New Zealand is a small economy, but it is a trend setter of sorts in central banking. The nation was among the first to adopt an explicit inflation target. The Reserve Bank of New Zealand’s mandate from the government is “to keep future annual inflation between 1 and 3 percent over the medium term, with a focus on keeping future inflation near the 2 percent midpoint” and to “support maximum sustainable employment.” In February 2021, the government formally added a clause to the RBNZ’s mandate, instructing it to consider housing prices in making monetary policy decisions. The change has drawn attention – and some raised eyebrows – from the world’s central bankers. Here’s what it’s all about.
What has changed?
Like the U.S. Federal Reserve, the Reserve Bank of New Zealand (RBNZ) is charged with maintaining stable prices and pursuing full employment. On February 25, 2021, Finance Minister Grant Robertson announced that “the Bank will have to take into account the Government’s objective to support more sustainable house prices, including by dampening investor demand for existing housing stock to help improve affordability for first-home buyers.” With this announcement, the scope of the central bank’s mandate was extended to housing prices for the first time. (To read the formal remit to the RBNZ, click here.)
What led to this move?
The government of New Zealand faced pressure to calm the housing market as the median house price increased 22.8% from February 2020 to February 2021. Prime Minister Jacinda Ardern rolled out a program to build 8,000 new houses as part of the 2020 budget. After her Labour Party won a landslide victory in October 2020, Ardern renewed her commitment to increase the housing supply. Critics said that was inadequate. On March 22, the Labour Party announced new policy initiatives, targeting first-time home buyers. Ardern increased the income thresholds for existing programs that provide grants and loans to first-time home buyers and adjusted policies aimed at taming demand for investment properties. All this contributed to the government’s decision to enlist the central bank in its efforts to make houses more affordable.
What does the change mean for the central bank?
RBNZ Governor Adrian Orr unsuccessfully tried to head off the move. In December 2020, he said, “Adding house prices to the monetary policy objective would be unique internationally, which could make monetary policy less effective and impact financial market efficiency.”
On March 4, 2021, Orr downplayed the implications of the changed mandate for future monetary policy decisions. “Importantly, the Monetary Policy Committee’s remit targets remain unchanged. We remain focused on maintaining low and stable consumer price inflation and contributing to maximum sustainable employment.” Orr signaled that the RBNZ is likely to pursue housing goals with macroprudential policies rather than rate hikes. “We will be considering our financial stability policy settings via our prudential tools – like loan-to-value ratios, bank stress testing, and capital requirements – against particular types of mortgage lending. This is done with a view to moderating housing demand, particularly from investors, to best ensure house price sustainability.”
In its November 2020 Financial Stability Report, the RBNZ had expressed concern about the booming housing market. On March 1, 2021, it reinstated loan-to-value restrictions on mortgage lending – seeking to protect borrowers and overall financial stability from the potential risk of a price correction in the medium term.
What does the change mean for central bank independence?
The announcement of the change to the RBNZ remit drove up 10-year government bond yields in New Zealand, perhaps signaling that the added consideration of housing prices will force the bank to raise rates sooner than expected. This concern is perhaps overblown, given Orr’s commitment to the use of macroprudential tools rather than interest rate adjustments to address housing. However, economists have also raised concerns over the wording of the change to the remit. Cameron Bagrie, founder of Bagrie Economics, told the Financial Times: “The use of the phrases ‘government policy’ and ‘government objectives’ in relation to house prices risk encroaching on the independence of the RBNZ. They should have just said house prices should be a consideration, an explicit mention of what already happens. I think linking it to government policy/objectives goes too far.”
Should central banks consider asset prices in monetary policymaking?
In making monetary policy, central banks generally focus on the prices of goods and services, but there are occasional calls for them to pay more attention to prices of assets, such as houses or the stock market. This debate is not new; as early as 2000, it was a topic of global discussion – the second Geneva Report on the World Economy was titled “Asset Prices and Central Bank Policy.”
There long have been calls to use interest rates as a tool to pop asset bubbles. However, in his first speech as a Federal Reserve Governor in 2002, future Fed Chair Ben Bernanke argued that it was crucial to use the right tool for the job when making policy. “As a general rule, the Fed will do best by focusing its monetary policy instruments on achieving its macro goal – price stability and maximum sustainable employment – while using its regulatory, supervisory, and lender-of-last resort powers to help ensure financial stability.”
In the same 2002 speech, Bernanke directly addressed the idea that the Fed should meddle directly with asset prices: “I think for the Fed to be an ‘arbiter of security speculation or values’ is neither desirable nor feasible.” However, asset prices can have implications for the Fed’s mandated goals of full employment and price stability – as well as for its responsibility for avoiding financial crisis – so a central bank cannot ignore developments in these markets. Bernanke favored the use of macroprudential tools to deal with financial market excess, rather than preemptive interest rate hikes. Identifying asset price bubbles is difficult, and taming them with the conventional tools of monetary policy has implications for the macroeconomy.
This is especially clear when considering the extent of monetary policy tightening that would be required to reliably control asset prices. Research from the San Francisco Fed has found that it would have taken 8 percentage points of monetary tightening between 2002 and 2006 to completely avoid the housing bubble that preceded the 2007-2009 global financial crisis. For context, the federal funds rate has not been 8 percentage points above its April 2021 level since October 1990. A monetary policy that contractionary would surely have slowed the recovery from the recession of 2001 and likely driven the economy back into recession.
Why might housing price bubbles be costly?
The costs of preemptive rate hikes still must be weighed against the costs of financial instability associated with asset price bubbles. Historically, costly bubbles have been associated with credit booms, while other bubbles are less damaging. Housing price booms can be especially dangerous because they are heavily financed by extension of credit by the mortgage market. These factors – along with other threats to financial stability – have to be considered by central bankers as they analyze the balance of risks in the economy.
However, the mandate given to the RBNZ from the Finance Minister appears to have a different priority. Rather than describing house prices as a potential threat to financial stability, the government mandate asks the RBNZ to consider the impacts of its policy decisions on housing affordability. Governor Orr has said that the RBNZ should consider housing prices as they pertain to financial stability with its macroprudential toolkit as opposed to trying to reduce housing prices for first-time buyers, a goal better met by increasing the supply of houses and targeted fiscal policy.
What does the current Fed leadership say about asset price considerations for monetary policy?
Like his predecessors, Federal Reserve Chair Jay Powell is skeptical of the use of interest rates to deal with asset price bubbles and prefers to turn to macroprudential tools for that purpose. In a January 2021 press conference, Powell said, “We don’t actually understand the tradeoff between if you raise interest rates and thereby tighten financial conditions and reduce economic activity now in order to address asset bubbles and things like that—will that even help? Will it actually cause more damage, or will it help? So I think that’s unresolved. And I think it’s something we look at as not theoretically ruled out, but not something we’ve ever done and not something we would plan to do. We would rely on macroprudential and other tools to deal with financial stability issues.”
In its updated statement of its monetary policy strategy, the Fed said it views financial stability as part of its assessment of risks, not as one of its primary mandated objectives: “[S]ustainably achieving maximum employment and price stability depends on a stable financial system. Therefore, the Committee’s policy decisions reflect its longer-run goals, its medium-term outlook, and its assessments of the balance of risks, including risks to the financial system that could impede the attainment of the Committee’s goals.”