RBNZ's Grant Spencer says rising interest rates give greater scope to ease or remove LVR restrictions

By Gareth Vaughan

The Reserve Bank appears to be laying the groundwork for an end to its experiment of restricting banks' high loan-to-value ratio (LVR) residential mortgage lending, with Deputy Governor Grant Spencer saying as interest rates rise to more normal levels, there'll be greater scope to ease or remove the restrictions.

In a speech to the Credit Suisse Asian Investment Conference in Hong Kong, Spencer noted the Reserve Bank stated from the outset the LVR restrictions weren't intended to be permanent. He also said the LVR restrictions were worth up to 50 basis points of Official Cash Rate (OCR) hikes, and the Reserve Bank sees a case to coordinate its monetary and macro-prudential policies, such as LVR restrictions, when the effects of those policies overlap.

"They (LVR restrictions) will be removed once housing market pressures have moderated and when we are confident there will not be a resurgence in house price inflation," said Spencer. "But how should the exit be coordinated with the expected OCR tightening cycle?"

"The factors to consider include: The degree of moderation achieved in rates of house price inflation and credit expansion; Factors that might affect the potential for a resurgence in house price inflation following the removal of the LVRs, such as the dampening effect of increased housing supply and mortgage rates, and the stimulatory effect of higher net immigration flows; Any distortions or inefficiencies that become apparent as a result of the policy," said Spencer.

Spencer's speech comes the day after the Government and Auckland Council said they're going to comfortably exceed a targeted 9000 new dwellings and sections approved during the first year of the Auckland Housing Accord.

"A decision to ease or remove LVR restrictions will ultimately take into account both the financial stability and price stability implications of doing so. We will be alert to the risk that the removal of LVR restrictions could produce a resurgence in house price inflation, which would potentially undermine both financial and price stability," said Spencer.

Dramatic effect

Introduced on October 1 last year with a "speed limit" for high LVR lending set at 10% of banks' new mortgage flows, the restrictions have had a dramatic effect on such lending where borrowers don't have a deposit or equity equivalent to at least 20% of the value of a housing loan. Figures released by the Reserve Bank this week show high LVR lending was just 4.2% of total new mortgage lending in February. That compares with over 25% last September, the last month before the speed limit took effect.

 As was widely expected, the Reserve Bank increased the OCR by 25 basis points to 2.75% on March 13. The central bank also slightly raised its forecast for further interest rate hikes this year, assuming around 1.25% of OCR increases before the end of 2014 and a further 1% in 2015.

"Given that the LVR restrictions began to moderate the housing cycle from October 2013, the monetary policy tightening cycle might have needed to be more accentuated in their absence. While the main benefit of the LVRs has been to redress the impact of the easier lending conditions, they may also have helped to take some pressure off the New Zealand dollar exchange rate," Spencer said.

"To be clear, the monetary policy tightening cycle that is now underway is motivated by the need to ensure that CPI inflation remains in the vicinity of 2 percent over the medium term. The boost to financial system resilience provided by the LVR restrictions, as well as a decision to increase risk weights for high-LVR housing lending, has meant that monetary policy has not needed to consider a tightening for financial stability purposes," said Spencer.

"However, while not motivated by the financial stability objective, the monetary policy tightening is expected to help in dampening further house price inflation. In this regard, as interest rates move back to more normal levels, we will expect to have greater scope to ease or remove the LVR restrictions." 

Next year?

JP Morgan economist Ben Jarman said Spencer's comments suggest the LVR restrictions won't be removed before next year.

"He suggests that LVR restrictions will be dropped only once house prices and credit growth are under control, and where a resurgence upon removal of the restrictions is unlikely – most probably once other factors are in force, such as 'the dampening effect of increased housing supply and mortgage rates'," said Jarman.

"This sounds more like 2015 than 2014, given the Reserve Bank’s view that house price levels are a significant concern. New housing supply is some way off, and so interest rates will need to rise several times. Provided the normalisation in housing is orderly, then, it appears likely that there will be a sustained period where the double-whammy of both rising interest rates and LVR restrictions are in play."

"This means that, later on (most likely in 2015), conditions may be benign enough that LVR restrictions can be removed at the same time that the urgency for rate hikes is beginning to wane," added Jarman.

'Important consideration in monetary policy assessment'

Spencer also said the Reserve Bank's initial expectation had been the LVR restrictions would dampen annual growth in house prices by 1-4 percentage points; house sales by 3-8%, and credit growth by 1-3 percentage points over the first year that the policy was in place.

"The evidence to date suggests that the dampening effect of the LVR restrictions on house prices has been broadly in line with these expectations. House sales have fallen by 13% since September, and there are early signs that this is beginning to translate into weaker house prices and credit growth."

"While LVRs have a financial stability purpose, they have been an important consideration in our monetary policy assessment. The dampening effect of LVRs on house price inflation and credit is expected to reduce wealth and credit effects on consumption that might have otherwise increased due to a rapid expansion in house prices. This, in turn, is estimated to have reduced CPI inflation pressures by an amount similar to a 25-50 basis point increase in the OCR," Spencer said.

'A clear case for their co-ordination'

Although monetary policy and macro-prudential policy should keep their separate primary objectives of price stability and financial stability, Spencer said the significant spill-over effects between the two "make a clear case for their co-ordination."

"However, such coordination must be conditional on each policy arm continuing to focus on its primary objective. Changing to joint objectives for both policies would: 1) complicate policy decisions; 2) undermine transparency; and 3) potentially be damaging to the credibility of monetary policy and macro- prudential policy," said Spencer.

"The policy framework in New Zealand is consistent with this conditional coordination approach. In the monetary policy targets agreement we have financial stability as a secondary objective. This means that the monetary authorities need to think hard if an OCR decision might have adverse effects for financial stability. Similarly, in the macro-prudential Memorandum of Understanding (with the Government) it is required that macro-prudential initiatives have regard to their potential impact on monetary policy."

There are areas of policy co-ordinations where a deeper understanding is needed, he added.

"These include: The quantitative effects of macro-prudential policy on macro-economic outcomes and their implications for monetary policy. The scale and timing of spill-over effects between the OCR and our four macro-prudential tools. How best to coordinate OCR and macro-prudential policy decisions at different points of the economic and financial cycles, particularly when the two cycles are out of sync and the policies are not complementary."

"This is an active area of the academic literature and a priority area for our own research. I look forward to the insights that this work will give us for our future monetary and macro-prudential policy decisions," said Spencer. 

The Reserve Bank said last year if it had been able to implement macro-prudential tools such as LVR restrictions in the past, it would've used them from 2005 until late 2008, or even into 2009.