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
References
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.
