September 17th, 2024
A Discussion Paper published by the Reserve Bank of New Zealand on Thursday examined the two types of unsustainability that influence housing market. The paper, authored by Andrew Coleman, identifies a demand for better quality housing and temporary house price surges driven by interest rate movements as key factors contributing to these unsustainable cycles.
Two faces of unsustainability in housing market
The first type of unsustainability occurs when a construction boom arises from a widespread increase in demand for better quality housing or a rapid population growth. This boom may face capacity constraints for several years, causing prices to rise and eventually fall back to normal levels. The paper suggests that this type of boom could be managed by a central bank, although there would be trade-offs to consider.
According to the Discussion Paper, the second type of price unsustainability happens when technical or regulatory changes reduce the usual cost of producing new houses. This type of unsustainability is driven by supply factors and is typically beyond the purview of the central bank.
Interest rate movements and house price surges
The paper highlights that temporary house price surges often result from interest rate movements. Lower interest rates can boost demand for better-quality housing, leading to price increases. As the construction industry responds by building more high-quality houses, the price surge eventually ends and prices can fall due to a gradual increase in housing supply.
“The demand for better quality housing (which cannot be quickly met from new supply) is a major reason for unsustainable house prices, and a reason why house price cycles are often so different from price cycles in other industries,” says Andrew Coleman, author of the Discussion Paper.
Construction boom and changing demands in housing
Between 1991 and 2020, employment in the construction sector nearly tripled due to a construction boom, driven in part by an increase in population and the Christchurch earthquake. Another contributing factor was the widespread demand for better quality housing, with the average size of new houses being approximately fifty percent higher than those built in the 1970s and 1980s since the late 1990s.
Recent decline in house prices
House prices began to decline in 2022 and continued into 2023, coinciding with a rise in interest rates. From their peak in late 2021, house prices have dropped by around 15% to date and are projected to fall by about 23% in total from their peak by 2024.
The Discussion Paper emphasi
ses that while higher interest rates can slow down housing market activity and mitigate house price and building cycles, central banks must consider a broader range of factors, such as inflation rate and employment, when setting local interest rates.
Conclusions and policy implications for New Zealand's housing market
The Discussion Paper delves into the conditions that render house prices unsustainable, particularly with reference to housing quality improvements. It outlines two conditions when house prices are unsustainable: cyclical backwardation and structural backwardation.
Cyclical backwardation and its impact
Cyclical backwardation arises from demand shocks, such as increases in income or reductions in interest rates, leading to a coordinated demand for better quality housing. Limited construction sector capacity causes prices to rise, with some of the increase being temporary, while some of it is permanent due to the difficulty of creating new properties in high-quality locations.
The paper highlights three issues with extended periods of cyclically backward prices. Firstly, it may reflect an inefficiently low level of construction sector capacity, or regulatory constraints limiting the development of new properties. Secondly, these periods can destabilise price expectations, leading to inefficient levels of production and considerable income redistribution. Lastly, the risk of financial crises and particularly damaging recessions increases during episodes of rapid house price increases and mortgage credit expansion.
New Zealand's exposure to cyclical backwardation
Over the last three decades, New Zealand has been prone to episodes of cyclical backwardation. Factors such as a low number of construction sector workers, small new houses, rapid falls in real interest rates, and an increase in incomes contributed to a quality-based construction boom. Despite the expansion of the construction sector, it struggled to keep up with the demand for better quality houses, inward migration, and the impact of the Christchurch earthquake.
Strategies to reduce cyclical backwardation in house prices
To mitigate cyclical backwardation, the Discussion Paper suggests three strategies. Firstly, the central bank could increase interest rates, reducing the demand for higher quality houses. However, the central bank needs to balance the potential welfare costs of unsustainable house prices against the implications of higher interest rates on the exchange rate, export sector profitability, and unemployment.
Macroprudential regulations and interventions
The second strategy involves macroprudential regulations and interventions, such as loan-to-value restrictions and capital-lending balance-sheet ratios. These measures can limit the borrowing capacity of individual households and banks. Although the effectiveness of interest rate changes and macroprudential regulations on economic activity, house prices, credit growth, and financial stability is still debated, most central banks, including the Reserve Bank of New Zealand, favour the use of such measures.
Enhancing construction sector capacity
The third strategy focuses on increasing the construction sector's capacity to meet the demand for higher quality housing. By enhancing capacity, the periods of cyclically backward prices can be shortened, leading to a more stable housing market. This strategy requires addressing regulatory and non-regulatory frictions, as well as investing in skills development and technology to boost the efficiency of the construction sector.
The Discussion Paper highlights the complexities of housing market sustainability and offers valuable insights into the factors contributing to unsustainability. It also proposes strategies that can help alleviate cyclical backwardation in house prices, fostering a more stable and sustainable housing market in New Zealand.
Structural backwardation and its causes
According to the Discussion Paper, structural backwardation is mainly caused by high construction costs, underdeveloped or congested transport networks, and restrictions that limit, delay, or increase the costs of development or redevelopment. International comparisons show that New Zealand's building costs are relatively high, and many of its cities have underdeveloped public transport infrastructure and poor motorway networks. Regulatory constraints further contribute to the problem by raising the costs of new land developments. Reducing these costs could potentially lead to long-term declines in housing rents and prices.
Reforms outside the monetary policy domain
Most of the necessary reforms to address structural backwardation fall outside the domain of monetary policy. However, they can influence the effectiveness of monetary policy. If land regulation reform, transport investment, and building productivity improvements are implemented, the length and depth of construction cycles may be reduced, making the building cycle a less important component of the economic cycle. Faster house building processes could also help absorb inward migration without generating or amplifying housing cycles, thus reducing the need for offsetting monetary policy.
Role of interest rates in housing demand
The paper suggests that interest rates affect housing demand primarily by changing the quality of housing people desire, rather than the number of houses they want. When interest rates fall, the quality profile of the housing stock is upgraded through four mechanisms: upgrading existing houses, building higher quality new homes, upgrading amenity access in existing suburbs, and developing new suburbs with good access to amenities. As interest rate changes affect many people simultaneously, they have the potential to fully utilise construction sector capacity and create cyclical price backwardation.
Interest rate changes also impact land prices by changing the capitalisation of the flow of "rents" into land prices. Temporary changes in interest rates may lead to temporary changes in land prices, while permanent changes in interest rates result in permanent changes in land prices. The effect on land prices depends on the extent to which land in different locations are substitutes and is higher when the supply of land is relatively inelastic.
Central Banks' role in addressing cyclical swings
Central banks set local interest rates to counter cyclical swings in the economy. Interest rates affect the amount of construction activity and the price of land and houses, but these factors have different economic consequences. Changes in construction activity have direct effects on the economy, while changes in house prices mainly affect wealth distribution.
The paper offers an in-depth analysis of the factors contributing to unsustainable housing prices in New Zealand, focusing on cyclical and structural backwardation. By understanding the role of interest rates and other factors in housing demand, policymakers can devise strategies to improve the housing market's stability and sustainability. Implementing reforms beyond the monetary policy domain, enhancing construction sector capacity, and optimising interest rate policies can lead to a more stable and sustainable housing market in New Zealand.