Now the dust has settled somewhat on Donald Trump's shock win and the Reserve Bank's not-nearly-as-shocking rate cut, it's worth looking in more depth at what Graeme Wheeler said in his news conference and select committee appearances yesterday, and what the bank published in its Monetary Policy Statement. around issues ranging from the inflation outlook to apartment supply and a limit on debt to income multiples.
Relying on a 'high pressure' economy
The juxtaposition of the Reserve Bank's GDP growth and inflation forecasts in its MPS makes for stunning reading these days, and none more so than in yesterday's edition.
It forecast GDP growth in 2017 of 3.7% and CPI inflation of 1.3%. Step back and think about that for a moment.
New Zealand is generating nearly 4% GDP growth and inflation is barely into the Reserve Bank's 1-3% target band. Growth is so hot that it is generating shortages of building materials and staff in some parts of the economy, yet the Reserve Bank just cut the Official Cash Rate to a record low 1.7%. Anyone who travelled back in time to the late 1980s and suggested such a combination to the likes of a Don Brash or a Bill English would be written off as a madman.
The MPS makes clear, and Wheeler and John McDermott said as much later in the day, that the Reserve Bank is happy to run the economy faster than its 'speed limit' of potential output growth of 2.9% to push inflation back up to around the 2% mid-point of the target band and to ensure the last two years of sub-1% CPI inflation doesn't turn into a downward spiral of falling inflationary expectations.
US Federal Reserve Chair Janet Yellen used this October 14 speech to talk about creating a 'high pressure' economy that generated more than enough inflationary pressure to move the US economy and interest rates away from a dangerous Japanese-like zero lower bound where deflationary risks are high. This suggests Yellen would accept an 'overshoot' in inflation to create some escape velocity for the US economy, and helps explain why she and some others in the Federal Open Markets Committee have been reluctant to put up interest rates quickly.
In essence, the Reserve Bank is doing something similar.
I asked Wheeler and McDermott about this 'high pressure' idea in the news conference. Wheeler was reluctant to engage with the idea in his answer, saying only that the Reserve Bank didn't want to surprise the markets with interest rate cuts that created excessive volatility.
McDermott was more direct with his follow-up answer.
"The plan that you've mentioned does sound like the plan that's been implemented in New Zealand. We are generating an economy that's growing faster than potential growth. It is absorbing resources and that will lead, ultimately, to non-tradable inflation moving upwards and we are seeing signs of that. And then in the next 18 months or so we will be back towards the midpoint of the target plan," he said.
"That's how you implement monetary policy. Sounds like a good plan to me."
The Reserve Bank forecast in its MPS that it would hold the OCR around 1.7% until at least the end of 2018, and that would see inflation rise to over 2% for the first time in more than seven years in the December quarter of 2018.
Wheeler was more accommodating about the idea of overshooting the 2% mid-point these comments in an interview with RNZ's Patrick O'Meara later in the day.
"We'd be comfortable if inflation overshot the 2%. That wouldn't be an issue for us. We've been undershooting inflation," Wheeler said.
"There's a lot of flexibility built in to the Policy Targets Agreement and we're required to look at a number of things in terms of financial stability related issues, volatility of interest rates, exchange rates and output. We've got some degree of discretion about how quickly one moves back to the target," he said.
"So if we did over-shoot 2%, then that wouldn't be a major issue for us."
'We reconsidered after Trump's win'
The first question in the news conference and the select committee was whether the Reserve Bank reconsidered its decision (which would have been pencilled in late last week) in the light of Trump's win on Wednesday evening.
Wheeler said the bank considered whether to amend the statement or rethink its decision and decided to do neither.
"We've cut because we've signalled the cut. We've been very clear in our communications about that a cut, we felt, would be needed to get the growth that we need to deliver the positive output gap, to deliver inflation to the middle of the target range, particularly given that we had negative tradables inflation for five years and it's a big drag on the institution's ability to get inflation back to the middle of the band," he said.
"We also felt that if we cut we would reduce the risk of short term inflation expectations falling, and that if we didn't cut we ran the risk of seeing the exchange rate appreciate. So we went through that reasoning and said ' has anything we've seen overnight caused us to change our assessment of that?' and we concluded 'no'."
'Wheeler open to currency intervention'
The Reserve Bank included its regular warning about the currency being too high in its statement, which was initially followed by a half cent rise to 73.5 USc.
But some comments around the intervention question in the news conference were slightly unusual and helped drive the New Zealand dollar lower late in the morning. It has since fallen to 72 USc this morning, although that will be partly due to rising US long term interest rates (the US 10 year Treasury hit 2.1% overnight), which have strengthened the US dollar.
Wheeler was asked about the potential for currency intervention to push the New Zealand dollar lower, given he had said in the MPS statement that the currency was higher than sustainable for balanced economic growth and a fall was needed. The word 'unsustainable' has been seen as one of the 'trigger' phrases or green lights for intervention in the past.
"That's something we would always have an open mind on," Wheeler said of the intervention option.
"We look at the case for intervening at the time that we take our decisions around an OCR. We've got a system of four traffic lights and we look to see whether the conditions are met at any point, so we have an open mind about intervention," Wheeler said.
The Reserve Bank has intervened once to sell New Zealand dollars during Wheeler's term after assessing its four 'traffic lights'. The system requires the bank to be sure the currency is extreme, unsustainable and that any intervention was consistent with current monetary policy. Any intervention would also have to have an impact by catching the market 'off guard' at times of volatile and illiquid trading.
Wheeler declined to say if the four 'traffic lights' were currently green.
His comments were unusually strong, given he often downplays the prospect or effectiveness of currency intervention. See more in this Hive News piece from March 2014 on the potential for intervention.
However in a later interview I had with Grant Spencer, he downplayed the immediate prospect of intervention, saying the Reserve Bank had not intervened in recent times "and that's suggestive."
"Our approach tends to be to try to hit peaks, and in recent times there's been more peaks than troughs, and we're not around peak situations at present," he said.
"The TWI is still at elevated levels, but it's not up there like it was a couple of years ago."
Spencer said he would not put a "huge emphasis" on the bank's use of the phrase "not sustainable" in its opening statement.
'Don't expect lower mortgage and deposit rates'
One feature of the reaction to yesterday's OCR cuts was the discussion about higher bank funding costs both overseas and locally, which is making it harder for banks to further reduce mortgage and term deposit rates.
I asked Wheeler about whether he expected yesterday's rate cut to be reflected in mortgage and deposit rates.
The background here is that the rate cuts of the last six months have not been fully passed on as banks try to arrest falls in net interest margins, keep well above core funding thresholds and build up their capital levels ahead of expectations that regulators (both the Reserve Bank and APRA) will require higher capital levels.
Wheeler pointed to the banks' higher funding costs, and page 16/17 of the MPS and figure 4.4 also detail the rise in funding costs on overseas wholesale markets and how banks have had to offer higher term deposit rates to attract more term deposits.
"If you look at the banks' funding situation at present, they have got lending growth rates exceeding their deposit growth and so they are having to move to offshore wholesale markets to get some of their funding, and that's more expensive funding for them," Wheeler said.
"So you are starting to see some upward pressure on deposit rates and you are also starting to see some increase in mortgage rates. So it's possible that we may not see a lot of adjustment in terms of lending rates," he said.
That was confirmed by BNZ, who said yesterday it would not be adjusting rates on the day and that the OCR was not directly linked to retail rates, while Westpac said it would not be changing mortgage rates because of higher offshore funding costs.
Figure 4.4 showed that marginal bank funding costs from local term deposits and from long-term wholesale funding offshore have risen around 30 basis points to a combined 70 basis points since the beginning of June this year. That would help explain the 10-30 basis point increases in 3, 4 and 5 year mortgage rates by ASB and BNZ over the last week.
'Pressure on apartment development supply'
Another feature yesterday for Auckland housing supply watchers was the surprisingly strong comments from Wheeler in the news conference and select committee about problems apartment developers were having getting funding and dealing with construction cost increases, and their fears about a turn in the cycle capping their ability to increase housing supply.
He said the Reserve Bank had talked to about 20 construction firms around New Zealand in recent times.
"A number of them in the Auckland market were talking about the inflation pressures that were there. Construction inflation is running at around 8%. Some of them were worried about scaling up activity because they've seen stop-start cycles in the past. They were worried about how much land might be available if they're going to make large development investments," he said in the select committee hearing.
"There's a number of issues around the construction sector and the pressures that are building up there, and how much supply we can get in terms of ample increments."
There was also detail in the MPS around funding problems for developers. Box B (page 24) included a summary from recent Reserve Bank visits to businesses that noted contacts saying they were having problems getting access to building materials with long wait times and cost increases.
The Reserve Bank also took the unusual step of including its Credit Conditions Survey (Figure 4.5) in the MPS (it's usually reserved for the Financial Stability Report), which showed a tightening of credit standards by banks across households, farmers and businesses.
"The tightening has been most notable in the commercial property sector, consistent with recent anecdotes that some property developers are finding it more difficult to access financing from banks," it wrote.
Later in Box B it gave more detail.
"Contacts note that new and small firms, as well as apartment developers, have been impacted most severely. A lack of funding has led to some construction projects being deferred or cancelled, and contacts expect that credit conditions will continue to tighten."
Retentions change creates NZ$250 mln working capital demand
Another warning sign for the Government's hopes that housing supply will address Auckland's housing affordability issues was a note from the Reserve Bank about construction companies not be able to use 'retention money' for cashflow purposes from early next year.
That's because the Construction Contracts Amendment Act 2015 applies from March next year and requires that 'retention money' be held in a trust account, meaning construction firms building apartments can't use that money for cashflow or working capital purposes. The law was changed after the Mainzeal collapse led to contractors missing out on 'retentions' money that was held by Mainzeal.
The current practice is that 5-10% of the payments to contractors are held back or 'retained' until the work is completed and checked to ensure it is done properly and standards are met, but the Mainzeal case showed there was a risk that 'retentions' being held by the development or the lead construction company could be lost in any collapse -- leaving contractors in the lurch. The trouble is the cure appears to have reduced a useful cash buffer for developers and has made it more difficult to fund the bigger apartment projects.
This MBIE Regulatory Impact Statement on the law change explained the issue. MBIE estimated from a 2014 survey it conducted that between NZ$150 million to NZ$250 million was being held in retentions, which means the change to holding that in trust will force these developers to raise up to an extra NZ$250 million in working capital.
"Payers usually use the retentions as working capital – effectively treating retentions as an interest-free loan," MBIE noted in the paper.
Challenges for a DTI, which Wheeler wouldn't use right now
The other feature of the day was the discussion around the introduction and use of a Debt to Income Multiple (DTI), which the Reserve Bank acknowledged was being challenged hard by Bill English and would not be used in the current market conditions.
Wheeler says he would not currently use a DTI right now, even if it was in his Macro-Prudential tool kit because the housing market appeared to be cooling off.
Wheeler said he was still in discussions with English about adding the DTI tool to the Memorandum of Understanding (MOU) that allows the Reserve Bank to use various Macro-Prudential tools, including its Loan to Value Ratio (LVR) restrictions. English had asked a range of questions about the suitability of using such a DTI tool and the potential risks and consequences, Wheeler said.
"We have requested approval from the Minister that these be included as in instrument in the memorandum of understanding around macro-prudential policy. We've had a couple of discussions with the Minster. He has asked a number of questions," Wheeler said.
"He asked questions such as 'how would these complement our loan to value ratios, what's the nature of the policy problem that we are trying to address, are there any unintended consequences from DTIs for example, are there issues around measurement of debt and measurement of income (and) who would be affected by DTIs," he said, adding he had had a couple of discussions with English and had another one scheduled in a couple of weeks.
"We should make it clear that at this point it is not our intention, if we had them as an instrument in the MOU, it is not our intention to apply them in this situation. We are seeing the housing market come off to some degree in terms of house price inflation," he said.
"There's a number of reasons for that, it might be linked to the LVRs themselves, it might also be linked to the fact that bank credit criteria has tightened up. You are seeing banks reluctant to lend. In fact, I believe they have stopped their lending to buyers who rely on overseas income to support the loan. You are seeing them tighten up against developers, particularly some apartment developers and you are seeing their funding costs increase, mainly because lending growth is exceeding deposit growth and they are having to look for offshore lending markets to finance.
"So if you put all those reasons together you are starting to see house price inflation slow. We don't know if that is going to continue. We are looking at that very closely, we are watching the data as one would expect and keep an open mind on it."
LVRs could complement DTIs
Asked if the Reserve Bank would prefer to further tighten the existing LVR restrictions before using the DTI, Wheeler was non-committal, but said they could be complementary.
"Both tools can be very helpful in terms of reducing risk to the banking sector. In essence, if you look at DTIs they reduce the risk of forced sales because the borrower has greater capacity to service the debt, so there is reduced risk of getting into distressed and forced sales," he said.
"The LVRs are helpful in that they reduce the risk to the bank if there are forced sales and that's because the borrower has greater equity in the transaction, so they can complement each other very well."
Wheeler said the Reserve Bank felt its current 40% deposit requirement for investors was useful to reduce default risk.
"We felt that at 40% at this stage we pretty well feel we've got it right in terms of that default risk. So that's something that we would need to consider to the extent that if, at any point, we would did need to raise LVRs, and I say 'if', one would have to think how does that match with the integrity of the underlying default data that you have."
Quote of the day:
New York Times columnist Maureen Dowd on Trump:
The press takes him literally, but not seriously; his supporters take him seriously, but not literally.
Trump got 1.1M fewer votes than McCain, 2M fewer votes than Romney. Clinton got 7M fewer votes than Obama 2012.
Have a great weekend. Look out for some useful long reads below on Trump et al. Whew. Sigh.