House-price inflation and interest rates are bound at the hip

Reducing house-price inflation depends on identifying the drivers. Right now, that means interest rate policy and quantitative easing must change. Everything else is band-aid as the fireball grows

House-price inflation is New Zealand’s hot-fire issue. Look back a year and very few people were predicting the fire. Now we have a fireball.

Quite simply, house-price inflation is driven by citizens’ loss of confidence in fiat currency. Having money in the bank has become a mug’s game.  As long as post-tax interest rates on savings are well below inflation rates, then the fireball cannot be doused. Investors have to find somewhere for their savings.

Prior to COVID19, there was a valid argument that urban planning rules combined with high immigration were the key drivers of house-price inflation. Those urban-planning issues had been in the background for many years but were then fanned by high immigration. 

 However, it is COVID-19 and the reactions of the State, particularly monetary policy under the control of the Reserve Bank, that have created the current fireball.

The current Reserve Bank inflation mandate belongs to another time
The Reserve Bank Governor has made it explicit that house-price inflation is not a central issue to the Reserve Bank mandate. In a technical sense, that is correct. However, house-price inflation is central to the future of New Zealand, and any sense that we can be a property-owning team of five million.

As long as monetary policy was focused on flattening short-term business and spending cycles, then independence of the Reserve Bank using standard monetary tools made a lot of sense. Some things are indeed best left out of the hands of politicians. However, monetary policy has strayed into areas well outside historical norms.

Interest rates have been declining globally for much of the last 20 years. That aligns with global growth rates declining everywhere. China is the outlier, but even there, economic growth as a percentage of the economy has been declining, and so have interest rates.

Since COVID-19, the extraordinary measures of quantitative easing have been extraordinarily successful in artificially reducing interest rates even further, particularly across the Western World.  And there lies the issue.

Back in June, I wrote about the flood of capital entering the market via the Reserve Bank’s quantitative easing programme. I tried to forewarn of the risks from excessive quantitative easing. However, at that time, most people were focused on more immediate issues relating to COVID-19 and jobs. Right through to the election, the issue of house prices remained in the background.

It is now no longer possible to obtain a bank interest rate that protects against inflation, yet the Reserve Bank is trying to increase inflation further. To at least some of us, it is a crazy world.

The increasing growth of digital block-chain currencies is another sure sign of a global loss of confidence in fiat (national) currencies. These digital currencies, led by bitcoin but with others in the wings, are highly speculative and have no inherent value. However, with confidence in fiat currencies declining, the search for alternative nest eggs expands. Hence, people are drawn to these digital currencies. Once again, it is the consequence of a crazy world.

The rush to investment properties
Here in New Zealand, the rush by investors to purchase investment properties is not driven by any fundamental wish to be landlords. Rather, it is driven by a belief that there is nowhere else to go. Accordingly, under current place settings, there is still a long way for house price inflation to run. There are still many billions of dollars – indeed approximately $200 billion – sitting in current accounts and term deposits with the citizen owners of those funds now becoming very scared.

Unfortunately, the Reserve Bank has very limited expertise when it comes to behavioural sciences. Their only tools for assessing behavioural changes that lie outside historical norms are to operate through a rear vision mirror. Accordingly, they have been and continue to be badly caught out as to what they have created. Their response is that the housing crisis is a ‘first class problem’, largely outside their mandate.

If ‘first class’ problem means a huge problem, then it is hard to disagree with that assessment. But if it means something else, and the evidence is clear that Reserve Bank Governor Adrian Orr does indeed mean it in a different context, then once again it is evidence of a crazy world unsuited for a team of five million.

House inflation does not soak up excess money supply
Very few people recognise that house-price inflation does not soak up the excess money that the Reserve Bank is creating. Every time someone buys a house there also has to be a seller. Money simply flows from one bank account to another.  The same principle applies with shares. It helps explain why bubbles keep growing until they pop.

This fundamental fact as set out above is why there is a fair chance that we are still in the early stages of the house-price inflation firestorm.   The only qualifier on that statement is if there is a change of Reserve Bank policy in regard to quantitative easing and hence interest rates.

In the meantime, there is nothing to stop house price inflation from continuing as savers flee the banks. 

Band-aids focus on the wounds rather than the cause
Some may think that the firestorm can be controlled by other means such as rent freezes and extending the bright-line taxation test for investor housing. But they are mistaken.  Such measures focus on outcomes rather than cause.

Rent freezes are extremely bureaucratic and can lead to multiple unintended consequence. It takes one back to the Muldoon days of wage and price freezes. These measures can douse a few flames but the flames soon return. This is because the fundamental issues lie elsewhere.

Increasing the bright-line period for capital gain taxation may also slow things down a little, but as long as savers have nowhere else to put their money, then the effects will be limited. 

If bright-line is to be extended then it needs to exclude newbuilds. Quite clearly, there is a need for newbuilds to continue.

Increasing loan to value requirements will surely have some effect. However, the likelihood is that it will affect first home buyers more than investors. The Reserve Bank could limit new restrictions to investors, but that would imply that the Reserve Bank was acting in a social context rather than a financial stability context.  And that is on not how the Reserve Bank Governor thinks.

The Reserve Bank Governor has now asked for debt-to-income tools to be made available to him. That tool, if granted, is likely to constrain first-home owners much more than investors.

There are no painless solutions to self-created problems
If the Reserve Bank really wants to control the so-called ‘first class problem’, then it has to rein back severely on its quantitative easing (QE) programmes. Reining back on QE means less digital money creation and thereby leaving more Treasury bonds out in the market place. At that point interest rates will stabilise and in high likelihood start to drift upwards again. Some savers may then begin to think that their bank deposits have some safety.

Of course, higher interest rates will be very unpopular for those who now have big mortgages. That illustrates that there are no painless solutions. Accordingly, our politicians have good reason to be cautious of declining house prices. However, the immediate aim is not to drop house prices. It is simply to put out the current inflationary fire.

Quite simply, the longer the fireball continues, the greater the long-term pain must be. And the more that any notion of a team of five million can only be an irony.

Interest rates cannot be changed in isolation
If the Reserve Bank steps back from QE but does nothing else then there may well be some damaging effects. In particular, there will be an inward flow of speculative funds from overseas and the exchange rate will rise. That will have to be addressed.

This illustrates how over the last thirty years New Zealand has become closely integrated within the American and European international financial system. Arguably, that has worked well, and has helped create financial responsibility here in New Zealand.  But these are now very different times.   It is a strange world where our physical economy aligns primarily with the East but our financial systems align with the West.

One ready tool the Reserve Bank does have to sit alongside the reining in of the QE system is to require New Zealand banks to place increasing reliance on NZ-resident funds. That is simple; it is just the stroke of a regulatory pen. 

Nothing will change without a change in the Reserve Bank inflation mandate
The current actions of the Reserve Bank all stem from the specific mandate that requires them to keep consumer price inflation between one percent and three percent, and with a long-term aim of two percent. This target is a consequence of a deep-seated belief within mainstream economics that inflation of this level is necessary to somehow stimulate productive investment.

An alternative perspective is that these mainstream economists have got confused between cause and effect. Even then, the relationship belongs to another time.

I have previously argued   that reducing the inflation target by one percent, so as to lie within a range of zero to two percent would have a transformational effect. That is where the target used to sit twenty years ago.

It would immediately mean that the New Zealand consumer inflation rate was within target and therefore QE could be reined in. To the extent that economic stimulus is still required, it would also place the emphasis firmly back on fiscal policy. But most importantly, it would be the first step to prevent saving behaviours being a mug’s game. And that would take a lot of heat out of the housing market.

A New Year’s wish directed at Grant Robertson
I hope that Grant Robertson will spend the summer break reflecting deeply on the long-term impact of the current Reserve Bank mandate.

 The consequence of that mandate is that pathways for young people without parental financial support to become part of a property-owning team of five million have largely disappeared.  Accordingly, major social inequalities are being further institutionalised. For a Labour Government, this must be a real irony.  Grant Robertson is the only person who can change that.


About Keith Woodford

Keith Woodford is an independent consultant, based in New Zealand, who works internationally on agri-food systems and rural development projects. He holds honorary positions as Professor of Agri-Food Systems at Lincoln University, New Zealand, and as Senior Research Fellow at the Contemporary China Research Centre at Victoria University, Wellington.
This entry was posted in macroeconomics, The economy, Uncategorized. Bookmark the permalink.

15 Responses to House-price inflation and interest rates are bound at the hip

  1. Jeff Gould says:

    Hi Keith
    To build a house in NZ is also very expensive and is aligned to house prices. To build has inflated by about 90% in ten years. (Just the build cost )
    A good portion of house build inflation must be as a result of regulation increasing costs.
    If house prices didn’t increase there would be no new builds.
    I agree with you but I think there are more problems.
    The solution could be ugly

    Ta Jeff Gould

    • Keith Woodford says:

      Jeff, I agree.
      But I think that section prices have increased even faster across much of New Zealand
      Owning a section in Auckland or Wellington is like owning a very productive goldmine
      Keith W

  2. Keith Woodford says:

    I agree that building a house in NZ is very expensive, for multiple reasons, including, but not only, structural issues relating to earthquake risks. But in much of NZ section prices have gone crazy. Right now, section prices in Christchurch are escalating rapidly, and I suspect there are big developer profits being earned. I think that is happening across most NZ cities. My biggest concern right now – or at least one of my biggest concerns – is that we might still be in only the early stages of house price inflation as savers continue to search for safe havens.

  3. Ev Moorhead says:

    Hi Keith. You are right on the money with your observation that investors have few places to run to with their money while Central Banks (CBs) keep driving down interest rates. Hence investor interest in real estate, gold, silver, cryptos and equities because of loss of confidence in fiat money as you rightly say.
    In my opinion CBs still print (thus reducing interest rates) because …even without covid…western economies are not really thriving at all. This inspite of recent NZ pronouncements that we have bounced back well. The world’s tech revolution has generated increased production…no doubt about that….but unlike the industrial revolution…over-all, the job increases have not flowed correspondingly. The political side of this is to respond with job creation schemes that may allow govt to show less unemployment, but do nothing to create limited production increases. To bite the bullet early and allow interest rates to rise would be political suicide, not to mention the effect on the $NZ which would put our exporters out of business.
    We must also not forget that just like supply/demand for money…where printing has dramatically increased the supply…forcing interest rates down…we simply do not have enough houses in NZ. Lack of land supply (zoning and land-banking) plus a pathetic RMA plus local council consents all have a restricting effect on quick building progress. How much Mr Twyford learnt in his failed attempt to fix this I do not know. But I hope Mr Robertson does a lot of thinking and research in his break and takes note of your points that band aids do not work.

    • Keith Woodford says:

      I am in agreement with you. But the most immediate challenge is not so much to raise interest rates but to stop them dropping even further. A key underlying issue that I have not really talked about to date except in a peripheral way is the lack of productive investments in the Western World.
      I agree that if interest rates were higher in NZ then this would lead to an increase in the exchange rate. However, the RB can easily deal with this by requiring banks to fund the majority of their lending with funds sourced in NZ.
      Keith W

  4. David Porter says:

    Thank Keith, really interesting. The longer it goes on, the harder the landing! I say again that Ireland had a similar bubble before the Great Recession and it was a VERY hard landing with the government having to take on a pile of bad mortgages.

    I understand that building costs have increased hugely but, taking a simplistic view, if there was a supply to match demand surely price would not increase to a great extent? Also, if investors could find no tenants because house supply matched demand, this should dampen investors ardour for bricks and mortar?

  5. Keith Woodford says:

    My perspective is that investor demand right now is not only, or even primarily, driven by yield considerations. Rather, it is driven by a search for a safe haven in times of storm. I expect the search for a safe haven to become even more dominant.
    I consider it feasible that rentals will drop over the coming year in those cities where significant building is occurring, with my own city Christchurch being a likely example. But each city will beat to its own drum.
    I also consider it likely that the Government will produce some band-aids to demonstrate that they are trying to do something. Any positive effects thereof will only be very short term and the longer term effects will be to create more distortions in the market.
    As long as citizens are progressively losing faith in the fiat currency (the NZD), with this being linked to the negative real post-tax returns associated with deposits and bonds held in that currency, then the search for a safe haven will continue.
    Keith W

  6. Tom Walker says:

    Hi Keith,
    To put the current situation into a historical perspective,during the Weimar Republic in Germany before the hyper-inflation took off, conditions were very similar too now with a booming stock market and generally a buoyant economy.And I agree with you that investors sitting on a ”melting ice cube” in the bank are looking for a safe haven, hence the huge rise in Bitcoin,gold,property and shares.

    I think we are on a cusp of a totally new financial system…the Economist magazine predicted the collapse of the present system and a new global currency in 1988 (they said it would come about in 2018)

    I know it all sounds very fanciful but not when you know that this is what John Maynard Keynes pushed for at Bretton Woods in 1944..he even had a name for the global currency..the ”Bancor”.

  7. Keith Woodford says:

    I think the differences between East and West, and particularly the fundamental tension between the USA and China will make it very difficult for there to be development of a global currency. I see it as more likely that in time the yuan will sit alongside the dollar as a competing global currency. I expect to see that happen gradually over the next 30 years although there is no sign of this yet occurring. I have doubts as to whether the euro can survive as a reserve currency.
    Keith W

  8. If the main driver of house prices (and the underlying land prices) is a search for a safe haven, why is NZ so far ahead of other countries in this respect? Maybe we just don’t have a sufficiently mature economy to provide alternative investment opportunities. There is also a cultural thing with housing. Everybody assumes the goals is a 1950s-style quarter acre section bungalow with 70%+ ownership rates, but there needs to be a shift to more apartment living and stable rental. That won’t address your issue, but once the Reserve Bank starts behaving more rationally and takes full account of it impact on house prices, then we have to nudge the housing culture in a direction that does not encourage constantly expanding urban sprawl. We are almost on the point of achieving that in Auckland, although uncontrolled migration – adding a million to NZ population in the last 15 years, without debate! – makes that difficult.

    • Keith Woodford says:

      I don’t have the data to make a good comparison with overseas. But I think that our high population growth from immigration in recent years clearly has something to do with it. Also, right now I am aware that the planes have been full coming to NZ but not so full leaving. Also, that those returning are wanting to buy houses whereas those leaving were people on short term visas and they don’t have houses to sell. Other factors that come into it are that we are a hilly country and there is a lack of flat land close to most of our existing cities for them to easily expand onto, with any such land also being valuable for agriculture. A lack of capital gains tax is another factor, with most investors willing to hold for longer than the bright-line test. My vision for NZ would still be as a property-owning democracy. Taking the Pacifica community as an example, I am told that only 20% own a house. That is not consistent with my vision.

      • I am quite happy with a property-owning democracy, but given the way house prices are going I cannot see how low-income people are going to afford to enter that group. And I worry that holding out this “vision” could temper the efforts to make rentals attractive, plentiful and affordable. One option is rent to buy, but what income do you need to sustain that? I saw someone suggesting that people on $60k should be able to buy houses. Lovely idea – but can they afford it on that income, and in a place close to work? Have you been to Auckland recently? If we were to unzip the urban boundary to facilitate the building of traditional owner homes, Auckland would be spilling over well on its way to the Bombay Hills. In Christchurch you have the luxury of a smaller population on a flat plain, and also building two-lane highways in every direction instead of trying to be a compact city! .

      • Keith Woodford says:

        I may be old fashioned but I am going to hold on to my vision of a property owning democracy. The alternative is ongoing rent assistance through into old age. And I absolutely hate the ‘haves versus have nots’ of a society where those on low salaries have no hope of home ownership. And yes, we do need to curtail immigration at least until we have those issues under control. I do agree with KiwiSaver being used for home deposits, but it is not enough. KiwiBuild was always doomed because it was not addressing the fundamental issues. As long as the RB keeps pushing down interest rates to less than inflation rates then the search for a safe haven will continue. In my opinion, less QE plus reinstating the minimum proportion of bank funding to be sourced from within NZ lies at the heart of the matter. And given the conventional thinking within Central Banks across the Western World, it is up to Grant Robertson to get his mind around those issues. The starting point is to lower the inflation mandate mid-point from 2% to 1%. That is the responsibility of the Government, not the RB. I would be happy to take that mid-point down to zero, but that would be a step too far for those who are terrified by the thought of deflation.
        Keith W

      • Well, I hope Grant Robertson is listening to such good sense! As for the property-owning democracy. We have been living it for a long time and in principle it is a great idea. But it can confuse the issue of getting people housed with the issue of giving people a property asset. If both go together, that’s fine. But that is is not 100%, and never will be. I cannot see how low-income people can find the deposits for ownership, leave alone the wherewithall to pay interest on the principal. Then you get governments who want to encourage ownership, so we get Labour building state houses and National selling them. You also have the danger of subsidy. In the UK, as I understand it, mortgage interest is tax-deductible, which obviously favours higher income taxpayers and those with expensive properties. Once in, it is very hard to get rid of. And you also get the dynamic we have now where people are more interested in their homes as a source of capital gain than they are as a roof over their head, and, again, the political dynamic is such as to encourage that goal. It is obvious that people take pride in homes they own and look after them well, and often it is their major wealth asset. But how much and how that should be an objective of public policy when it mainly favours the haves (we have the same arguments about how much subsidy for university fees and support), and how to achieve a roof over people’s heads without wondering about the ownership status are questions that must trouble policy makers and politicians alike!

      • Keith Woodford says:

        I doubt whether Grant Robertson receives my messages, although sometimes I do receive evidence that some articles do get read in Wellington.
        In most cases, interest and other ownership outgoings do not greatly exceed rental charges, and often not at all, particularly once the first few years have passed. Two or three years at the start with two incomes, and before children come along, can be a big help. It is a case of being able to get on to the ladder. There are many factors at play, but safe haven behaviours responding to fixed deposit rates being below inflation are, in my opinion, the fundamental driver right now. I would like to see LVRs for investment properties drop to no more than 50% with the possible exception of new builds, but that would have to come from the Government rather than the RB, because the purpose does not relate to the current RB mandate. And I will keep hammering the notion that the mid-point of the RB inflation target needs to be reduced from 2% to no more than 1%. That is where it was some 20 years ago.
        Keith W

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s