The Reserve Bank says recent homebuyers are "particularly vulnerable" to declining house prices, warning a larger correction is still possible.
In its Financial Stability Report for May, the Reserve Bank said despite recent declines, house prices are still above sustainable levels and a larger correction isn't off the table.
The report noted new buyers with limited equity are the most at risk from declining prices and increasing interest rates.
"While a gradual adjustment to a more sustainable level is desirable for the stability of the financial system, a larger correction remains a possibility," the Reserve Bank said in its report.
"Recent buyers with limited equity are particularly vulnerable to house price declines. Furthermore, a large fall in house prices would significantly reduce housing wealth and could lead to a contraction in consumer spending."
The report said increasing interest rates along with new measures introduced by the Government are making it harder to borrow and pushing house prices down.
"The borrowing capacity of potential buyers has reduced due to tighter loan-to-value ratio requirements, higher mortgage rates, and changes to responsible lending processes under the Credit Contracts and Consumer Finance Act (CCCFA) 2003."
The report said an increase in housing supply, muted population growth, increasing interest rates and tax policy changes affecting investors mean current prices are "unsustainable".
Along with house prices, the report highlighted financial challenges brought on by Russia's ongoing invasion of Ukraine and the COVID-19 pandemic.
Reserve Bank Governor Adrian Orr said the disruptions are impacting business confidence and increasing costs. Labour shortages brought on by travel restrictions are also causing challenges, Orr said.
"Trade flows are being severely disrupted by economic sanctions and logistical issues. With Russia and Ukraine being significant global producers of energy and food commodities, this conflict has lifted global commodity prices."
But overall New Zealand's financial system is robust and banks and insurers are well placed to support the economy, Deputy Governor Christian Hawkesby said.
"Banks remain profitable and well capitalised – the latter in line with our requirements. The banking system is well funded and positioned to maintain lending in the event of a downturn.
"Our actions are safeguarding ongoing economic and financial stability. By raising the Official Cash Rate and signalling further tightening to come, the Monetary Policy Committee has acted to head off rising inflation expectations and minimise any unnecessary volatility in output, interest rates, and the exchange rate in the future.
"Our loan-to-value ratio requirements for mortgage lending have also limited the accumulation of highly leveraged loans, building economic and financial resilience."
It comes as annual inflation hit a 30 year high of 6.9 percent for the year to March 31 - pushing up the costs of goods and services.
As a result the Reserve Bank has been hiking the OCR since October 2021. In April it raised the OCR by 50 points to 1.50 the highest it's been since before the pandemic.
