New Zealand – Page 19 – Digital Finance Analytics (DFA) Blog

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.

Conclusion

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.

NZ Tightens Mortgage Lending Rules From 1 October

The NZ Reserve Bank today confirmed that new macroprudential rules tighten restrictions on bank lending to residential property buyers throughout New Zealand. Residential property investors will generally need a 40 percent deposit for a mortgage loan, and owner-occupiers will generally need a 20 percent deposit.

From 1 October, residential property investors will generally need a 40 percent deposit for a mortgage loan, and owner-occupiers will generally need a 20 percent deposit. In both cases, banks are still allowed to make a small proportion of their lending to borrowers with smaller deposits.

Confirmation of the new rules is in the Reserve Bank’s response to submissions to its public consultation about changes to Loan to Value Ratio (LVR) rules that was issued on 19 July.

The Reserve Bank is modifying its proposals in response to public consultation, and also through meetings and workshops with banks that are subject to the rules.

The new rules take effect on 1 October 2016, but banks have chosen to start following the new limits already.

Existing exemptions to LVR restrictions will continue to apply under the new rules and have been extended to include borrowing for a newly-built home, or to do work needed for a residence to comply with new building codes and rental-property standards.

Monetary Policy Faces Challenges in Turbulent Times

Interesting speech from New Zealand, illustrating the difficulty in the current low growth, low rate, low inflation, high exchange rate environment. Expect more rate cuts!

In a speech written for the Otago Chamber of Commerce, Mr Wheeler said the scope and influence of monetary policy, particularly in small, open economies, is heavily constrained by economic and financial developments outside their borders. As a result, expectations of what monetary policy can achieve often run ahead of reality.

“Nearly 10 years on from the Global Financial Crisis, economies face a difficult global economic and financial climate, with below-trend growth despite unprecedented monetary stimulus, declining merchandise trade and rising protectionism, very low inflation and interest rates, and high asset prices presenting financial stability risks. Many of these issues have complex structural elements that are unlikely to fully self-correct as global growth recovers.

“Central banks must make finely balanced judgements when setting monetary policy, based on evidence, research, scenario analysis, and continual review of their policy record and international experience,” he said.

“As is the case elsewhere, there are a range of views about what monetary policy can achieve and how it should be operated. In New Zealand, these include a view that flexible inflation targeting is no longer an appropriate framework for conducting monetary policy.”

Mr Wheeler said that flexible inflation targeting remains the most appropriate framework for conducting monetary policy in New Zealand. Provided sufficient flexibility is allowed to accommodate the frequent and often severe impact of external shocks, the most important contribution monetary policy can make to promoting efficiency and the long-run growth of incomes, output and employment is the pursuit of price stability.

“There is nothing sacrosanct about what particular inflation band or target should be adopted as a measure of price stability. However, changing a target when times become tougher reduces the incentives on central banks to achieve earlier agreed goals. It could damage the central bank’s credibility – particularly if a perception develops that the central bank will continually seek to respecify goals.”

The Bank also encounters a view that it should not lower interest rates, because current strong economic growth makes interest rate cuts unwarranted and undesirable.

However, if financial markets believe that the Bank is content with below-target inflation, they would conclude that the easing process is over and proceed to bid the exchange rate up, perhaps substantially.

“The TWI exchange rate is already at a high level based on the Bank’s models. A sizeable appreciation would further squeeze incomes in the tradables sector, and drive tradables inflation lower for longer, thereby lowering overall headline inflation.”

Low headline inflation could also bring down inflation expectations in a self-perpetuating spiral.

“If inflation expectations fall too far, it can be very difficult to raise them back up. In such a situation, even further cuts in interest rates would be needed to stimulate economic activity and increase inflationary pressures.”

Mr Wheeler said a third view maintains that the Bank should rapidly lower interest rates to bring inflation quickly back to the mid-point of the inflation band.

However, an aggressive monetary policy that is seen as exacerbating imbalances in the economy would not be regarded as sustainable, and would not deliver the exchange rate relief being sought.

Rapid ongoing decreases in interest rates would likely result in an unsustainable surge in growth, capacity bottlenecks, and further inflame an already seriously overheating property market. It would use up much of the Bank’s capacity to respond to the likely boom/bust situation that would follow, and place the Reserve Bank in a situation similar to many other central banks of having limited room to respond to future economic or financial shocks.

Mr Wheeler drew heavily on and emphasised the messaging contained in the recently released August Monetary Policy Statement.

“The key rationale for cutting the OCR in August was to lower the risk of a further decline in short-term inflation expectations.

“Our present judgement is that the current interest rate track, involving an expected 35 basis points of further interest rate cuts, balances a number of risks weighing on the economy, while generating an increase in CPI inflation back towards the mid-point of the 1 to 3 percent target range.

“We remain committed to the inflation goals in the Policy Targets Agreement. We do not believe that the outlook and balance of risks warrants a position of no policy change, nor a position of rapid easings. If the emerging information and risks unfold in a manner that warrants a change in our judgements, we will modify our policy settings and outlook.”

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

Rising 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.

A 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.

NZ Housing risks require a broad policy response

Growing imbalances in the housing market require policy action on a number of fronts, New Zealand Reserve Bank Deputy Governor Grant Spencer said today. In an excellent speech he draws important links between the elements driving house prices, and also underscores the limits of the banks range of options, especially considering the target inflation range of 1-3%.

New Zealand is experiencing a housing market boom. House prices are increasing at 13 percent per annum nationally, and at 15-20 percent in Auckland and close-by regions. Evidence from housing cycles in several advanced economies suggests that the longer this continues, the more likely there will be a severe correction.

Speaking to the Wellington Branch of the New Zealand Institute of Valuers, Mr Spencer said that a range of factors had contributed to strong demand for housing, including record low interest rates, rising credit growth, and population increases.

While housing demand has been strong, the housing supply response has been constrained by rigid planning and consent processes, community preferences in respect of housing density, inefficiencies in the building industry, and infrastructure development constraints around financing and resource consents.

When the Bank had introduced LVR restrictions in 2013, they saw some markets slowing, but “House price pressures have re-emerged in Auckland following an easing in late 2015 and have also strengthened across other regions”.

New Zealand house price inflation began to accelerate again from around March 2016 as demand pressures intensified in Auckland. In the meantime, other regions were contributing to higher national house price inflation from mid-2015, particularly those areas adjacent to Auckland. Most regional centres are now experiencing annual house price inflation in excess of 8 percent. Similarly, sales activity increased across the country in the first half of 2016. Reflecting the underlying housing shortage, new listings have remained flat. Listings as a proportion of sales are now 40 percent below the previous low seen at the height of the pre-GFC boom in 2007.

He also highlighted an increase in investor purchases, and significant mortgage refinance, including increased interest-only and high debt-to-income lending. New mortgage commitments are also elevated, running at an annual rate of 35%. Debt servicing ratios are also elevated.

Supply is not meeting demand he concluded. This is a recipe for potential disaster.

The longer the boom continues, the more likely we will see a severe correction that could pose real risks to the financial system and broader economy.

Mr Spencer said a broad range of initiatives is necessary to increase the long-term housing supply response, particularly in Auckland, and to help ensure housing demand is kept in line with supply capacity.

The Reserve Bank has no direct influence over supply, but can influence housing demand through the credit channel. In this regard, we see the Reserve Bank as part of a team effort.

A dominant feature of the housing resurgence has been an increase in investor activity, which increases the risk inherent in the current housing cycle.

The Reserve Bank is considering tightening Loan-to-Value Ratios (LVRs) further to counter the growing influence of investor demand in Auckland and other regions, and to further bolster bank balance sheets against fallout from a housing market downturn. Such a measure could potentially be introduced by the end of the year.

Limits on Debt-to-Income ratios (DTIs) might also have a role to play but would be a new instrument that would have to be agreed by the Minister of Finance under the Memorandum of Understanding on Macro-prudential policy. Further investigation of this option will be undertaken.

A third option is a housing capital overlay. The Reserve Bank has already indicated that it will be conducting a full review of bank capital requirements over the coming year.

Consideration might be given to further reducing the tax advantage of investing in residential housing. Supply side issues also need attention. But much of this lays beyond the remit of the Central Bank.

He concluded that the causes of the imbalances are complex with a number of important drivers on both the demand and supply side. Addressing these imbalances will require policy action by a variety of agencies on a number of fronts. The underlying housing shortage needs to be urgently addressed, particularly in Auckland where population growth continues to outstrip housing construction. A step up in supply is required and finalisation of the Auckland Unitary Plan will be a key opportunity to facilitate such a step.

On the demand side, the key drivers are population growth and easy credit. The low cost of credit is making higher debt levels affordable, particularly for investors who can deduct interest costs from taxable income. Residential investors are accounting for an increasing share of house sales and new mortgage credit.

The Bank’s interest rate policy must have regard to financial stability concerns, but the global environment is likely to keep interest rates low for some time yet. Macro-prudential policy can assist in containing the growing risk to financial stability as the current housing market reaches new extremes. In light of the growing risk, the Reserve Bank is closely considering measures that could be progressed in the coming months.

RBNZ Enhances Mortgage Reporting – 40% New Loans Interest Only

The New Zealand Reserve Bank has introduced new statistics on residential mortgage lending by payment type (i.e. interest-only and principal-and-interest). ‘Investor’ and ‘owner-occupiers’ are defined by the intended use of borrowed funds. A particular loan application may include a portion of both interest only and principal-and-interest payment terms. Figures in the new table represent the balance of new and existing lending for each payment type, not the number of loans.

In May 2016, almost 60 percent of all new mortgage lending was on principal-and-interest payment terms, while 40 percent was on interest-only payment terms. These proportions have been fairly stable since July 2015 when the data was first available. Interest-only loans tend to convert to principal-and-interest loans after a period of time. In March 2016, 40 percent of new lending was on interest-only payment terms. However on the banks’ loan books only 28 percent of all existing mortgages are on interest-only payment terms. These proportions have been fairly steady over time.

Interest-only lending is less likely to be high loan-to-value ratio (LVR greater than 80 percent) compared to principal-and-interest lending. The proportion of high LVR new lending has
declined slightly for all payment types since data was first available in July 2015. The portion of high LVR lending for all existing mortgages is somewhat higher than for new lending (12.9 percent compared to 7.9 percent in March 2016) but this has also been declining over time. The lower ‘high-LVR’ portion on new lending is due to the LVR restrictions, which will gradually filter through to existing lending as new lending is added to the banks’ loan books.

In May 2016, about 55 percent of new lending for investor purposes was on interest-only terms compared to about 33 percent for owner-occupier purposes.These proportions have
been fairly steady over time. Only 1 percent of interest-only lending for investor purposes is above 80 percent LVR and this has been declining over time.

RBNZ Cash Rate unchanged at 2.25 percent

Statement by NZ Reserve Bank Governor Graeme Wheeler:

The NZ Reserve Bank today left the Official Cash Rate unchanged at 2.25 percent.

Global financial market volatility has abated and the outlook for global growth appears to have stabilised after being revised down successively over recent quarters. There has been a modest recovery in commodity prices in recent months. However, the global economy remains weak despite very stimulatory monetary policy and significant downside risks remain.

Domestic activity continues to be supported by strong net immigration, construction, tourism and accommodative monetary policy. The dairy sector remains a moderating influence with export prices below break-even levels for most farmers.

The exchange rate is higher than appropriate given New Zealand’s low export commodity prices. Together with weak overseas inflation, this is holding down tradables inflation. A lower New Zealand dollar would raise tradables inflation and assist the tradables sector.

House price inflation in Auckland and other regions is adding to financial stability concerns. Auckland house prices in particular are at very high levels, and additional housing supply is needed.

There continue to be many uncertainties around the outlook. Internationally, these relate to the prospects for global growth and commodity prices, the outlook for global financial markets, and political risks. Domestically, the main uncertainties relate to inflation expectations, the possibility of continued high net immigration, and pressures in the housing market.

Headline inflation is low, mostly due to low fuel and other import prices. Long-term inflation expectations are well-anchored at 2 percent. After falling in recent quarters, short-term inflation expectations appear to have stabilised.

We expect inflation to strengthen reflecting the accommodative stance of monetary policy, increases in fuel and other commodity prices, an expected depreciation in the New Zealand dollar and some increase in capacity pressures.

Monetary policy will continue to be accommodative. Further policy easing may be required to ensure that future average inflation settles near the middle of the target range. We will continue to watch closely the emerging flow of economic data.

RBNZ Cuts Cash Rate to 2.25%

The NZ Reserve Bank today reduced the Official Cash Rate (OCR) by 25 basis points to 2.25 percent.

The outlook for global growth has deteriorated since the December Monetary Policy Statement, due to weaker growth in China and other emerging markets, and slower growth in Europe. This is despite extraordinary monetary accommodation, and further declines in interest rates in several countries. Financial market volatility has increased, reflected in higher credit spreads. Commodity prices remain low.

Domestically, the dairy sector faces difficult challenges, but domestic growth is expected to be supported by strong inward migration, tourism, a pipeline of construction activity and accommodative monetary policy.

The trade-weighted exchange rate is more than 4 percent higher than projected in December, and a decline would be appropriate given the weakness in export prices.

House price inflation in Auckland has moderated in recent months, but house prices remain at high levels and additional housing supply is needed. Housing market pressures have been building in some other regions.

There are many risks to the outlook. Internationally, these are to the downside and relate to the prospects for global growth, particularly around China, and the outlook for global financial markets. The main domestic risks relate to weakness in the dairy sector, the decline in inflation expectations, the possibility of continued high net immigration, and pressures in the housing market.

Headline inflation remains low, mostly due to continued falls in prices for fuel and other imports. Annual core inflation, which excludes the effects of transitory price movements, is higher, at 1.6 percent.

While long-run inflation expectations are well-anchored at 2 percent, there has been a material decline in a range of inflation expectations measures. This is a concern because it increases the risk that the decline in expectations becomes self-fulfilling and subdues future inflation outcomes.

Headline inflation is expected to move higher over 2016, but take longer to reach the target range. Monetary policy will continue to be accommodative. Further policy easing may be required to ensure that future average inflation settles near the middle of the target range. We will continue to watch closely the emerging flow of economic data

IMF Highlights Risks In NZ Economy

On February 5, 2016, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with New Zealand. In the report, they examine a number of issues, including high house prices in Auckland, trade exposures, low GDP per capita and chronic low household savings. “From the 2000s, New Zealand has lagged behind top OECD countries in output per worker by 20–25 percent. This gap can be explained by both substantial productivity gaps and lower levels of capital. While the latter may be partly influenced by the low savings rate (and higher interest rates), the productivity gap is striking, particularly when taking into account New Zealand’s sound institutional and policy settings: New Zealand’s per capita should be 20 percent above the OECD average based on structural policy settings, not 20 percent below”.

The economy’s strong growth after the global financial crisis has been supported by rising terms of trade and reconstruction activity after the 2010–11 Canterbury earthquakes, as well as high net immigration. Growth peaked at 3.5 percent year-on-year (y/y) in Q4 2014, bringing output slightly above potential. However, the tailwinds have recently waned. In 2014, dairy prices began to fall from historic highs, leading to a sharp drop in income growth after the positive effect of declining oil prices had worn off, and investment activity related to the Canterbury rebuild has reached a plateau. As a result, output growth is estimated to have slowed to 2.3 percent in 2015, despite resilient consumption. Meanwhile, unemployment has been edging up reaching 6 percent in Q3 2015. Due largely to the decline in oil prices, inflation has dropped to 0.3 percent (y/y) in Q3 2015. House price inflation in Auckland has remained high, driven fundamentally by supply shortages.

The exchange rate depreciation has cushioned some of the impact of the decline in dairy prices. The bilateral exchange rate against the U.S. dollar has depreciated as dairy prices fell and the Reserve Bank of New Zealand (RBNZ) eased monetary policy. The depreciation has mitigated the impact of the international dairy price decline on farmers’ incomes, and supported exports of travel and education services.

With growth below potential, measures of core inflation around the lower half of the target band, and a still strong exchange rate, monetary policy has been eased since June and the Reserve Bank stands ready to reduce rates further if warranted.

To manage risks arising from house price inflation in Auckland, macroprudential measures were introduced in 2013, leading to a temporary slowdown in price hike. A package of additional macroprudential regulations and tax measures was announced in May 2015, but having become fully effective only in November. The banking sector has increased capital and liquidity buffers, but reliance on offshore funding and a large share of mortgage lending remain sources of vulnerability.

Fiscal policy is also supportive of the economy in the short term, while consolidation is projected to resume in the medium-term. Automatic stabilizers have been allowed to work and public investment is being increased. Net debt is projected to decline further to around 5 percent of GDP in the medium term.

With chronically low national saving, New Zealand’s economy is dependent on borrowing from abroad. Its persistently negative savings-investment balance has led to the accumulation of a large net negative international investment position (IIP) which reached65 percent of GDP in 2014.

The short-term outlook is challenging with both external and domestic risks, the latter arising from rapid house price inflation in Auckland. However, New Zealand’s flexible economy is resilient, and medium-term prospects remain positive. New Zealand’s main exports—agricultural consumer products and tourism—should benefit from the ongoing shift to a more consumption-oriented growth model in China. Consumer demand in other Asian countries is also expected to grow. Overall, output growth is projected to recover to its estimated potential rate of 2.5 percent. With measures of core inflation around the lower end of the target range and expectations consistent with the band’s midpoint, inflation is forecast to rise to within the RBNZ’s target range of 1–3 percent in 2016.

Executive Board Assessment

Executive Directors welcomed that New Zealand’s economy continues to perform well despite the slowdown imposed by the fall in dairy prices, plateaued investment associated with the Canterbury rebuild, and slower growth in trading partners. Directors agreed that New Zealand’s sound and flexible policy frameworks, including the important buffer provided by the flexible exchange rate, position the country well to weather the recent slowdown. Medium-term prospects remain positive, and Directors were encouraged by the authorities’ alertness to the downside risks and challenges arising from real estate market pressures, a persistently low savings rate, and relatively low productivity.

Directors considered the current accommodative monetary stance to be appropriate and agreed that, if needed, the authorities should stand ready for further easing given low inflationary pressures and below potential output. With regard to fiscal policy, they agreed that the planned easing this year and next, including through an acceleration of public investment in infrastructure, combined with a resumption of gradual fiscal consolidation thereafter, is appropriate. These measures should support the economy in the short term and bolster the public sector balance sheet in the longer term.

Directors noted that the banking system is resilient and well-supervised. They commended the proactive prudential and tax measures being taken to address the risks stemming from the housing market. Noting that the underlying cause of the housing market boom in Auckland is a supply/demand mismatch, they encouraged the authorities to be ready to use additional prudential measures and consider steps to reduce the tax advantage of housing over other forms of investments, while continuing to address supply-side bottlenecks.

Directors agreed that raising national and in particular private saving is critical to reducing external vulnerabilities from the still heavy reliance on offshore funding. They noted that higher saving may also reduce capital costs by lowering the risk premium and thereby support productive investment and long-term growth. They encouraged the authorities to consider comprehensive policy measures to boost long-term financial savings, including through reform of retirement income policies, as this could also help deepen New Zealand’s capital markets and broaden options for retirement planning.

Directors observed that, notwithstanding high living standards, New Zealand incomes lag those of other advanced economies, due to relatively low capital intensity and productivity. Acknowledging that the economy’s small size and distance from markets likely limit gains from trade, they encouraged the authorities to build on the country’s business-friendly environment to take steps to boost competition in key service sectors, leverage ICT more intensively, and address key infrastructure bottlenecks. They welcomed the focus of the government’s Business Growth Agenda on these issues.