deteriorate further.”

Deputy Governor, Grant Spencer, said: “New restrictions on lending to property investors with high loan to value ratios (LVRs) came into force on 1 October. These restrictions, along with the earlier LVR restrictions, are increasing the resilience of bank balance sheets to a downturn in the housing market.

“However, the share of bank mortgage lending to customers with high DTI ratios has been increasing and this could increase the rate of loan defaults during a housing downturn.


“The banking system has strong capital and funding buffers and profitability remains high. Despite being relatively concentrated, New Zealand’s banking system also appears to be operating efficiently from an international perspective based on metrics such as the cost-to-income ratio and the spread between lending and deposit rates.

“However the banking system’s reliance on offshore wholesale funding is beginning to increase due to a widening gap between credit and deposit growth. Banks could become more susceptible to increased funding costs and reduced access to funding in the event of heightened financial market volatility.


“Damage from the magnitude 7.8 Kaikoura earthquake on 14 November is being assessed. While it is too early to estimate the cost to insurers, the sector is well positioned in terms of catastrophe reinsurance cover and capital buffers.

“The Reserve Bank continues to make progress on a number of regulatory initiatives, including a review of bank capital requirements, amendments to the outsourcing policy for banks and a dashboard approach to quarterly disclosure.”

What’s Driving Inflation So Low?

Interesting speech from Dr John McDermott, Assistant Governor and Chief Economist of the Reserve Bank of New Zealand, looking at what is behind low inflation in NZ. He concludes international factors have a stronger influence now, as the drivers and composition of net immigration influence the degree of associated inflationary pressure for any given migration flow, and inflation expectations appear to now place more weight on past inflation outcomes than they did prior to the GFC.

Based on this conclusion, we think the globalisation of inflation drivers have relevance in other markets too, and makes domestic management of inflation via monetary policy much more difficult. Taking the cash rate lower rates won’t cure it.

In recent years, inflation has been low – and below the rate targeted – in many advanced countries around the world. The possible reasons for this are a focus of discussion for central bankers, financial market participants, politicians, academics and journalists, both here and abroad. Low inflation in New Zealand is what I want to talk to you about today.

The consumer price index (CPI) for the September quarter will be released next Tuesday, and it is widely expected to reveal continued low inflation. The Bank’s goal is to keep future annual CPI inflation outcomes between 1 percent and 3 percent on average over the medium term, with a focus on keeping future average inflation near the 2 percent target midpoint. As described in the September Official Cash Rate (OCR) review, monetary policy will continue to be accommodative. Interest rates are at multi-decade lows, and our current projections and assumptions indicate that further policy easing will be required to ensure that future inflation settles near the middle of the target range.

The Reserve Bank’s forecast in the August Monetary Policy Statement was for annual headline CPI inflation to be 0.2 percent in the September quarter. More recent information, including movements in petrol and food prices, remains consistent with this low number. Our typical margin of error in forecasting near-term annual CPI inflation is about 0.2 percentage points. So, while we have no prior knowledge, next week’s outturn could be between zero and half a percent.

Actual inflation has been low, despite robust growth in the New Zealand economy. Looking at individual items in the CPI basket, low annual inflation in the September quarter is expected to result from: falling prices for petrol; further reductions in ACC vehicle levies (resulting in cheaper car licensing fees); cheaper and better quality audio-visual and computing equipment; and reductions in domestic and international airfares. These lower prices are expected to be only partially offset by increases in the prices of housing-related goods and services – things like construction costs, rents, property maintenance, and local authority rates – and increases in cigarette and tobacco prices. In annual terms, these large negative and positive factors have been at play for at least the past year (figure 1).

Annual inflation is expected to return to the lower end of the target band in the December 2016 quarter, as previous petrol price declines drop out of the annual calculations and housing-related goods and services prices continue to increase strongly.

Stability in the cost of living maintains the purchasing power of New Zealanders’ incomes. Inflation that is too high or too low has economic costs, and is of concern to the Reserve Bank. High inflation distorts the signals being sent from relative price movements, which results in resources in the economy being misallocated. On the other side, low inflation becomes a concern if it leads to the possibility of deflation. Although we do not see any significant risk of deflation in New Zealand, deflation carries important costs. Deflation would likely lead to consumers and businesses significantly delaying purchases or investment, in the expectation that these will become cheaper in the future. By delaying purchases and investment on a large scale, demand in the economy as a whole is reduced. This then leads to even lower prices. Deflation is particularly concerning as monetary policy eventually reaches a point where it cannot go any lower in order to stimulate the economy (known as the effective lower bound). A buffer above zero inflation is also needed to account for any measurement error in the price index. Across inflation-targeting central banks around the world, inflation of about 2 percent per annum is generally viewed as an appropriate medium-term goal.

Although headline CPI inflation is expected to remain low in the near term, lowering interest rates now would do little to change these outturns. Monetary policy operates with long and variable lags. Accordingly, monetary policy in New Zealand is focused on the medium-term outlook for inflation, as directed by the Policy Targets Agreement (PTA) between the Governor of the Reserve Bank and the Minister of Finance. Focusing on inflation a year or two ahead avoids unnecessary instability in output, interest rates and the exchange rate, again consistent with the PTA. The Reserve Bank must also have regard to the efficiency and soundness of the financial system.

The Bank responds to low inflation outcomes if these outcomes are expected to have an effect on medium-term inflation. If households and businesses respond to low inflation outcomes by reducing their expectations for future inflation, and wages and prices are set accordingly, then these lower inflation expectations would weigh on future actual inflation over the horizon relevant for monetary policy. We carefully monitor developments in inflation expectations, at various horizons.

Looking back over recent years, annual CPI inflation in New Zealand has been lower than expected by the Bank and other forecasters. Understanding why this has been the case – and what the effects on inflation expectations have been – is important in order to set policy going forward.

Annual CPI inflation has been below the 2 percent target mid-point since it was formalised in 2012, and below the bottom of the target band since the final quarter of 2014. Low inflation has been accounted for by an unusually long period of falling prices in the tradables sector (those exposed to international competition), as well as a decline in average non-tradables inflation (figure 2). Various measures of core inflation have also been low, although appear to have trended higher since the start of 2015 (figure 3).

At a high level, low inflation could be due to two factors:

  • Developments in the cyclical drivers of inflation; or
  • Structural changes in the way in which the New Zealand economy generates inflation.

A key factor that has led to low inflation has been the underlying weakness in the global economy (figure 4). Although GDP growth in New Zealand’s trading partners has been near average levels, this moderate growth has required a significant degree of monetary stimulus abroad in the major economies. Quantitative easing and negative interest rates have become regular features of the global economy.

A weak world economy has been a key factor underpinning the New Zealand dollar, with New Zealand’s performance relative to other advanced economies supporting demand for New Zealand dollar assets. The New Zealand dollar exchange rate has been higher than the Bank had assumed for much of the period (figure 5). The New Zealand dollar has remained elevated despite periods of increased risk aversion and steep declines in New Zealand’s export prices. The strength of the New Zealand dollar has dampened the prices of New Zealand’s imports, and contributed significantly to the current low inflation, particularly in the tradables sector.

The prices of the goods and services that New Zealand imports have also been lower than expected – even once the effects of high exchange rate have been taken into account. Again, a weak global economy has been the contributing factor, with significant spare capacity across the globe dampening the world prices for New Zealand’s imports.

In addition to this impulse, there was a sharp decline in the price of oil over 2014 and 2015, reflecting a combination of increased global supply and a moderation in growth in emerging economies. This drop in oil prices has contributed further to low inflation in New Zealand.

It is possible that structural changes may have also contributed to negative tradables inflation in New Zealand. This could include developments such as a change in exchange rate pass-through, or a permanent shift in distributor or retailer margins. However, Bank research suggests that such structural developments do not appear to account for weakness in internationally-driven inflation in New Zealand. That is, although movements in the drivers of low tradables inflation – the exchange rate, oil prices and global prices for our imports – have led to negative tradables inflation, it does not appear that there has been a material or permanent change in the ways that these drivers transmit through to domestic inflation.

Domestic inflation in recent years has been dampened by some sector-specific factors. Communications prices have been falling since 2011 (figure 6). The lower measured prices reflect an increase in quality: an increase in the size of broadband packages offered (at similar monthly charges); increased data and call minutes for mobile services; and the more-recent introduction of ultra-fast broadband. The net reduction in vehicle relicensing fees (reflecting a change in the way ACC calculates levies for light vehicles) has also held inflation lower since the September 2015 quarter (figure 7).

Other cyclical developments have also contributed to weakness in non-tradables inflation. New Zealand experienced a sharp decline in the prices of its exports over 2014, following a boom in commodity prices that had seen New Zealand’s terms of trade reach a 40-year high. The key driver of the fall was a substantial decline in the global price of dairy products (figure 8).

A number of developments contributed to the fall in dairy prices over 2014. A broad range of commodity prices declined over that period in line with the sharp decline in the price of oil, likely reflecting a combination of weaker global demand and the pass-through of lower energy costs. More specifically in the international dairy market, supply increased substantially – particularly in Europe following the relaxation and subsequent removal of production quotas that had been in place for nearly 30 years.

This drop in New Zealand’s commodity prices acted as a headwind to the domestic economy, reducing on-farm investment and rural spending. The flow through to demand in the economy more generally ultimately contributed to weaker domestic inflation.

A key structural development that has led to persistent weakness in inflation has been the stronger growth in New Zealand’s potential output (figure 9). This has enabled the New Zealand economy to grow at a robust pace without generating significant inflation, and is likely to continue to do so over the medium term.

Over recent years, most of the increased growth in potential GDP has been due to an increase in labour supply – through greater participation in the labour force and high net immigration. Employers, like yourselves, have been able to absorb this additional labour supply over recent years. More people entering the New Zealand workforce acts to dampen labour costs, and general inflation as a result. The ability of New Zealand businesses to find a productive use for the remarkable increase in the supply of labour is one of the most positive aspects of the current economic expansion.

More people increase both demand in the economy and growth in potential output. In previous cycles, the increase in demand has often outweighed the contribution to the supply capacity of the economy. Migration in previous cycles was therefore usually associated with an increase in overall capacity pressures and inflation, as well as a strong pick up in house price inflation.

The consequences of the recent migration inflows on consumer price inflation have been much more modest in this cycle. Two key factors can account for this more muted response. First, the composition of migration matters a great deal for inflationary pressures. Younger migrants (17-29 years old) tend to have a positive but more muted impact on domestic demand compared to older cohorts (30-49 years old). Second, the source of the migration impulse also matters – higher inward migration to New Zealand that is driven by a weaker Australian economy tends to result in a higher unemployment rate – all else equal – while inward migration to New Zealand driven by other factors has the opposite effect. That is, people who move to New Zealand because their job prospects in Australia have deteriorated are likely to spend less once here.

In recent years, we have seen a larger share of younger migrants than in previous cycles (figure 10), and weakness in the Australian labour market has been a driver of trans-Tasman flows.

There also appears to have been a structural change in how households and businesses form their expectations of prices. Inflation expectations now seem to respond more to past inflation outcomes than they did prior to the global financial crisis (GFC). This would mean any direct shocks to headline inflation (even if the shocks themselves are expected to be short-lived) now appear to have more persistent effects on inflationary pressures than they did in the past, via the expectations channel. This suggests that weak tradables inflation may have had a greater dampening impulse on non-tradables inflation through inflation expectations than would have occurred in previous periods.

Two key factors that businesses and households take into account when setting prices are the degree of capacity pressure and inflation expectations. The Bank has reviewed its frameworks for estimating capacity pressure (also known as the ‘output gap’ – the difference between actual and potential GDP) and inflation expectations in New Zealand.

Reserve Bank research re-emphasised the challenge in accurately estimating the output gap in real time. When assessed against a vast range of possible capacity indicators, the Bank’s estimate of the output gap in 2015 was around the middle of this range of estimates.

The Bank also developed a methodology to better incorporate and monitor the vast amount of information on inflation expectations into the Bank’s policy making. The analysis shows that low inflation outcomes have lowered expectations of inflation at shorter horizons, which may dampen near-term price- and wage-setting. However, analysis points to longer-term inflation expectations remaining well anchored close to the mid-point of the bank’s inflation target (figure 11).

In view of low inflation outturns since 2014, the Bank undertook a review of its forecasting performance. Reviews of forecast performance help to update our understanding of economic relationships and identify any areas were we could improve our accuracy. Generally, the Bank’s recent forecasts have performed better than external benchmarks. Looking at the period since the GFC, the Bank has generally been better than others at forecasting inflation, and its forecasts have been of a similar quality to those produced by a suite of statistical models. This forecast review suggests that there were no obvious sources of new information that the Bank could reasonably have been expected to incorporate when preparing its forecasts.


Annual CPI inflation for the September quarter is going to be low, as incorporated into the Bank’s most recent projections. However, it is expected to rise in the December quarter and be at the bottom of the target range as the transitory effects of earlier declines in oil prices dissipate. As described in the September OCR Review, monetary policy will continue to be accommodative. Our current projections and assumptions indicate that further policy easing will be required to ensure that future inflation settles near the middle of the target range.

Actual inflation has been low, and lower than forecast, for several years – both here and abroad. The potential reasons for this are a topic of discussion around the world. In New Zealand, much of this weakness can be attributed to global developments that have presented themselves via the high New Zealand dollar and low inflation in our import prices. Strong net immigration and increased labour market participation have also boosted the supply potential of the economy, meaning that New Zealand has been able to grow at a robust pace without generating significant inflation.

There also appear to have been changes in how inflation is generated in New Zealand: the drivers and composition of net immigration influence the degree of associated inflationary pressure for any given migration flow, and inflation expectations appear to now place more weight on past inflation outcomes than they did prior to the GFC. The Bank will continue to closely monitor developments in the drivers of inflation and investigate any persistent changes in how inflation is generated. Our goal will be to achieve future inflation outcomes within the target range on average over the medium term, with a focus on keeping future average inflation near the target mid-point.

New Zealand Banks Will Benefit from Tighter Rules on High-LTV Mortgage Loans – Moody’s

According to Moody’s, New Zealand banks will benefit from tighter rules on high-LTV mortgage loans.It is also worth noting how the market responded to earlier less aggressive macroprudential measures.

On 19 July, the Reserve Bank of New Zealand (RBNZ) released a consultation paper outlining a proposal to limit bank lending to home investors at loan-to-value ratios (LTVs) above 60% to 5% of new originations and lending to owner-occupiers at LTVs above 80% to 10% of new lending. These restrictions are credit positive for New Zealand banks and their covered bond programs because they reduce their exposures to higher-risk lending at a time when house prices are at historic highs.

The proposal will be particularly beneficial to New Zealand’s four major banks, ANZ Bank New Zealand Limited, ASB Bank Limited, Bank of New Zealand and Westpac New Zealand Limited. These four banks hold approximately 86% of all New Zealand residential loans.

The tighter restrictions on LTV limits will benefit banks and their cover pools by providing a buffer against declining house prices before the size of the loan exceeds the value of the property. In the longer run, banks will have fewer high LTV loans to sell into their cover pools, which will strengthen the pools’ credit quality.

The new rules would replace existing limits that restrict new lending to investors in Auckland at LTVs greater than 70% to 5%, lending to owner-occupiers in Auckland at LTVs above 80% to 10%, and all other housing lending outside of Auckland at LTVs above 80% to 15%. The proposal is in response to the boom in New Zealand house prices, which are at historical highs, creating a sensitivity to a sharp reversal in home prices.

Moody-NZ1Although LTV restrictions protect banks against a sharp correction in house prices, it remains to be seen how effective these measures will be in moderating house price appreciation if interest rates decline further. In March 2016, the Reserve Bank of New Zealand reduced its policy rate by 25 basis points to 2.25%, the fifth reduction since June 2015, while also stating that further policy easing may be required. Furthermore, strong immigration and supply shortages continue to support house prices, particularly in Auckland.

The first of New Zealand’s macro-prudential measures, introduced in October 2013, had a sharp but temporary effect on house price growth. Further measures were introduced in 2015 that also immediately reduced house price growth in fourth quarter of 2015. However, prices rebounded and have appreciated in 2016.

Moody-NZ2 The Reserve Bank of New Zealand is inviting market feedback on its proposal until 10 August, after which, a final policy will be released to take effect from 1 September 2016.

NZ Reserve Bank releases latest economic update

The latest New Zealand Reserve Bank update says that prospects for growth in the global economy have diminished despite very stimulatory monetary policy and low oil prices.  Significant downside risks remain.  Financial market volatility increased following the UK referendum and long-term interest rates have fallen. 

DownturnDomestic growth is expected to remain supported by strong inward migration, construction activity, tourism, and accommodative monetary policy. However, low dairy prices are depressing incomes in the dairy sector and weighing on farm spending and investment.

There continue to be many uncertainties around the outlook.  Internationally, these relate to the prospects for global growth and commodity prices, the fragility of global financial markets, and political risks.  Domestic uncertainties relate to inflation expectations and the potential for continued high net immigration, ongoing pressures in the housing market, and the high New Zealand dollar exchange rate.

The trade-weighted exchange rate is 6 percent higher than assumed in the June Statement, and is notably higher than in the alternative scenario presented in that Statement.  The high exchange rate is adding further pressure to the dairy and manufacturing sectors and, together with weak global inflation, is holding down tradable goods inflation.  This makes it difficult for the Bank to meet its inflation objective.  A decline in the exchange rate is needed.

House price inflation remains excessive and has become more broad-based across the regions, adding to concerns about financial stability.  The Bank is currently consulting on stronger macro-prudential measures aimed at mitigating risks to financial stability from the current boom in house prices.

Annual CPI inflation was 0.4 percent in the year to June 2016.  Headline inflation is being held below the target band by continuing negative tradables inflation.  Long-term inflation expectations are well-anchored at 2 percent, but short-term inflation expectations remain low.

Despite rising capacity pressures and some recent increase in fuel prices, the stronger exchange rate implies that the outlook for inflation has weakened since the June Statement.

Monetary policy will continue to be accommodative.  At this stage it seems likely that further policy easing will be required to ensure that future average inflation settles near the middle of the target range.  We will continue to watch closely the emerging economic data.

Reserve Bank NZ consults on new nationwide investor LVR restrictions

The Reserve Bank has today released a consultation paper proposing changes to loan-to-value restrictions (LVRs) to further mitigate risks to financial stability arising from the current boom in house prices. The proposals simplify the current policy by applying two nationwide speed limits for owner-occupier and investor lending.

New Zealand house prices have increased by around 50 percent since 2010, driven by strong immigration, low mortgage rates and sluggish housing supply. With house prices becoming increasingly disconnected from underlying household incomes and rents, there is significant potential for house prices to fall very rapidly if the factors currently supporting the market reverse. Average house prices in New Zealand are now around 6.5 times average household income. When combined with the preexisting imbalance built up prior to the GFC, the house price-to-income ratio is further from its historical average than in almost any other OECD country

NZ-LVR-ReviewRising investor defaults pose significant risks to the financial system, with a growing body of international evidence suggesting that loss rates on investor lending are significantly higher than owner-occupiers during severe housing downturns. There are caveats to applying evidence from other economies to New Zealand, including that mortgage origination standards can vary significantly across countries and time. These problems are mitigated by focussing on the differential between default rates for investors and owner-occupiers identified in international studies. Moreover, the tendency for higher investor default rates is consistent with a range of structural characteristics of investor loans in New Zealand. Direct evidence for New Zealand or Australia is limited as there has not been a severe housing downturn for many decades.

“The banking system is heavily exposed to the property market with residential mortgages making up 55 percent of banking system assets. Investor lending has been increasing rapidly and is a significant contributing factor to the current market strength.  The proposed restrictions recognise the higher risks associated with such lending,” Governor Graeme Wheeler said.

Investor lending is growing strongly, rising from around 28 to 36 percent of overall mortgage lending over the past eighteen months. This suggests that the share of investor loans on bank balance sheets has increased significantly (especially given that more than half of investor loans have been on interest only terms in recent months). Despite tighter LVR restrictions, the investor share of sales has increased in both Auckland and the rest of New Zealand. This suggests that many Auckland investors have been able to increase borrowing capacity by
revaluing their existing properties.

Under the proposed new restrictions:

  • No more than 5 percent of bank lending to residential property investors across New Zealand would be permitted with an LVR of greater than 60 percent (i.e. a deposit of less than 40 percent).
  • No more than 10 percent of lending to owner-occupiers across New Zealand would be permitted with an LVR of greater than 80 percent (i.e. a deposit of less than 20 percent).
  • Loans that are exempt from the existing LVR restrictions, including loans to construct new dwellings, would continue to be exempt.

These proposed new restrictions would take effect on 1 September 2016 and simplify the LVR policy by removing the current distinction between lending in Auckland and the rest of the country.

Mr Wheeler said: “The drivers of the housing market strength are complex and action is required on many fronts that extend well beyond financial policy.  Broad initiatives to reduce the underlying housing sector imbalances need to remain a top priority.

“A sharp correction in house prices is a key risk to the financial system, and there are clear signs that this risk is increasing across the country.  A severe fall in house prices could have major implications for the functioning of the banking system and cause long-lasting damage to households and the broader economy.

“LVR restrictions to date have improved the resilience of bank balance sheets by reducing banks’ exposure to riskier mortgages. This policy initiative is intended to further improve the resilience of bank balance sheets, and it will assist in restraining credit and housing demand.

“We expect banks to observe the spirit of the new restrictions in the lead-up to the new policy taking effect.”

Consultation concludes on 10 August.

Mr Wheeler said that the Bank is progressing its work on potential limits to high debt-to-income ratio lending, which would be a potential complement to LVR restrictions.

“We have had positive initial discussions with the Minister of Finance on amending the Memorandum of Understanding on Macro-prudential policy to include this instrument.”

How RBNZ Makes Its Cash Rate Decision

The New Zealand Reserve Bank today published a Bulletin article that explains the monetary policy decision-making process. Seven times a year, the Reserve Bank makes a decision on the appropriate Official Cash Rate (OCR) setting.The Reserve Bank conducts monetary policy to achieve the goals of the Policy Targets Agreement, but is faced with significant uncertainty when making OCR decisions.

RBNZ-ProcessA robust system is needed to address the inherent uncertainty that the Reserve Bank faces when making these decisions. The Bulletin article describes the detail of this process. The article discusses: the research behind a monetary policy decision; how the Governing Committee reaches a monetary policy decision; how the Bank communicates the decision to its key stakeholders; and how the decision-making framework is reviewed in the face of new developments.

The Bulletin article notes that a key element of the monetary policy decision making process is the need for constant review and innovation, and the Reserve Bank’s approach to decision making will continue to evolve over time.