House prices might be sustainable but they're still a worry

Guest post by Brian Fallow

Federal Reserve independence under Trump: “a slight backward step:” Adrian Orr.

Source: RBNZ

Despite their falls over the past three years, house prices are still around the top of the Reserve Bank’s estimate of sustainable levels.

That’s a worry, having barely sustainable house prices which comprise so much of household wealth, when the risks of the economy being sideswiped by another major shock have just increased with the election of a capricious, authoritarian isolationist to the White House.

By “sustainable” the bank means the level house prices should move towards based on the medium-term outlook for underlying drivers of the housing market like household incomes, population growth, the responsiveness of housing supply, tax policy and, not least, interest rates.

It should not be confused with affordability. That’s about whether most households are able to buy their own home and practically everybody can afford to rent. It’s about how much of household incomes is pre-empted by housing costs.

“The housing market can be sustainable from an economic perspective but still create social outcomes that are seen as undesirable,” says an analytical note on the subject the bank published three years ago at the peak of the latest cycle.

“For example restricted land supply can cause prolonged upward pressure on house prices as demand increases.

Becoming less affordable

“This in turn can lead to historically high house prices that are sustainable due to persistent land restrictions, while at the same time becoming less affordable to many New Zealanders.”

That is by way of preamble to what the bank’s latest biannual financial stability report released this week has to say about the housing market which, given that home loans make up more than 60 per cent of bank lending, is central to the stability of the financial system.

The bank’s nationwide house price index peaked three years ago and has fallen 13 per cent since then.

The median house price is now 9.3 times the median household income nationally (10.4 times in Auckland). While that is the lowest the multiple has been for four years it is still painfully high by longer-term standards, having been around 5 times income back in 2000.

One key metric of house price sustainability the Reserve Bank monitors is mortgage servicing costs (principal as well as interest) as a share of median household income.

It takes the median house price and assumes a two-year fixed rate loan and an 80 per cent loan-to-value ratio.

Those mortgage servicing costs have fallen to 50 per cent of income, the lowest for four years but still well above the levels, around 40 per cent, prevailing between the global financial crisis and the onset of the covid pandemic.

Renting comparison

Another key metric compares mortgage interest costs to renting. Interest costs are now 10 per cent higher than rents, down from 42 per cent higher at the end of 2022, but again still high compared to the 2010s.

The bank reckons debt servicing costs are around their peak and beginning to fall. It is in easing mode, after all, and borrowers’ recent preference for shorter term fixed rates means about half of all mortgage loans are expected to reprice within the next six months and around 75 per cent within a year.

The prospect of a bit more consumer spending power will no doubt be welcome to many businesses but given that the labour market is a cyclical laggard unemployment is expected to get worse before it gets better.

The bank also sees recent changes to the tax treatment of investment properties as positive for house prices.

Of the other major drivers of house price sustainability, population growth has slowed markedly from its post-Covid surge, reflecting haemorrhagic net outflows of New Zealanders, but on the other hand building consents for new dwellings have fallen from a high of 51,000 in 2022 to around 34,000.

The biggest threat

So far, so insular. Arguably the biggest threat to household wealth comes from the other 99.8 per cent of the world.

“A severe recession remains the key risk to the New Zealand financial system,” the bank says.

“As part of our stress testing programme this year we asked 13 banks to simulate the most plausible scenario that would cause them to breach capital requirements. The aim of the exercise was to improve banks’ risk management by examining their vulnerabilities and the actions they could take in response.”

Seven of the 13 banks cited geopolitical risk as the likeliest trigger of a recession that could threaten the adequacy of their capital buffers.

Other primary shocks cited were an earthquake on the Alpine fault, preceded by a collapse of the global reinsurance industry; a volcanic eruption in the Auckland region, again with insurance retreat; an outbreak of foot and mouth, or another pandemic.

A preoccupation with geopolitical risks was unsurprising in the context of wars raging in Europe and the Middle East, both of which look more likely to escalate than to end any time soon. Then there is the mounting tension between an increasingly assertive China and an increasingly defensive United States.

The Trump threat

The salience of the banks’ geopolitical concerns has just risen with the election of Donald Trump.

It threatens a return to the 1930s, when economies were hobbled by protectionism, democracy was in retreat while far-right populism was on the rise, and aggression was met with appeasement.

It did not end well.

Appearing before the finance and expenditure select committee yesterday the Reserve Bank predictably took a more sanguine line.

Labour finance spokeswoman Barbara Edmonds asked what it was doing internally to grow its own capability to assist the banks or provide guidance to the banks, in the light of their geopolitical concerns.

Deputy governor Christian Hawkesby said geopolitical risk covered a range of things: trade wars, loss of confidence ,higher inflation pressures as a consequence, and then higher interest rates. Cyber attacks and issues with access to capital could also arise. Those were all key channels the bank would look at in future stress testing.

When National MP Nancy Lu asked directly about the impact of Trump’s election Hawkesby said the big picture is that a Trump presidency would mean higher tariffs than currently across the board and particularly against China, lower taxes both business and personal, and less regulation.

The immigration question

Less immigration as well. “From a macro-economic point of view we think that, at the margin, is a higher inflation package than the alternative but one that is very much manageable in the world of operationally independent central banks.”

From the financial stability perspective that was a central scenario but there were risk scenarios around that, about for example tit-for-tat trade responses. The bank’s focus would be on ensuring the system was resilient not only to the central case but those outlying scenarios.

NZ First’s Mark Patterson found that response quite sanguine in the context of US federal debt over $30 trillion, tariffs not seen since the 1930s, and two hot wars.

Governor Adrian Orr said that at a recent meeting of his international peers at the IMF and World Bank meetings they were far from sanguine.

The election might be a slight backward step on the independence of the Federal Reserve. “You can talk yourself to some dark corners. Our job is to ensure we are as resilient as possible,” he said.

“And the last one of course is climate change. It probably wasn’t a vote for ongoing climate management. That is the most significant challenge to the globe at present.”