Westpac economists say house price growth definitely easing, but LVR limits will have only 'modest' impact

There is "no doubt now" that the housing market is past its peak, Westpac economists say.

In their first "Economic Overview" for the year - the text for which was actually finalised before QV figures out this week showing an easing of house price growth in January - the economists said that sales have fallen, the average time to sell is lengthening and "there are early signs that house prices are rising at a slower pace.

Westpac is sticking with its forecast that house price growth will ease to 6.5% this year. Last year Westpac economists produced detailed forecasts for the next 10 years, including a prediction that house prices would actually decline for a period starting in 2016.

In their latest economic overview the economists said they expected that higher interest rates would be the main restraint on house price growth this year.

"Our 'investment value' approach shows that the valuation gap has already closed as term mortgage rates have risen over the last six months. Rising incomes and stronger net immigration make it difficult to argue for a downward correction in prices in the near future, but we expect prices to start flattening out by next year," they said.

But the economists still thought the impact on house price inflation of the Reserve Bank's 'speed limits' on high loan-to-value lending would be "modest".

Low-end effect

"The drop in sales has been concentrated in the lower-priced end of the market, which is consistent with first-time buyers being hit hardest by the regulations.

"Meanwhile, two-tier mortgage pricing and lenders’ efforts to grow the low-LVR portion of their loan books (if anything, they seem to have been surprised by the potential for growth in this area) have created some very favourable conditions for buyers with large enough deposits," they said.

Just under a year ago the Westpac economists put out a paper, which said that Auckland needed to build 9500 more houses a year to make up its shortfall.

In the latest overview the economists have revisited their projections in the light of 2013 census figures showing the Auckland population not growing by as much as expected.

"Auckland’s shortage of housing is not as severe as we thought last year," the economists said.

"We now estimate that over the past five years Auckland has built 13,640 too few dwellings. A year ago the comparable figure was 21,840.

Faster than estimated

"...Our calculations also reveal that the rate of increase in Auckland’s housing stock has been faster than previously estimated. (Our estimate of new dwelling construction relies on a ‘conversion rate’ from dwelling consents to actual increases in the housing stock. The 2013 Census revealed a higher conversion rate than the 2006 Census.)"

The economists are now saying that Auckland needs 9169 new houses a year, which would be a 53% increase on the 5986 consented in 2013, but is annually about 330, or 3.5%, fewer than they were calling for a year ago.

In terms of the general economy, the Westpac economists are now picking GDP growth to accelerate to 4.2%, which is an increase in forecast from 3.8% as of their last economic overview in November.

"Over the last two years, we have highlighted a lift in construction activity and a resurgent housing market as key catalysts for the economy’s upturn. These two factors will continue to play a major role in the level of economic activity this year, but they have probably passed their peaks in terms of the rate of growth," they said.

"Instead, we expect them to share the spotlight this year with a third factor, namely, a sharp and sustained lift in national income as a result of New Zealand’s record-high terms of trade."

Upgraded assessment

Since their November overview, the Westpac economists have upgraded their assessment of the sustainable long-run level of the terms of trade.

"We recognise that there are substantial risks to this view – particularly in light of the recent wobbles in some global markets – and it’s not a judgement that we came to lightly. Indeed, we’ve been only gradually persuaded by two factors: the sheer level of New Zealand’s export commodity prices, at a time when the global economy is fairly lacklustre, and the massive shift in New Zealand’s level of engagement with the Chinese market in recent years."

The economists said it was difficult to find precedent for "such a significant step-change in New Zealand’s trade performance".

While the terms of trade had been higher in the past, such as in the 1973 boom, that period of prosperity (and eventual overheating) was much shorter-lived than the economists are proposing now (within two years the OPEC oil shock had sent our terms of trade down to record lows).

'Substantial benefits'

"The benefits to the New Zealand economy over the next year alone will be substantial," they said.

"The combination of higher world prices and higher export volumes (which were depressed last year by a severe drought) translates to an income boost of nearly $5bn this year. If high export incomes are to become a regular feature rather than a one-off, the impact on the wider economy will be greater still."

The boost to nominal incomes would flow through to real activity in "myriad ways, which are not easy to pin down".  The economists are forecasting that around half of the income boost will be saved or used to pay down debt; the other half will translate into higher household spending, construction activity and business investment in plant and equipment.

"Business investment in particular tends to be strongly procyclical, and with a large imported component; there is already tentative evidence for a sizeable upswing, based on surveys of business intentions and a strong lift in imports of capital equipment in recent months.

Dollar higher for longer

"However, the effect on balance will still be higher savings and a smaller current account deficit. Another significant transmission channel is the exchange rate; in keeping with our higher terms of trade projections, we now expect the New Zealand dollar to remain elevated for a longer period."

A higher exchange rate also implied that tradables inflation would remain subdued for longer, providing a substantial offset to the build-up of domestic inflation pressures as the economy uses up its spare capacity.

"For this reason, our forecast of the OCR [Official Cash Rate] in coming years is little changed despite an upgrade to our economic growth forecasts.

"We expect the OCR hiking cycle will proceed in increments of 25 basis points (bps) – OCR hikes of 50bps or more are highly unlikely. The hikes will be well signalled in advance, as will any decision to pause. The RBNZ will eschew on-the-day surprises, such as lifting the OCR without having given prior warning."

The economists said there were a number of reasons the RBNZ would want to keep the OCR hiking cycle well-signalled, smooth and unsurprising. Credible signals could push longer-term interest rates up in advance of actual OCR hikes, doing much of the RBNZ’s work for it.

'Clear and credible signals'

At the same time, clear and credible signals helped to minimise financial market volatility by reducing the scope for markets to "go on wild-goose chases".

"Another of the RBNZ’s motivations is more subtle and political in nature. In New Zealand there is a strong body of opposition to inflation targeting, stemming from a mistaken belief that the RBNZ is responsible for the high exchange rate.

"The RBNZ won’t want to antagonise the general public any more than it has to, for fear of gifting its perennial critics political ammunition – especially after the public-relations challenges of the high-LVR mortgage restrictions.

"A good way to avoid antagonising people is to make sure that they are well warned in advance. Another is to ensure that, on the day of OCR hikes, any increase in market interest rates and the exchange rate is kept to a minimum."

'Slow and steady'

The economists said the inflation outlook was such that the RBNZ could afford a slow and steady approach. The economist's inflation forecast (showing inflation slowly rising to 2.4% by June 2016) now featured "fairly benign inflation" in the near term due to the likelihood of a sustained high exchange rate and a few expected one-offs such as falling ACC levies.

"True, we are still forecasting an extended period of inflation above the RBNZ’s 2% target, but this outlook is more uncomfortable than panic-inducing for the RBNZ. We are forecasting OCR hikes of 25bps in March, April, June, July and December this year.

"But in keeping with the theme of this section, we may adapt our near-term OCR forecast in light of RBNZ communications. Regarding the eventual extent of the OCR hiking cycle, we have not changed our view. We forecast the OCR to peak at 5.5% in 2016, and to subsequently fall as the Canterbury rebuild winds down."