It's house prices not China that is the biggest threat to growth

Mon, 31 Mar 2014  |  

The RPData five city house price index rose a thumping 2.3 per cent in March which is a stunning rate of increase at a time when house prices are already elevated.

For the first three months of 2014, the RPData series shows house prices up 3.5 per cent, or an annualised pace of close to 15 per cent. This is a rate of increase that must be causing the RBA some concerns as it continues to sit on official interest rates at a record low 2.5 per cent.

While the RBA does not target house prices with its monetary policy settings, it is well aware of the macroeconomic policy risks that come with house price booms... and busts. House price booms generally lead to a pick up in speculative borrowing and a ratcheting down of lending standards by financial institutions as every one wants to get on board the price surge.

House price busts, which have not occurred to any significant extent in Australia in modern economic history, are characterised by faltering consumer confidence, an escalation in bank bad debts, a fracturing of bank balance sheets and inevitably, recession.

Indeed, the recent deep recessions in the US, UK, Ireland, Spain, Japan and Span (to name but a few) were all driven to a large extent by house price crashes.

A house price crash is not good news.

So how should a house price crash be averted?

Simple – don't let the house price gains get too big in the first place. The time tested and easy way to lean against unwelcome house price booms is interest rates. A nudge up in rates at a time when the economy is travelling smoothly and when there are some signs that broader inflation risks are ticking higher is clearly prudent.

It is a preventative approach which the RBA seems to be slow to cotton on to in the current phase, at least in its actions, if not its words.

An interest rate hike soon would serve multiple purposes – importantly it would provide a material back up to the RBA Governor Glenn Stevens' view on the imbalances in the housing market. Borrowers might be more cautious as their debt servicing costs edge up with the prospect of more hikes down the track. Lenders would also take note and tighten their stress testing of potential borrowers looking to enter the housing market. From a macroeconomic perspective, it would guard against some of the price pressures showing up in the recent CPI data.

The RBA meets tomorrow knowing house prices - and not China - are perhaps the biggest threat to the 23 years of unbroken economic growth in Australia. It knows the economy is rebalancing to the point where 3 per cent GDP growth in 2014 is all but locked in, with the risk tilted squarely to growth at 3.5 per cent. It also knows that a 2.5 per cent cash rate is not appropriate.

The solution is clear - rates need to rise. While interest rate action is unlikely tomorrow, the RBA Board should, in its statement at 2.30 pm, be setting the markets, home buyers and mortgage lenders up for the prospect of higher interest rates in the months ahead.

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