Interpretation of the Section 68B housing direction
In February, the Minister of Finance issued a direction under Section 68B of the Reserve Bank Act for the Reserve Bank to have regard to house price sustainability when making its financial stability policy decisions.2 The direction aligns well with the Reserve Bank’s objective to promote the maintenance of a sound and efficient financial system. Unsustainable asset price growth can lead to a sudden correction in prices, which would have negative implications for the financial system and the broader economy. Housing equity makes up about half of household net worth, and mortgage lending 62 percent of total bank loans.
The direction frames the Reserve Bank’s role in the context of a broader set of government policies, which is important because a wide range of factors affect the housing market and various government agencies will need to work together to achieve what is set out in the policy.
Historically, the Reserve Bank has regularly monitored, assessed, and reported on the risk of a downturn in the housing market and on the vulnerabilities of household and lender balance sheets. The results of these assessments factor into macroprudential policy settings aimed at both leaning against boom-bust cycles and building up financial system resilience to a downturn.3
The Reserve Bank is now expanding this framework by defining and explicitly incorporating the concept of house price sustainability. In terms of the Reserve Bank’s financial stability approach, this means developing our understanding of what contributes to sustainable house prices, and integrating this into decisions on financial policy. The work involved will call for a more active engagement with other public organisations on housing policy.
The Reserve Bank’s working definition of a sustainable house price is the level that the price would be expected to move towards over several years, given the outlook for fundamental drivers. The sustainable price level itself can change when the outlook for the drivers changes. For example, the decades-long decline in global interest rates has gradually lifted sustainable price levels. Similarly, the recently announced tax changes may cause a decrease in sustainable price levels. When house prices deviate significantly from a sustainable level the risk of a correction is elevated. This definition reflects that distributional or supply issues in the housing market cannot be resolved with financial policy tools, although they are important and need to be resolved.
At the core of the Reserve Bank’s framework for assessing the sustainable level of house prices is the value that people derive from housing services (figure A.1). Everyone needs a place to live, whether that is through renting or home ownership, and a significant share of income is spent on housing. Therefore, one key group who have demand for houses is households who must decide whether they will own or rent. The other group is investors, who must decide whether to invest in housing and rent it out or to invest in other assets.
When the expected costs, benefits, and constraints faced by households or investors shift, the interlinked markets for housing services and houses adjust through changes in rents, home prices, and household size. For example, anticipated changes in population growth, tax policy, interest rates or other factors can shift buyer decisions and by extension house prices.
Ultimately, the extent and persistence of price swings driven by shifts in demand depend on whether supply is able to respond to prices and how well market participants can anticipate the supply response. If supply can respond flexibly to prices, then upward pressure on prices will induce an increase in the total quantity of housing and prices will re-adjust. This should similarly occur in different parts of the market, where unbalanced price pressures induce a change in the mix of quality, size, and location of new builds.
However, even if supply is eventually able to adjust, the response can take several years. If a supply response requires policy reforms to ease structural impediments, then the adjustment will likely be more delayed and the outlook for supply more uncertain.
Taking a long-term view, prices are sustainable if the following conditions hold.
- For investors, the expected risk-adjusted returns of investing in housing should be comparable to other long-term investments.
- For renters and prospective owner-occupiers, the expected costs of owning should be comparable to the expected benefits of owning. For example, any difference between the cost of owning and renting should be explainable by fundamental drivers.
- Current housing demand from investors and owner-occupiers should be consistent with the outlook and risks around supply and demand for housing services, and their implications for future rents and house prices.
The Reserve Bank is in the process of refining a suite of metrics to indicate unusual or stretched prices based on the above conceptual framework. The Reserve Bank will consider these metrics when setting financial policy, potentially adjusting settings to steer prices toward a more sustainable level, while taking into account that market price changes take time and not every fluctuation warrants a policy response.
The Reserve Bank’s financial policy tools can help address some of the challenges around housing, particularly when they relate to financial stability, but a broader response is needed to address more wide-ranging societal issues. For instance, the house price level may be sustainable in a market sense, even though rents may be high and deposits unaffordable for prospective first home buyers. In this case, there are social costs that go beyond the implications of house prices for the Bank’s financial stability mandate and these call for a broader public policy response. The Reserve Bank is supportive of the Government’s housing affordability goals, and intends to engage constructively in policy conversations on housing affordability as well as the narrower question of price sustainability.
The market for housing services