Reserve Bank mulls risks of housing, currency dilemma

The Reserve Bank is in a conundrum in dealing with an over-valued currency and property market where surging prices are starting to look like a bubble, either of which could force its hand to move interest rates.

The June monetary policy statement weighs up the risks of either scenario escalating beyond the bank's base case, which could lead to either a rate cut or a hike.

Governor Graeme Wheeler has been at pains to point out the kiwi dollar is over-valued, which has kept headline inflation below the bank's target band of between 1 percent and 3 percent by making imports cheaper.

At the same time, he has pointed to supply shortages in Auckland and Christchurch have fuelled rapid growth in house prices, which threaten to create inflation pressures as households feel wealthier and take on more debt, as potential risks to the stability of the country's financial system.

If the trade-weighted index climbs over the coming three months and stays outside the bank's projections, the 90-day bank bill rate, seen as a proxy for the benchmark official cash rate, will fall below 2 percent next year.

The bank ramped up its projection for the trade-weighted index by about 200 basis points for the currency, seeing it average 77.5 in the June quarter this year, falling to 73.1 at the start of 2016.

Alternatively, if house price inflation peaks three percentage points above the base case at 14 percent and stays higher, that would likely lead to increased domestic demand, leading to the forecast track of the 90-day bank bill is steeper, rising to about 1 percentage point higher than forecast at 5 percent.

"The monetary responses to these two scenarios are very different," the bank says in its report. "However, in real time it would be difficult to disentangle the relative effects if both started to come through simultaneously."

The bank has already intervened in foreign exchange markets at the margins in a bid to take the tops of rallies, and is mulling the use of new macro-prudential tools, which could impose capital buffers on lenders or restrict the use of low-equity home loans, to try and cool threatening asset bubbles.

(BusinessDesk)