New research for the Reserve Bank says if central banks had mandates to prevent unsustainably high house prices they would likely find interest rate changes more effective than macroprudential tools, such as LVR limits, to achieve this goal

Central banks "could be justified" in using interest rate rises to combat high house prices, new Reserve Bank research has found.

A comprehensive discussion paper by Reserve Bank economist Andrew Coleman has examined the reason why housing markets have such unusual price and building activity cycles.

It follows on from a suite of research issued by the RBNZ last year, which followed the inclusion in 2021 and 2022 of housing in the RBNZ Monetary Policy and Financial Policy Remits.

In a wide-ranging paper, Coleman discusses "cyclical backwardation", which occurs when current house prices (or rents) are temporarily above the usual cost of building homes and developing land, and are expected to fall back to usual levels in the future and "structural backwardation", which occurs when current prices (or rents) are at usual levels, but the normal costs of building homes or developing land are expected to fall permanently. Property prices can be said to be “cyclically backward” or cyclically unsustainable when capacity constraints in the property construction and development industry lead to temporarily high house prices and temporarily high construction costs, Coleman says.

He says one conclusion seems clear.

"If a central bank wants to reduce the extent that property prices are cyclically backward, it could do so by raising interest rates. There is little reason to doubt that a period of temporarily higher interest rates would reduce the demand for better quality property, and thus reduce the extent that property prices are unsustainably high," Coleman says.

"There are some reasons to believe that central banks could be justified in choosing interest rate paths that reduce cyclical house price backwardation. House price expectations have an important role in determining actual house prices, and there is considerable evidence that these expectations depend on recent house price movements. When this occurs, house prices can be subject to periods of substantial under-or over-valuation, movements that have significant effects on construction activity. In these circumstances, decisions to use higher interest rates rather than higher prices during periods of cyclical backwardation may be warranted."

Coleman notes that most central banks do not have a mandate to prevent unsustainable house prices. Rather, they have a mandate to achieve general price stability, maximum sustainable employment and financial stability.

"During the last decade there has been extensive research examining the relative merits of using interest rate changes rather than macroprudential regulations and interventions (such as loan-to-value restrictions or capital-lending balance-sheet ratios) to prevent financial crises or episodes of financial instability.

"While these issues are far from settled, most central banks including the Reserve Bank of New Zealand favour the use of macroprudential interventions to prevent financial instability rather than as a means to directly target economic outcomes. This is one reason why central banks have not attempted to raise interest rates to prevent rapid increases in house prices in recent years.

"Nonetheless, the literature consistently suggests that macroprudential interventions have relatively minor effects on house prices. Consequently, if central banks had mandates to prevent episodes of unsustainably high house prices, they are likely to find interest rate changes to be more effective than macroprudential interventions to achieve this goal."

Population growth & demand for better houses drivers of new construction

Coleman says both population change and an increased demand for better quality houses have been "an important driver" of new construction in New Zealand over the last three decades, "and they are likely to be jointly responsible for the pressures that have caused cyclical price backwardation".

"Between 2000 and 2020 the population increased by 1,225,000 people, or by 1.4% per year, twice the average rate in the OECD.

"Given an average occupancy rate of 2.75 people per household, this population increase implies the need for an additional 450,000 houses.

"At the same time, estimates linking the change in building activity to population change suggest there is a 'background' construction rate of 30 houses per 10000 people even when there is no population growth, to replace dilapidated houses or to change the housing stock as the demographic structure and tastes change.

"This implies demand for a further 250,000 houses over the period. In combination, these numbers indicate that between 30% and 40% of the potential demand for new houses was for quality improvement over the two decades," Coleman says.

"Only 510,000 new dwellings were consented over the period, however, suggesting there was a large shortfall in new construction.

"These numbers further suggest that improvements in quality may have accounted for half of the new building that actually occurred between 2000 and 2020, particularly since builders tend to construct high quality houses before low quality houses as they are more profitable. The demand for higher quality properties has most likely stemmed from changes in income, interest rates, and the tax regime."

Coleman says there is very little formal analysis of the extent that "episodes of cyclical house price backwardation" redistribute income or wealth or cause welfare losses.

"Without such analysis it is not clear how to evaluate the costs or benefits of strategies that reduce cyclical backwardation."

He says given the inclusion of housing into the RBNZ's Monetary Policy remit, "it is perhaps time that this analytical work was undertaken".

Areas for further work

Coleman says there are three areas for further research work that stand out.

First, there is limited literature examining how quality improvements are related to fundamental supply and demand factors, including interest rate changes.

"This area is difficult, as the flow of quality improvements is related to differences in the current and desired quality profile of the whole stock of houses. Little is known about the relative demand elasticities for bigger houses rather than better located property, for example."

Secondly, little is known about the welfare consequences of price backwardation, especially price backwardation that is associated with construction-sector capacity constraints.

"There are many aspects of this question to understand. Some are technical. For example, is the rationing that occurs when the construction sector reaches a capacity constraint efficient? In reality, does the construction sector disproportionately build higher quality houses because they are the most profitable to build? Are there adverse welfare consequences arising from the tendency of the construction sector to build the most profitable, highest quality houses? Other questions concern the appropriate metrics that should be used to evaluate welfare, including the appropriate time horizons and the way to consider the welfare of different generations."

Thirdly, the appropriate monetary policy response to price backwardation is not well understood.

"It depends on the welfare costs of price backwardation, if any; it depends on the importance of these welfare costs to the central bank, if any; it depends on the tools available to the central bank to respond to these episodes; and it depends on the relative costs of these interventions relative to other interventions.

"This is a long list of topics for future research, suggesting there is a lot of work to be done," Coleman says.