Wednesday, August 21, 2013

The RBNZ and macro-prudential tools

After much consideration and consultation the RBNZ has opened its new macro-prudential tool box and, as was widely expected, restrictions on high loan-to-value ratio (LVR) lending have popped out.  The RBNZ has announced that lending to high LVR loans (over 80%) will be restricted to no more than 10% of new lending from October 1st.   That ratio has recently been traveling around 30% so this new restriction therefore constitutes a potentially significant reduction in the supply of credit to the housing market.

This action is primarily intended to preserve financial stability.  However the RBNZ is clearly anticipating this action will also act to slow demand and assist with their recent predicament that we have described as being between a rock (the high exchange rate) and a hard place (the strong housing market.  Indeed in its statement today the RBNZ essentially said that if it were not for its new LVR restrictions, interest rates would be higher now.

The RBNZ believes that LVRs will be more effective than the other macro-prudential tools at its disposal in constraining private sector credit growth in the housing sector.  That may well prove to be correct.  However, I continue to believe that if financial stability is the primary objective of deploying macro-prudential tools, then requiring banks to hold more capital via the use of a counter-cyclical capital buffer would be more effective in that aim.

The most effective tool in constraining credit growth is undoubtedly higher interest rates.   The problem for the RBNZ is that the broader economy hasn't, and still doesn't, warrant higher interest rates.  But we are moving closer to that point.  Economic growth is accelerating and is running faster than potential and the output gap is closing.  At the same time pricing intentions and inflation expectations are now rising.

A strong housing market was never enough by itself to warrant higher interest rates.  But given where growth is heading, where forward inflation indicators are pointing, and the amount of work the RBNZ will inevitably need to do, my concern is that while relying on LVR restrictions to do the job they won't act early enough on interest rates to contain the inevitably higher inflation.  That would mean an ultimately more aggressive tightening cycle than would be the case if they started the process in a more timely and gradual fashion.

The RBNZ is clearly concerned about the exchange rate and the impact that a tightening here will have in a world where we the only developed economy tightening.  The reality is that many things other than interest differentials impact on the exchange rate.  However to the extent they do matter, an early and gradual tightening that locks in a relatively low interest rate cycle (compared with the last cycle that saw the OCR peak at 8.25%) will likely have less impact on the exchange rate than a more aggressive tightening further down the track.