Opinion: Why the RBNZ should take the IMF's advice and lean hard against the property price bubble

By Bernard Hickey

Now that the world has avoided going over the financial cliff, at least for now, the powers-that-be are doing a post-mortem of what went wrong.

The International Monetary Fund (IMF) has just produced a 42 page paper titled "Central Banking Lessons from the Crisis" that makes for an interesting read.

It diagnoses a bunch of problems, including keeping interest rates too low for too long, not watching the shadow banks, and light handed regulation.

But it also raises a topic of great interest in New Zealand, where a doubling of property prices between 2002 and 2008 distorted our economy in favour of consumers over producers, and sucked in around NZ$100 billion of foreign debt. This buildup of hot air in an asset bubble became a key factor in the Reserve Bank's thinking over that period, albeit indirectly.

The Reserve Bank shied away from deliberately targeting this asset bubble in its monetary policy and instead had to deal with the fallout using just one tool, the Official Cash Rate (OCR). Increasingly frustrated by cheap fixed rate mortgage lending funded by short term wholesale bank funding, it cranked up the OCR to 8.25% in a desperate attempt to slow the economy. It seemed behind the curve.

Now the IMF is saying central banks should revisit the area of targeting asset bubbles and of using supplementary tools to help keep the economy stable as well as keep inflation under control.

"The longstanding debate on whether central banks should “lean against” emerging financial imbalances or “bubbles” by raising policy interest rates has been reopened by the crisis," the IMF said.

A common view has been that leaning mechanistically against financial imbalances could increase inflation volatility, require strong interest rate responses to be effective and thus impose high output costs, and may be counterproductive in small open economies where high interest rates can attract capital inflows," it said.

"Nevertheless, the high costs of systemic financial instability shown by the crisis can be seen as strengthening the case for using monetary policy to lean against asset price bubbles. Until financial developments are better structurally incorporated in monetary policy decision making, central banks should best utilize judgment in deciding whether to maintain interest rates somewhat higher than otherwise in order to avoid imbalances from undermining financial stability, which would ultimately endanger price stability," it said.

"For example, the combination of rising asset prices and rapid credit growth may warrant a higher policy rate. "

Politically explosive

This would be a major change in the way central banks think. It would also be politically explosive. Now that high house prices are now embedded in the psyches and balance sheets of middle New Zealand, changing the way the Reserve Bank Act operates to reduce or control that 'wealth' would hit the front pages and focus groups.

But that shouldn't prevent a debate.

Up until now central banks have said they find it difficult to measure the timing and size of bubbles. They worried any attempt to prick the bubbles would destroy the overall economy.

The US Federal Reserve and its then leader Alan Greenspan took this stance right through the last 20 years, in particular during the Dot.com bubble of 2000 and the housing bubble of 2005 to 2007. He chose the easy option at the time, but clearly disastrous policy now, of letting the bubble grow.

Our own central bank under the leadership of Don Brash and Alan Bollard were less sanguine about the risks, but were similarly doctrinaire in saying their single focus was inflation and their single tool was the Official Cash Rate.

As recently as 2006 the Reserve Bank of New Zealand looked into the use of 'supplementary tools and concluded "that there are no simple, or readily implemented, options that would provide large payoffs in the near-term, without significant complications and costs."

The shock of the Global Financial Crisis and the freeze in interbank funding markets in late 2008 and early 2009 forced the Reserve Bank under Bollard to revisit the area of supplementary tools.

To its credit, the Reserve Bank was the first of the central banks to suggest and implement a supplementary tool called the Core Funding Ratio, which forces the banks to fund more of their lending from domestic and longer term sources.

This fits into the 'macro-prudential' category of supplementary tools. It is primarily aimed at keeping the financial system stable, rather than targeting inflation or asset prices. Here's Deputy Governor Grant Spencer's Reserve Bank Bulletin paper on the tool.

Loan to value ratios?

This IMF report suggests a closer look at using other supplementary tools to try to control asset bubbles, in particular housing bubbles.

"Macroprudential tools will need to be developed and a greater emphasis given to systemic financial risks," the IMF said.

"These need to build on prudential tools that apply to individual institutions (such as capital and liquidity requirements) and contracts (e.g. loan-to-value ratios). "

The Reserve Bank has steered away from getting so down and dirty with regulating bank activities and prices, but I wonder if the Reserve Bank should now revisit this area.

It was a bubble

It's clear now as the economy struggles to get going again that it has become dependent on the debt growth fueled by the housing market's ever-increasing values.

When the values stopped rising, so did the borrowing and the spending that went with it.

Our Roost Home Loan Affordability report shows just how out of line with fundamental earning power house prices got at their peak. In the main centres prices were at bubble levels when it cost the equivalent of 90% of after tax earnings to service an 80% mortgage on a median house. House prices were also well over 8 times earnings. They remain unfeasibly high and affordability is close to 80% in the main centres.

The Reserve Bank has yet to really look at targeting asset bubbles.

Now might be a good time.