House prices above sustainable levels
House prices are above their sustainable level the Reserve Bank – Te Pūtea Matua – says.
In comments prepared for a hearing of the Finance and Expenditure Committee, Reserve Bank Governor Adrian Orr said New Zealand’s house prices are above a level that is sustainable given the outlook for the supply of, and demand for, housing.
“The key drivers of housing supply and demand have turned around,” he said.
Underlying demand for housing has declined significantly due to low population growth since the outbreak of COVID-19 last year. At the same time, house building is at record high levels and mortgage interest rates are rising.
We expect house price inflation to moderate significantly in the period ahead. In our projections, house prices are assumed to eventually fall as momentum in the housing market fades,” said Mr Orr.
“In the face of the COVID-19 pandemic in early-2020 we acted quickly to best meet our inflation and employment mandate. Our ‘least regrets’ policy was to reduce interest rates to very low levels to support the economy.
Subsequently, government support for jobs and business, low interest rates, a closed international border, and New Zealand’s health response helped prevent a sharp rise in unemployment, declining inflation (deflation), and general financial instability. Employment and inflation expectations remain consistent with our mandate, and New Zealand’s financial system is robust.
House prices also rose as spending and investment was diverted. This is a pattern seen in many other countries in response to fiscal and monetary support designed to underpin economic recoveries. The magnitude of the recent house price increases across countries is related to the supply situation and the strength of their economy. In New Zealand, housing supply was low and the economy strong.
“Our ‘least regrets’ policy now is to further reduce monetary policy stimulus to best ensure we meet our inflation and employment mandate in the period ahead”.
The Bank looked at house prices in our August Monetary Policy Statement and has responded to recent questions about house prices from the Finance and Expenditure Committee.
The following is an abbreviated summary of these two documents.
The role of house price projections at the Reserve Bank
The Reserve Bank pays close attention to developments in the housing market for a number of reasons:
- Wealth is one driver of household spending, and equity in housing represents 55 percent of household net wealth. Rising house prices leads to higher household spending, which in turn influences economic activity, employment and consumer price inflation. Rising house prices also more directly influence a number of components of the Consumers Price Index, such as construction costs and rents. As a result, actual and projected house prices are an important input into monetary policy decisions.
- Housing market outcomes are also important for financial stability, as unsustainable house prices can be an indicator of future financial instability. For this reason, we have been further developing our tools to assess the sustainability of house prices. Our assessment of house price sustainability feeds into decisions on the use of some of our financial stability tools such as loan-to-value ratio restrictions and whether to introduce debt serviceability restrictions.
For both of these purposes, we form projections of the most likely direction of house prices. House prices, as with all asset prices, reflect buyers’ expectations of their future earnings. This means that house prices can move rapidly when expectations change, making them inherently volatile.
We update our projections for house prices every six weeks, reflecting the latest developments over that period. This means we can adapt our policy settings as data evolves, thereby avoiding policy surprises.
Explanation of recent Reserve Bank house price projections
Prior to the onset of COVID-19 we observed an increase in house price growth at the end of 2019. Our February 2020 projections were for annual house price inflation to slow in response to projected moderation in net immigration, high residential construction activity, and the effects of past lower mortgage rates fading.
Our baseline scenario for house prices changed materially as a result of the impacts of COVID-19. In May 2020 we assumed that house prices would decline by around 9 percent by the end of 2020. At that time our central projection was for unemployment to rise to 9 percent, and that was expected to exert material downward pressure on the housing market.
High levels of unemployment were also expected to lead mortgage lenders to be more cautious in their lending decisions, reducing the availability of mortgage loans.
Over the course of 2020 the economy proved more resilient than we had expected, due to the effective health response and significant fiscal and monetary support for the economy.
The much stronger than expected economy, and the associated improvement in job security, has been a key reason for higher house price outcomes. As of the March 2021 quarter, the unemployment rate was 4.7 percent, well below earlier projections and has since fallen to 4 percent in the June 2021 quarter.
Demand for housing has also been supported by other unanticipated factors. An initial surge of returning New Zealanders and visitors deciding to stay at the start of COVID-19 led to higher population growth than forecast. Momentum dynamics, which could reflect factors such as expectations of future capital gains have also played a part in amplifying house price growth. In addition, lower interest rates have lifted housing demand by making mortgages more affordable.
Globally, asset prices have also risen more generally following COVID-19, in response to fiscal and monetary support designed to underpin economic recoveries.
House price sustainability
In New Zealand, house prices have grown rapidly over the past year from an already elevated level. A confluence of factors suggests that house prices are above what is sustainable. While house price inflation has slowed in the past three months, momentum has been stronger than expected. A moderation in house prices is expected over coming years, but the precise timing of this is uncertain.
House prices appear to be above their sustainable level
- Underlying demand for housing due to population growth has declined significantly since the outbreak of COVID-19 last year. While New Zealand citizens who returned from abroad before the pandemic stayed on and others returned early in the outbreak, this inflow was shortlived. Border restrictions have since limited inward migration, and there has been a small but steady flow of departing residents. Net migration is not anticipated to return to pre-COVID-19 levels over the next few years, even if border restrictions are eased.
- Meanwhile, house building is at record high levels (figure 1). Residential building consents and discussions with construction sector firms suggest there is a signficant pipeline of new housing supply ahead. Previous large increases in housing supply in New Zealand, such as during the 1970s, have reduced real house prices. In recent decades, several other countries have experienced declining house prices following significant increases in supply.
Building consents data suggest that by the middle of next year, the total number of houses will be growing at its fastest pace since data became available in the early 1960s.
Figure 1: Indicative new housing supply and population growth (monthly, 12-month moving average)
Source: Stats NZ, Electricity Authority, Reserve Bank estimates.
Note: Additional houses built is based on the change in electricity connections to residential properties, while residential building consents are scaled to produce estimates prior to 2003 and a projection for the next year. Additional houses demanded is population growth divided by people per dwelling.
Housing supply did not keep up with population growth over most of the past decade, lifting house prices and encouraging people to live in larger households. We consider this undersupply to already be reflected in current house prices. As a result, further strong house building will put downward pressure on house prices, even given the historic undersupply.
Other factors moderating demand
- The return on investing in housing will be reduced significantly by the removal of the tax deductibility of interest from rental income and the extension of the brightline test. Along with tighter LVR requirements, these policy changes have reduced investor buying activity in the housing market. The share of new mortgage lending for investment property has declined to 17 percent from around 26 percent at the beginning of 2021.
- Interest rates are low relative to the neutral level, and therefore below where they will eventually converge. As interest rates rise, this will impinge on demand for housing in several ways. Higher interest rates will make investing in housing relatively less attractive than interest-bearing assets. In addition, the ability of new buyers to service debt while leaving enough income for consumption will become more constrained (figure 2). Households are borrowing more relative to their incomes, in part because at current low interest rates debt servicing costs are low for a new buyer. However, if interest rates increase back to a more neutral level then borrowing capacity would be reduced. In this scenario, it is likely that demand to purchase houses at current prices would fall significantly.
Figure 2: Estimated debt servicing cost for new buyers as a share of income
Source: RBNZ estimates.
Note: Debt servicing costs includes both interest and principal repayments, based on a 30-year mortgage term. They assume buyers purchase a house at the median selling price, with a 20 percent deposit.
We anticipate a realignment in house prices
With house prices above what is sustainable, some form of realignment is anticipated.
However, as seen recently, momentum in house price growth can persist even when prices look disconnected from the fundamental factors that should determine them. This reflects that sentiment, expectations, and prevailing narratives surrounding the housing market can have a significant bearing on housing demand and house prices. The further house prices rise above their sustainable level, the larger the required realignment will need to be.
It is not clear when and how a realignment of house prices will occur. Growth in household incomes could lift the sustainable level over time to a point that current prices would be sustainable. However, even if house prices stay at their current level and incomes grow as they have historically, it would take eight years for house prices to return to the same level relative to incomes as in early 2020. Alternatively, falls in house prices could facilitate a faster adjustment towards a more sustainable level (figure 3).
Figure 3: Indicative median house price-to-income scenarios
Source: Stats NZ, REINZ, RBNZ estimates.
Note: All scenarios assume that median household disposable income grows at 4 percent annually, which is close to the 10-year average annual growth rate. Scenario B assumes that the median house price grow at the same rate as our projection for the Corelogic House Price Index. The line for Scenario B ends in the September 2024 quarter, at the end of our projection horizon.
We expect house price inflation to moderate significantly over the coming quarters, consistent with the factors discussed above – low migration, high levels of house building, higher interest rates, and tax policy changes. In our projection, house prices are assumed to eventually fall as momentum in the housing market fades. A more significant fall in prices is possible.
The Reserve Bank will be consulting on a proposal to tighten restrictions on mortgage lending at high loan-to-value ratios. It also intends to consult on introducing debt-to-income (DTI) restrictions and/or floors on the interest rates banks use in their mortgage servicability assessments. These measures are intended to ensure borrwers are resilient to a range of future economic and financial conditions.
The MPC remains focussed on its inflation and employment objectives. The MPC will continue to assess the impact of monetary policy on sustainable house prices, as required in the Remit.
Table A: Summary of the relationship between housing and the Reserve Bank
|Monetary policy||Financial Stability (Prudential) policy|
|Primary objective||Price stability
Support maximum sustainable employment
|Promoting the maintenance of a sound and efficient financial system.
Avoiding significant damage to the financial system that could result from the failure of a registered bank.
|Other objectives||Have regard to the efficiency and soundness of the financial system
Seek to avoid unnecessary instability in output, interest rates and the exchange rate
Discount events that have only transitory effects on inflation
|Reduce the risk that the financial system amplifies a severe downturn.
Have regard to the impact of prudential policy on economic growth.
|Housing considerations||Assess the effect of its monetary policy decisions on the Government’s policy to support more sustainable house prices, including by dampening investor demand for existing housing stock, which would improve affordability for first-home buyers.
||Have regard to the Government’s policy to support more sustainable house prices, including by dampening investor demand for existing housing stock which would improve affordability for first-home buyers.
|Impact of housing on objectives||MPC take housing market dynamics into account when forming monetary policy, as housing wealth is an important driver of household spending and housing market-related prices are included in the Consumer Price Index.
||The Bank takes housing market dynamics into account when assessing financial stability risks and forming prudential policies, as mortgages are the NZ banking system’s largest exposure and houses are the largest household asset.
|Monetary policy||Financial Stability (Prudential) policy|
|Tools||The level of retail interest rates as influenced by:
Official Cash Rate; Large Scale Asset Purchases; Funding for Lending Programme; and Purchase of Foreign Assets
|Capital and liquidity requirements
|Impact of tools on housing||Monetary policy affects house prices and housing affordability by influencing mortgage and renting costs, economic growth and employment.||Prudential regulation affects the availability and cost of mortgages by placing requirements and restrictions on mortgage lenders.|
Table B: What we mean by sustainable versus affordable house prices
|Sustainable house prices||Affordable house prices|
|Tools||The level that house prices will converge to over several years given the outlook for supply and demand||The international standard is that adequate and decent housing accommodation should not cost the worker more than a reasonable proportion of income (e.g. 30% of their income), whether by way of rent for, or by way of payments towards the purchase of, such accommodation.|
|Distributional||While house price sustainability doesn't consider who the buyer is, the direction from the Minister of Finance includes dampening investor demand to support affordability for first home buyers.||Majority of households are able to buy their own home, and practically everybody can afford to rent.|
|Key determinants||Changes to policy settings, the economy, supply and demand impact sustainable house prices. Key drivers of demand are incomes, trends in interest rates, and demographic variables. Key drives of supply include the supply of developable land, construction costs, and the existing stock of residential dwellings.
||The price of housing relative to income determines affordability. In an efficient market, the price of housing is set by replacement value (cost of constructing a new house plus land price). In an uncompetitive urban land market, prices are set as the net present value of the future expected income stream.
|Metrics||Cost of owning vs renting, housing returns relative to other investments, metrics of new supply and new demand
||Home ownership rates, rent to income ratios (distribution as well as central tendency), cost of owning as share of income.