Rodney Dickens says the Reserve Bank has opened Pandora’s Box and nothing good will result; says new LVR rules are unjust

By Rodney Dickens*

Between 2001 and 2004 the average mortgage interest rate charged by the major banks averaged 7.3% compared to an average of 8.9% between 1992 and 2000 (see the top left chart below that has the 2001 to 2004 period highlighted).

This was largely as a result of an experiment with low interest rates conducted by the Reserve Bank (RB).

The average mortgage interest rate charged by the major banks was highly correlated with the OCR in this period, as shown in the top right chart.

Despite the extremely strong surge in net migration in 2001 shown in the second left chart and continued high net migration in 2002 and 2003, the RB largely continued with the experiment with low interest rates.

Reflecting the risk that the RB had overly stimulated the housing market and economic growth, Acting Governor Carr implemented four 0.25% OCR hikes in 2002, but these were largely reversed by Governor Bollard in 2003.

Sustained low interest rates and the above average population growth driven by the strong net migration is the perfect recipe for a speculative bubble in the housing market.

National annual house price inflation peaked at 25% in 2003 and averaged 15% between 2003 and 2007 based on the QV median house price (right chart above).

A speculative bubble occurs when the price of an asset gets way too high relative to the income stream the asset will generate in the future.

The adjacent chart below shows this in the context of the national average house price having got way out of line with the national average annual gross rental income during the 2003 to 2007 mega-boom in house prices.

This has resulted in a large fall in the national average rental yield, with major negative implications for the medium-term outlook for house prices, as detailed in the Housing Prospects reports.

For information on these reports use the this link to our website - while the this link is to a report that reviews our 100% track record at providing clients with advance warnings of upturns and downturns in the housing market.

The magnitude of the experiment with low interest rates conducted by the RB in the early-2000s is better revealed when we compare like with like.

When net migration was last high in the mid-1990s, the RB’s actions ensured much higher mortgage interest rates than existed in the 2001 to 2004 period.

Between 1994 and 1997 the average mortgage interest rate charged by the major banks averaged 10.1% versus the 7.3% over the period the RB experimented with low interest rates in the early-2000s.

Having played a major part in fuelling the speculative bubble in house prices with the low-interest-rate experiment, the RB responded by delivering thirteen 0.25% OCR hikes between January 2004 and July 2007.

By letting the speculative bubble in the housing market go so far before acting the inevitable consequence was large interest rate increases, just as I had warned clients would occur when I was Head of Research at ASB during most of this period.

Governor Wheeler has acknowledged this risk and pointed out that if the RB allowed the housing market to get too much of a head of steam up again the result would be more severe increases in interest rates than the RB is predicting.

Having made such a major blunder in the mid-2000s the RB and the new governor are very keen not to repeat the same mistake even though they are already somewhat behind the ball.

But at least this time actions are being taken before annual house price inflation exceeds 10%, while Governor Bollard didn’t start to hike in January 2004 until after annual house price inflation was above 20%.

It is more than just low interest rates that are driving up house prices

The robust increases in the national average house price over the last couple of years is a result of more than just low interest rates and, more recently, improved population driving higher demand.

In the last six months the number of dwelling sales reported by REINZ has averaged 6,875 on a seasonally adjusted basis. This is 35% below the peak six month period in 2003, when there were 10,542 sales per month on average, while recent experience is well below the peak level experienced during the boom in the mid- 1990s when six-month average sales peaked at 8,295 in 1996.

Just as existing house prices are still in speculative bubble territory compared to rents (see page 2), section prices have not fallen back to affordable levels following the 2003 to 2007 mega-boom (left chart below).

In the case of Auckland, the situation is even more extreme with the median section price reported by REINZ having headed well above $300,000 in the last year. Rising section prices are at the heart of the problem, but a range of council and government policies have made new housing unaffordable for a large group of would-be new home owners (e.g. double glazing and scaffolding).

As a result of the major affordability problem with new housing, the national level of house building has been low for the last five years, while reflecting the greater affordability challenge in Auckland it has performed much worse in terms of the level of consents for new dwellings (right chart below).

The low level of house building has contributed to a much tighter demand-supply balance in the existing house market than can be attributed to low interest rates stimulating demand.

The government’s housing initiatives are designed to deal with the supply-side problem, but not quickly enough to solve the challenge the RB faces.

The actions by the RB and the government housing initiatives have major implications for the medium-term outlook for house prices, as discussed in the Housing Prospects reports.

But the focus here is on the route the RB is taking to achieve the cooling in house price inflation rather than the medium-term outlook for house prices or how housing in general stacks up as an investment option.

The Reserve Bank has opened Pandora’s Box and nothing good will result

The bank lending restrictions that start tomorrow are discriminatory, divisive and will impose what economists call a “deadweight loss” (i.e. the costs of the intervention will exceed the benefits).

Adding to the divisiveness, the RB appears to have raised the possibility of targeting investors as well as low deposit borrowers.

People understandably see the lending restrictions as unjust and will find ways around them, albeit at a cost.

Even the Bankers’ Association (BA) is making suggestions of how the restrictions can be overcome.

Directly along the line of what the BA is suggesting progress is being made by real estate agents in parts of the country working with finance companies to provide sources of deposit money.

Australian-based and other non-bank lenders will be major beneficiaries.

If the history of intervention repeats itself, people will find ways around the original restrictions, the RB will respond with more restrictions and an unnecessary and expensive roundabout of action and reaction will play out until sanity eventually prevails.

Of course, the alternative to discriminatory and divisive lending restrictions is a few OCR hikes that impact on all borrowers.

If as I and many others expect, the lending restrictions ultimately get circumvented even though they could bite a bit initially, OCR hikes will eventuate anyway.

Early hikes are much better than belated ones that increase the odds that more hikes will be required. This is something Governor Wheeler and I agree on.

However, don’t underestimate the desire of a new governor to try a new experiment.

It could take some time before sanity prevails and the lending restrictions are relegated to the same forgotten corner in history as the Monetary Conditions Index the RB experimented with in the late-1990s.

Of more direct relevance or comparison is the raft of bank lending and other restrictions Muldoon implemented in the first half of the 1980s that caused lots of distortions and extra costs, and at the peak culminated in around 40% of all mortgage lending being conducted via lawyers’ trust accounts that were outside the regulatory net. Just as relevant are the temperance laws that proved to be abysmal failures.

Policies that are seen as being unjust are doomed.

But Governor Wheeler is willing to try the new experiment in the hope it will work enough to be worth the disruption, injustices and costs it imposes on a select group of people.

And in the misguided hope it will help by keeping the exchange rate lower than would be the case otherwise.

-----------------------------------------------------------------------------------------------------------

*Rodney Dickens is the managing director and chief research officer of Strategic Risk Analysis Limited.