This article first appeared on The Wire, the web page for FIIG, at this link: https://thewire.fiig.com.au/article/commentary/opinion/2018/11/19/rba-ignores-property-at-its-peril
RBA ignores property at its peril
The RBA rolls the dice on house prices
The usually careful and well considered Reserve Bank of Australia is taking a huge gamble on the Australian economy into 2019 and 2020.
The RBA is betting that the current slump in house prices and dwelling approvals are orderly and will not have any material or lasting consequences for the economy. In fact, RBA Governor Philip Lowe believes the fall in Australian house prices “is good news”, “manageable” and “a welcome development”. Further, in its November Statement on Monetary Policy, the RBA suggested that house prices “have continued to ease gradually”, which is a remarkably bland assessment given that close to $400bn has been wiped off the value of Australian houses since the price peak in September 2017.
Governor Lowe and the RBA’s open indifference to what is a major shift in the $7trn valuation of residential property is bold.
Wealth and household spending – The link
While some cooling in house prices was always inevitable following the price boom in the four years to 2017, the price falls are getting close to a point where the loss of household wealth will impact household spending. The RBA itself and a bevy of global academic research show a link between changes in household wealth and growth in household spending.
The research findings differentiate regarding the extent of the link and the time lag between the change in wealth and its impact on spending growth, but there is unambiguously a strong correlation between the two. These differences are largely driven by the speed and size of the price falls and the level of debt held against house prices. When wealth rises, household spending growth picks up; when wealth falls, household spending growth slows.
Household wealth is falling.
Plain and simple.
Nationwide, house prices have fallen 6% from the late 2017 peak and coincidentally the value of Australian shares has fallen sharply as the ASX dropped around 20% from its August 2018 high. With near record low auction rates, the tightening in credit and increase in dwelling supply feeding into market conditions, there is no doubt house prices will register further sizable falls over the next six months, perhaps longer.
Reputable housing analysts are expecting the peak-to-trough movement in house prices to be in the order of 15 to 20%. At 20%, this would see household wealth in housing assets drop around $1.25trn.
Figure 1 shows a strong correlation between the change in house prices and growth in the volume of real retail sales per capita. While the correlation is not perfect, it is a good fit that shows changes in house prices leading to changes in retail sales by one to two quarters.
Even if the current fall in house prices was to come to an end in the next month, retail sales growth on this measure can be expected to dip to around zero, or a little lower. Based on the scenario where house prices fall around 7 to 10% in annual terms over each of two years (15 to 20% in total), real retail sales per capita will fall by about 1% in each of those two years. Retail figures have not been that weak since the global financial crisis and the early 1990s recession.
Bottom line GDP growth at risk
Such weakness in retail spending and household consumption would leave a significant hole in bottom line GDP. In particular, at a time when new dwelling construction is poised to fall and subtract from GDP, when numerous public sector infrastructure projects are close to competition, and when the world economy is showing signs of material weakness (note falls in GDP in Japan and Germany and slowing in China) – Australian growth is set to dip towards 2.5%, or lower.
A broad slowdown is inevitable, unless there is a surprising upswing in some other segment of the economy or house prices stabilise.
Playing with fire
The RBA ramped up its optimism for the economy with its November Statement on Monetary Policy. In that Statement, it lifted its forecasts for GDP growth and lowered its forecasts for the unemployment rate.
It did this in full knowledge of recent house prices and global trends. It is a scenario that assumes everything that can go right, will go right. It assumes falling house prices and lower wealth has a trivial impact on household spending and assumes that wages growth will register a strong pick up, even with the unemployment rate remaining around 4.75%.
There is little or no margin for error, which means the forecasts have little upside risk.
The downside to the RBA’s rose coloured assumptions are more extreme.
What about inflation and wages?
The RBA has – perhaps had – an objective of having annual inflation tracking around 2.5%. Up until two years ago, this meant occasional periods where inflation was near 2% or less, or just over 3%. The ‘misses’ on inflation outside the broad 2 to 3% target were usually short lived. When the momentum for inflation was tracking higher or lower, the RBA would adjust monetary policy to recast the momentum in the economy to get inflation back around 2.5% over a reasonable time frame. Until two years ago, the RBA forecast for inflation on an 18 to 24 month time frame was always 2.5%.
To forecast a different inflation outcome would indicate that the RBA’s current policy was wrong, either being too tight or too easy.
More recently, the RBA has lowered the importance of inflation as its prime concern and instead has been looking at financial stability in the form of household debt and house prices as its main area of concern. By definition, it has kept monetary policy tighter than necessary. The result has been inflation below target and in the September quarter, underlying inflation actually slowed to 1.7%. It has been below target for the best part of three years and inflation is not forecast to hit the middle of the target at any stage in the RBA’s forecast profile.
The inflation target is dead – long live the inflation target!
The RBA is reactive not proactive – is the next interest rate move up or down?
For the past year, the RBA has been telling the market that the next move in official interest rates is likely to be up, not down. It is still banging the drum about financial stability and as indicated, it is welcoming the falls in house prices and probably has the most upbeat view on the economy of any forecaster. For the RBA to make an about face on this view and move to actually cut interest rates, there needs to be a material weakness in the economy. This is possible and would be likely if the link between house prices and household spending retains its long run historical relationship.
As such, the hurdle for the RBA to clear before it moves to an interest rate easing bias, let alone delivering an interest rate cut is very high. The RBA will need to change its internal analysis of financial stability and see the hard data on the economy deteriorate.
It is safe to say that it will not cut interest rates pre-emptively to head off disinflationary weakness in the economy. It is not in the mindset of the current Board and senior staff. Put simply, the RBA will need to see some mix of a stalling in GDP growth and an uptick in the unemployment rate. The big question is whether the decline in house prices (and other factors including weaker global growth) will be sufficient to deliver this news. The research suggests it is more likely than not
If house prices slide 15 to 20%, it would be a rolled gold certainty that household consumption spending growth will weaken and with that, inflation will remain well away from the target.
Where to look?
While all economic data is important, the highlights to test the RBA theory will come from changes in house prices and household consumption spending. Data on inflation, wages and unemployment are of course important, but it is houses and households that are the key in the current cycle. Corelogic publishes daily house prices for the five main cities – Sydney, Melbourne, Brisbane, Perth and Adelaide – and monthly data for Australia. The beauty of this series is that it shows broad and remarkably timely trends in the housing market.
Without getting caught up in the daily moves, trends in prices on a weekly and fortnightly basis and as the month unfolds can and do provide an early signal as to whether the RBA is likely to be wrong or right when it comes to its current upbeat view on the economy.