The imbalance between housing supply and demand poses an increasing risk to financial and economic stability, the Reserve Bank is warning.
Reserve Bank Deputy Governor Grant Spencer has urged the Government and Auckland Council to do more to address what he calls the imbalance in the housing market.
In a speech to the Rotorua Chamber of Commerce, Mr Spencer said the problem had become more pronounced since late last year, particularly in Auckland, where there was a supply shortage and prices had tripled since 2002.
"Irrespective of the mix of demand and supply-based factors, the longer the excess demand persists, the further prices will depart from their underlying fundamental determinants, and the greater the potential for a disruptive correction," Mr Spencer said.
"New Zealand is one of the few advanced economies that has not had a major house price correction in the past 45 years."
Rising global interest rates or a downturn in the global economy and financial markets could prompt a fall in New Zealand house prices, he said. Such a downturn would put the banking system under severe pressure as 60 percent of its lending was in residential mortgagees.
The resulting credit contraction would amplify the impact to the domestic economy and financial system, making it hard to avoid a severe downturn.
Therefore, policies to ease the supply constraints must be the main priority, despite the fact they were unlikely to yield quick results, Mr Spencer said.
The best prospect for substantially increasing the supply of dwellings over the next one to two years appears to be in apartment development, he said.
"The Government and the Auckland Council might consider focussing their efforts on simplifying the approvals process and increasing the designated areas for high-density residential development."
Mr Spencer said the introduction of loan-to-value ratio (LVRs) restrictions in October 2013 helped moderate housing market pressures despite strong migration and the ongoing shortage of housing, and also improved the resilience of bank balance sheets. They would be removed or modified as market conditions allow.
"Other macro-prudential options are being assessed, including in relation to investor lending. However, such tools are not a panacea - their impact is inevitably smaller than the main drivers of the current housing market imbalance," Mr Spencer said.
The Reserve Bank Deputy Governor said, moreover, that new taxes were needed to curb rental housing investors, particularly in Auckland.
He said in the 18 months to February, the proportion of houses sold to investors has risen from nearly 34 per cent to 37.5 percent.
Mr Spencer said the growing role of investors in Auckland is increasing pressure on a growing shortage of homes, and is being boosted by the expectation of untaxed capital gains.
He repeated his warnings of the fiscal risk to the country if an economic shock overseas caused a sudden fall in house prices,
Mr Spencer has advocated a wide range of policy consideration, from increasing land supply, and higher density housing in Auckland, to faster processing of resource consents to speed up development.
Little says capital gains tax would not work
The Labour Party says it took the idea of a capital gains tax to the electorate twice and voters did not like it because it is a blunt instrument to use on rising house prices.
Labour's leader Andrew Little said a capital gains tax would not work.
"The real problem are the people who are multiple property owners at one time who are constantly in and out of the market who are pushing the price up.... you've got to have a policy that deals with them."