Monday, August 26, 2013

Macroeconomic Prudential Policy in New Zealand

As a result of the concern about recent housing price hikes in Auckland, and the potential destabilizing effects to the financial system, the Minister of Finance and the Reserve Bank of New Zealand’s governor signed a memorandum of understanding about macroeconomic prudential policy on May 13, 2013. The core idea is that the central bank stands ready to maintain the stability of the financial system by reducing and managing the risks to the financial system.

Systemic risk is something like a market-wide risk, where shocks affect certain variables and those variables affect other variables in an unpredictable way. Obviously, systemic risk is hard to measure.

The memorandum identifies a set of instruments, such as adjustments of core funding ratio, a counter-cyclical capital buffer, adjustment to sectoral capital requirement, quantitative restrictions on the share of high loan-to-value ration, and outright limits on the proportion of the value of the residential property that can be borrowed. For example, policy calls for the central bank to increase capital requirement at the upturn of the business cycle and reduce it at the downturn. Presumably, the policy will work alongside monetary policy to deal with credit and asset price increases. The rationale for such a strategy is that monetary policy alone is incapable of moderating booms without inflicting severe damage on the economy, Bean et al. (2010).

This discretionary policy should be seriously and critically assessed before implementing it. I have not seen empirical research in this area in New Zealand, and the memorandum admits that this framework is a ‘developing area’ and it will evolve over time. 

John B. Taylor aired his views in a speech last April at the Federal Reserve Bank of Atlanta, and I would like to bring his points to the attention of the New Zealand people, just in case it was missed. Taylor lists a number of problems. He says:

First, “…if [interest] rates had not been unusually low and we still had rapidly accelerating housing prices, then the case for capital buffers would be more reasonable. But there is a lot of evidence that rates were too low.”

“Second, policymakers would have to use a great deal of discretion in implementing the policy. Little is known about the short-run dynamic impact of a temporary change in capital requirements, especially when people are forward looking and endeavour to understand the meaning of such a change. We may not even know the sign of these impacts. And policy lags can create classic unintended consequences in which the lagged impact of a temporary increase in the capital buffer occurs at just the time the bubble is bursting and greatly worsen the downturn.”

“Third, there is a problem coordinating these decisions with traditional monetary policy actions. The policy will likely bring the central bank into political controversy, especially if the instrument is targeted on sensitive sectors like housing. It will be very hard for central banks to take on another cyclically-focused discretionary policy instrument without completely overloading the system.”

Then Taylor suggests,

“Rather than manipulating capital buffers in this complex and temporary way a more effective approach is simply to set the required capital ratios at an appropriate level on a permanent basis and keep them there. This automatically will create a more predictable environment for decision making. Ideally, the appropriate amount of capital should be decided in conjunction with an appropriate amount of subordinated long-term debt to facilitate the orderly bankruptcy.”

This policy focuses on the housing market in New Zealand per se because housing is the most important asset on the household balance sheet.  Hence, housing price instability is an important issue, perhaps the main issue, for the macro prudential policy.

The Reserve Bank of New Zealand’s Bulletin article, Chris Hunt (2013), takes a look at the past decade and conducts a counterfactual experiment to map the Bank’s new macro prudential policy onto the past financial development. It concludes that such policy, had it been adopted, would have been “a compelling case for macro-prudential intervention from 2005 onward to address a build-up of systemic risk within the financial sector.” The article does not shy from showing that the interest rate during that decade was low. The author says, “In short, an unexpected surge in net migration over 2001, and a supportive interest rate environment following monetary policy ‘insurance cuts’ in the face of perceived risks to global growth in the early part of the decade laid the foundations for a sustained expansion in house prices and household net worth.”

By ‘supportive interest rate environment’ he probably meant that monetary policy was easy. If this is the case, there must be some ‘interest rate’ level to compare to, e.g., the neutral real rate or the interest rate implied by some policy rule. If monetary policy was easy, then Taylor’s remark above also applies to New Zealand.  Keeping monetary policy easy for a long period of can cause prices increase.

The increase in house prices led many to talk about a ‘housing price bubble.’ The idea of bubbles implies that the price of the house does not reflect market fundamentals, i.e., supply and demand forces. The problem is that there is no credible empirical evidence that support the existence of bubbles in the housing market. Arthur Grimes and others studied land and housing price dynamics in New Zealand. I read this research a few years ago and my understanding is that the reason for high housing price in New Zealand could be building restrictions imposed on land and construction, which reduced the supply and, hence, increase the price. I quickly searched this subject in Google Scholar and found only one paper published on this matter, Fraser, Hoesl and McAlevey (2008). I interpret their conclusion to be that there is no evidence for bubbles in the housing market over the period 1970-2005. More research is needed.

Bubbles are hard to measure. Before we plunge into arguments about bubbles and design policies to deal with unobservable variables one should begin with something more elementary, but important: estimating the elasticity of the supply of housing (or land and housing or land) because these would tell us something important about housing prices in the face of excessive demand. The elasticity is a measure of the responsiveness of the supply to small changes in the price.

In the diagram below, the price is on the y-axis and the quantity is on the x-axis, hence demand and supply curves intersect each other. The steeper the supply curve (fixed), the higher the probability that the price of housing will increase significantly when there is a positive demand shock for housing. In other words, when the supply curve is vertical—as a polar case—an increase in demand would result in an ever higher price. In the sketch below, P3 is higher than P2.

Another concern stems from the effect on productivity. The housing sector stimulates the production in other sectors, such as manufacturing. There is evidence that New Zealand has a shallow level of capital relative to OECD countries, which could be correlated with low labour productivity. See the New Zealand Treasury (2008). So what is the effect on labour productivity in the housing sector and the other related sectors if the Reserve Bank underestimates or overestimates the amount of capital required over the business cycle? Or fails to identify the nature and the permanency of the shocks? Or fails to identify the boom or the bust, i.e., makes an error in the timing of the cycle and instructs the banks to reduce or increase the capital ratio and credit?

Even though the policymaker has the honourable intention of stabilizing the financial market, it is easy to make errors in policy and these errors are usually very persistent. It would cost a lot to undo them.

Since the main concerns of policymakers are pertinent to recent housing price rise, recently, some politicians called for laws to restrict non-residents from buying property in New Zealand in order to reduce demand and moderate the price of housing. But markets experience ups and downs and for many different reasons. The question is what would they do to stimulate the market when demand is low? Would they suspend the proposed law?

The increase in discretionary and regulatory policies has become alarming in free and democratic societies. Although research always lags policy, this should not prevent more economic research in this area to aid politicians in making informed policies in the future. The memorandum of understanding above allows for more research and potential amendments.

The role of monetary policy is very well understood. Some objectives are beyond the reach of monetary policy, e.g., it cannot reduce unemployment beyond the natural rate of unemployment without inflating the economy in the long run. Similarly and for the reasons outlined by Taylor above, a macro prudential policy on its own would be unable to permanently manage demand pressures.

A strategy to stabilize housing prices should have all of the following policies together:

First, the first thing we need is to increase the supply of land and housing and simplify building regulations. Don Brash, Hugh Pavletich, Phil Hayward, and Nick Smith, among others, advocate such policy. In the diagram above, an increase in the demand for housing results in a price P2 instead of P3.

Second, the government and the Reserve Bank must reign on, or have moral hazard in-check jointly.
Third, most OECD countries have some form of capital gains tax, except New Zealand, and maybe the Netherlands. Careful research into this area is necessary to design an optimal tax rate that should reduce the risk that arises from excessive speculations in the housing market. Obviously this policy cannot work effectively if the supply of housing is fixed and moral hazard is unchecked. 

Fourth, monetary policy should follow a rule rather than discretion. So far central banks have resisted this approach. However, monetary policy could target the price level in addition to inflation. A price index could be designed, where more weights are put on housing and assets than goods and services. Gorodnichenko and Shapiro (2007) and Coibion and Gorodnichenko (2011) show that this rule guarantees determinacy even under trend inflation; and it is straightforward to show that it is akin to a super-inertia rule, i.e., the interest rate will be highly persistent. The diagrams below show the difference between inflation targeting and the price-level targeting. They show a demand shock, which causes the price to increase in period 1. Under price-level targeting, in period 2, the central bank has to bring the price level back to its level before the shock.

Inflation Targeting 

Price-Level Targeting 


Bean, Charles, P. Matthias, A. Penalver and Tim Taylor, (2010), Monetary Policy after the Fall, Federal Reserve Bank of Kansas Annual Conference, Jackson Hole, Wyoming, August 28.

Coibion, O. and Y. Gorodnichenko, (2011), Monetary Policy, Trend Inflation, and the Great Moderation: An Alternative Interpretation, American Economic Review 101, 341-370.

Hunt, C., (2013), The last financial cycle and the case for macro prudential intervention, Reserve Bank of New Zealand: Bulletin, Vol. 76, No. 2, 3-16.

Fraser, Hoesl, and McAlevey, (2008), House Price and Bubbles in New Zealand, Journal of Real Estate and Financial Economics, 37: 71-91.

Gorodnichenko, Y and M. Shapiro (2007), Monetary Policy When Potential Output is Uncertain: Understanding the Growth Gamble of the 1990s, Journal of Monetary Economics 54 (4), 1132-62.

Taylor, John B. (April 2013), Simple Rules for Financial Stability, Dinner Keynote Address at the Financial Markets Conference “Maintaining Financial Stability: Holding a Tiger by the Tail” Federal Reserve Bank of Atlanta, Atlanta, Georgia.

Treasury Department, (2008), Investments, productivity and the cost of capital: understanding New Zealand's shallowness of capital, Productivity Paper 2008/03.