The introduction of loan-to-value ratio limits on mortgages (LVRs) by the Reserve Bank on 1 October 2013 has been a controversial policy development this year. It appears to have been responsible for a spike in house sales in the middle of the year, with the seasonally adjusted number of house sales increasing by 5.1% in the September quarter. Thus it seems very likely that there will be a natural decline in the number of house sales in the December quarter, irrespective of the extent that the LVR regulations will have an ongoing impact on the housing market.
Although protecting the integrity of the financial sector underpins the development of LVRs, the reasoning provided by the Reserve Bank, seems to have morphed into being about protecting new, highly leveraged, entrants into the housing market from the risks of house price declines. I must admit hearing this type of justification for policy intervention fills me with considerable unease. There is no discussion of normal policy considerations like market failures or externalities. Instead it smacks of the glorious and all-knowing Bank protecting us from our own ignorance and excessive greed. My experience is that when it comes to self-interest, people from all walks of life on the whole tend to be very astute in assessing what is best for them.
In the case of home ownership, as I have discussed previously, there are obvious tax incentives that make it highly advantageous for people to own their own home, and the younger one begins the better. This in turn suggests that the LVRs have two associated problems. First rather than addressing the tax-related root cause to an excessive demand for home ownership it is trying to curb demand by introducing a new set of regulations. If you cannot change the tax rules then there may be some merit in a LVR scheme, but the result will invariably be worse than an approach that directly addresses the tax design issue.
The second issue relates to one of the political mandate for the LVR regulations. Tax laws are determined by government and parliamentary votes. If it is the political will to have a tax system that favours home ownership, what is the political mandate for a non-elected body like the Reserve Bank to introduce regulations to “protect” people from taking advantage of these tax rules? Ultimately the Bank is imposing highly selective regulations that are limiting free choice and redistributing wealth across society. These are the type of actions that normally require a political mandate, and it is not obvious that the Bank possesses this mandate. Unlike the elected government, we do not have the recourse to vote out the Reserve Bank Governor at the next election if we are not happy with the Bank’s performance.
On balance New Zealand is well served by systems that protect roles like the Reserve Bank Governor from political interference. We know from experience that political influence can undermine the effective implementation of monetary policy. A key purpose of the 1989 Reserve Bank Act was to provide this type of protection to the Governor, and this independence has contributed to the generally low inflation environment that New Zealand has sustained since then. We can quibble about the appropriateness of monetary policy settings at any particular point in time, but such concerns are second order in comparison to the overwhelming success of the institutional framework established by the 1989 Reserve Bank Act. The independence of the Reserve Bank has served New Zealand well.
But one reason for this success was the narrow focus of the Act, with the primary aim being the protection of the value of the New Zealand monetary system via inflation control. The Bank also has a responsibility for protecting the integrity of the financial system, and this role has increased in importance since 2007, and is ostensibly a key consideration behind the introduction of the LVR regulations.
Irrespective of the merits of the LVRs in protecting the integrity of the financial sector, it is being sold by the Bank as a means of influencing the demand for housing. This might simply be rhetoric in order to make their introduction more palatable (although why calling new home buyers stupid should be regarded as good spin escapes me). I am concerned that using such spin to justify the LVRs represents a step by the Bank into the political domain, which if unchecked risks leading to an erosion of the Bank’s operational independence.
Another part of the spin associated with the introduction of the LVRs has related to linking the expected impact of the LVRs to interest rates (see p5 of the September 2013 Monetary Policy Statement). The inference is that the LVR has joined the official cash rate (OCR) as a new, housing market targeted, instrument for implementing monetary policy. Again this might simply be spin, but if so it is dangerous. What is the true purpose of the LVR? Is it to protect the financial system, to protect new home buyers from themselves, a new precision instrument for reducing inflationary pressures sourced from the housing market, or a wonder drug that does all three things at once?
Now I really hope that all my confusion about the LVRs simply reflects my own stupidity or, at second best, just some inept communication by the Bank. My real concern is that the Bank may be equally confused. One thing that is for sure is that the introduction of this new regulation is going to make the implementation of monetary policy a lot more complicated and uncertain in coming months.
The Bank has introduced this new regulation just at the time that inflation pressures appear to be on the rise. In the September quarter inflation jumped from 0.7% to 1.4%. With non-tradeable inflation at 2.8% one could imagine that inflation could very quickly be threatening the top of their 1-3% target range. But if the introduction of the LVRs is expected to quell inflation pressures from the housing market, then maybe much of the recently observed increase in inflation pressures could also dissipate quite quickly. But how will the Bank know which path we are on? The first sign of the effectiveness of the LVRs might be to see some reductions in the number of house sales. But if there was a boost in house sales in September in anticipation of the introduction of the LVRs, a fall back in sales in the December quarter might be expected anyway and so tell you very little about the impact of the LVRs. Maybe it is best to wait until we get information about house sales in the March quarter? How long will it take before a LVRs induced slowdown in the housing market will feed through into lower generalised inflation pressure? What does the Bank do if the expected slowdown in house sales takes longer to appear and inflation pressures continue to mount?
What perhaps looked to the Bank like a king-hit new policy six months ago, must now be starting to look like a big gamble and could become an almighty headache in coming months.