Sound economics or virtue signalling?

Depending on the demographic of our dear reader we’ve either caused eyes to glaze over or heckles to excitedly raise. Here’s a graph showing the median price of houses in New Zealand. In 11 years from 2010 to 2021 the median house price has more than doubled (129 percent increase).

This increase is on the minds and lips of policymakers presently. The newest instance is a clause added to the Reserve Bank of New Zealand’s (RBNZ) remit stating: “[…] However, the new remit now requires the [Monetary Policy Committee] to assess the effect of its monetary policy decisions on the Government’s policy to support more sustainable house prices.”¹

The intended effect of the policy change is not clear at all. Does “more sustainable” mean that the price of houses should increase at a slower rate than it has in recent history? What the optimal rate of increase in house prices is remains a mystery.

What is clear is that this policy is largely driven by political considerations. For whatever reason, voters seem to believe there is a “just price” for a house and the current median price is not that price. Politicians seeking re-election have a clear incentive to propose policy with the intent to move the actual price of a house toward the imagined “just price”. This is all stock standard public choice theory – applying economics to the humans who work as politicians.

The actual, and unintended, effects of this policy are much more interesting. Firstly we have to acknowledge that the RBNZ already has a dual mandate:

1. To keep core price inflation (as measured by the CPI) between one and three percent
2. To support maximum employment.

These targets are antagonistic. To see why we need to slog through a bit of theory. Consider first target number 2 – to support maximum employment.

In economic parlance we make a distinction between a real and a nominal wage. Your nominal wage is simply the amount of New Zealand Dollars (NZDs) you are paid from employment (how many dollars are deposited in your bank account). Your real wage is the level of consumption this nominal wage affords you (how many houses/ hats/ cheese/ phones/… you can buy).

Monetary policy works on the assumption that all the workers are simpletons who can only understand a nominal wage. But all the employers understand real wages. So long as the number of NZDs one receives increases it is assumed that one is none the wiser to any change in the level of consumption afforded.

Under this assumption you can quickly surmise that if you apply upward pressure to the price level (and so put downward pressure on real wages) then employers will see the real wage decrease and hire more workers.² Meanwhile workers will, by assumption, be none the wiser. Experience being a human runs contrary to this assumption, as do increasingly loud discussions about inequality.

Following this logic, the policies that meet target 1, by keeping price inflation in relative check (and so not pressing down real wages much) will tend to move away from target 2 and vice versa.

The new remit, including house prices in monetary policy decisions, is also antagonistic of target 2. House prices are a subset of the general price level (even if not officially measured as part of the CPI). So policies that tend to move toward “sustainable house prices” will tend to move away from target 2, simply because they are the same policies that move toward target 1.

It is forgivable to assume “sustainable house prices” means lower house prices, or at least lower increases. This is not explicit in the remit announcement. A particularly jaded and cynical reading of these words is that house prices are now mandated to perpetually increase. If that is the case, then we will continue to see the same bias toward policies which support monetary expansion we’ve seen for some time.

Interestingly, financial markets seemingly think the bias for monetary expansion may be lessened. After the new remit was announced (Feb 25, 2021) the New Zealand Dollar faced upward pressure, indicating that the market decided interest rates would increase, or at least not decrease any further (the NZD/USD hit a peak of 0.7445 on Feb 25).

Further, what does “assess the effect” mean in practice? What’s the chain of accountability on this? It’s trivial to a trained economist to follow a chain of reasoning from a proposed OCR announcement to a likely effect on house prices at the margin. One might guess “assess the effect” imposes a requirement to quantify the effect, but this is not clear.

This lack of detail certainly provides support to the observation that the policy is driven more by a need to be seen “doing something” than sound economics.

Overall, this change in policy is interesting from a historical standpoint (NZ is the first to do this). From the POV of economics the policy change is notable as another case study in public choice theory.