David Hargreaves sees a likely need for substantial changes to migration settings and for application of more Reserve Bank 'macro-prudential tools' in the year ahead

By David Hargreaves

They say a week's a long time in politics. In economics, it seems, a month can be like a lifetime.

Since the Reserve Bank finalised its projections for the last Monetary Policy Statement on September 2 and Governor Graeme Wheeler put his signature to the 'policy assessment' part of the MPS on September 9 some of the most fundamental assumptions contained in those projections have undergone severe reversals.

These are what the RBNZ described as its most important policy judgements in that MPS:

• the exchange rate will remain low, boosting tradables inflation and stimulating activity in the tradables sector;
• New Zealand’s export commodity prices have troughed, and the recovery is assumed to be gradual;
• world growth will remain near its past average
• net immigration has peaked, and its boost to demand and supply will wane over coming years; and
• rebuild activity in Canterbury has peaked, while house building in Auckland will continue to accelerate. 

The MPS was released on September 10, with an accompanying cut in the Official Cash Rate to 2.75% from 3%. On that day the Kiwi dollar dropped sharply, falling to US62.72c and 68.34 on the trade weighted index measuring a 'basket of currencies' of 17 of our trading partners.

The Reserve Bank said this of the Kiwi dollar: "We assume it will fall further over the next year to about 65 on a Trade Weighted Index (TWI) basis. Two key factors behind the depreciation are lower export prices and heightened uncertainty about the global economic outlook. Both imply weaker prospects for New Zealand’s growth, and inflation, and so lower interest rates."

Further down the RBNZ said this: "A higher exchange rate than assumed would imply lower near-term inflation. The medium-term inflationary impacts would depend on the factors driving the move in the exchange rate. One potential cause of a higher exchange rate would be a rebound in export prices. In such a scenario the medium-term outlook would be for stronger incomes, growth and inflationary pressure. Alternatively, the exchange rate could be higher than assumed if the Federal Reserve or other central banks were to delay interest rate increases because of concerns about a weaker or more uncertain economic outlook. In that case, the implication for New Zealand would be both lower near-term inflation and weaker medium term growth." The bold type is mine, for emphasis.

Sod's law rules

Well, Sod's law and all that, the RBNZ has seen BOTH its alternative scenarios come to pass. Dairy prices have bounced with a strength nobody foresaw, while the US Fed didn't deliver the rate rise on September 18 (NZ time) that it's pre-match bravado might have led people to believe it wanted.

On dairy prices, the Wholemilk Powder (WMP) price is now some 35.9% higher than it was when the RBNZ pulled its projections together. This is what the RBNZ said at the time: "We assume the recovery in world dairy prices, towards a more sustainable level, will be slow [my bold emphasis]. Prices on the GlobalDairyTrade platform are assumed to remain subdued over the next year before picking up."

Slow and subdued? Not really. As things stand at the moment this dairy season is now starting to look like a pretty unenjoyable one for farmers - but not the disastrous one it looked like being just two months ago.

So what of the US Fed? Reasonably dire labour figures released in the US since the non-rate-rise decision suggest that it would be an extremely brave, if not unbelievably quixotic, move for the Fed to hike rates this month. Which leaves only the December decision this year for a move before the US heads into a Presidential election year when the whole process of rate moves becomes incredibly fraught and political. There's got to be a fair chance now there will be no US rate rises certainly this year and with big question marks over how feasible it would be next year.

Kiwi finds wings again

As at time of writing the Kiwi dollar is up over 4% against the US currency since the release of the September MPS, while it's up over 3.5% on the trade weighted index. The TWI is not far short of the 71 mark, which is about 8.5% higher than the level the RBNZ is anticipating  in a year's time. And yes, a year is a long time, but watch this space, since there now appears little to stop the Kiwi dollar continuing to rally in the short-term, certainly ahead of the US Fed's pre-Christmas decision on rates, which comes on the same day (December 10) that the RBNZ makes its last OCR call for the year.

Then there's migration. The RBNZ's now looking for this to have "peaked". Subsequent to the release of the MPS, Statistics New Zealand released the August migration figures on September 21. These showed us hitting a new peak of 60,290 net migrants in the past 12 months. On a seasonally adjusted basis the country's had a net gain every month so far this year of between 4790 migrants and 5730 (in July). The figure in August was the second highest this year so far at 5470. If it's peaked, it's peaked at very high levels and there's no immediate sign of it dropping away from those levels.

The context to all these developments is that the RBNZ is on the one hand trying to satisfy its monetary policy target and get inflation back to around 2%, while on the other hand under its financial stability hat it wants to get rampant house prices back under control. To help to achieve the latter it has new rules coming into effect next month that will mostly prevent property investors in Auckland borrowing more than 70% of the value of the house they are buying. The RBNZ's also loosening a little the amount of money the banks can make available for loans to high-LVR (above 80%) customers outside of Auckland.

The inflation puzzle

Let's look at inflation. In the June quarter it was 0.4%. Ditto the annual rate in the year to June. That's a hell of a long way short of the 2%. The Government's frustration with how far away from the inflation target the RBNZ has been on a consistent basis is growing. New inflation figures for the September quarter are out next week. The market's expecting a benign figure (around 0.4%) and the RBNZ's expecting a benign figure.

The heat goes on the RBNZ into next year, when it is expecting big things to happen. It's predicting chunky 0.7% increases in the CPI in both the March and June quarters, principally as the impacts of the lower dollar (which may or may not be currently starting to partially reverse itself) feed through into price increases. The RBNZ reckons it will hit that 2% midpoint of its 1-3% official targeted range by the September quarter next year.

But will it? I think the Kiwi dollar will continue to fight back, particularly if there's no US interest rate rise and particularly since the enormous drops in dairy prices from March onward have now close-to been reversed. Wage pressures are likely to remain subdued here because unemployment's now seen as rising again, and the influx of migrants has already been officially acknowledged by the Government as something that has kept the lid on wages in lower-paid jobs.

I don't think the RBNZ has a prayer of making that target. If it doesn't the heat will go right on it to try to rectify the situation, and that can only mean a need for lower interest rates.

But of course still lower interest rates will add fuel to the fire as far as the housing market goes.

Some impact

The original impost of the 10% LVR 'speed limit' in 2013 did dampen the market then (though you've got say, and the RBNZ rather skirts over the fact these days, that the ill-starred hiking of the OCR from 2.5% to 3.5% in the early part of 2014 helped a lot too). So, it is to be expected that the new curbs on lending to Auckland investors will have an impact in Auckland. I've said previously I think prices will drop in Auckland.

But what about elsewhere? Already the signs are that markets nearby to Auckland are perking up. The RBNZ has already shown some signs of concern with indications it may delay a proposed phase-out of the LVR rules outside of Auckland.

Personally I think that will just be the start of it, because with potentially even slightly lower interest rates available next year it is going to continue to be A/ Unrewarding to invest money on fixed deposits and B/ Still cheap to get mortgages.

Investing in houses is still going to be hot. If people feel constrained in Auckland they will go elsewhere, which will push prices up elsewhere. There's no doubt in my mind that before we've got as far as say March the RBNZ will have reversed its earlier loosening of LVR rules outside of Auckland.

Where to?

But where does it then go from there, after the impact of that move starts to wash through the market and as, inevitably the rules on Auckland housing investment start to lose some of their impact - I would pick by halfway through the year?

With no ability to lift interest rates the RBNZ will again have to go back to its macro-prudential tool kit. What it might come up with I'll perhaps ruminate on another day. But before next year's out, something else will be needed.

But the Reserve Bank is going to need more Government help. About 27,000 of the new migrants in the year to August indicated they were settling in Auckland. That puts upward pressure on housing. It puts pressure on the labour market.

If the tap doesn't turn itself off - and I don't think it's going to - then the Government needs to step in. The huge complication for the Government is that so many of our tertiary institutions are now clearly dependent on attracting offshore students in order to keep funding levels up. However, at least some of those students are clearly here really to seek work rather than education per se.

Something is going to have to give. But the Government will need to act. If the funding of tertiary institutions needs looking at, then look at it. But I just don't think the Government can keep assuming that rampant inbound migration is something that will go away of its own accord. It needs controlling.