As the Reserve Bank raises interest rates, house prices will fall – but by how much? A proven model suggests the change could be drastic.
The Australian property market is worth $10 trillion, so any significant correction in its value will have a significant impact on the wealth of Australians.
There is a debate about falling house prices with the lifting of the Reserve Bank interest rate. Its own models used to suggest that any change of 100 basis points (bps) would cause a corresponding 20% change up or down in house prices. This model had a good track record. More recent modeling showed less impact.
If we use the old proven model with some risk discount, the first four increases (100 basis points) will be enough to cause a 15% drop in house prices. This seems plausible today given that house prices were already falling before the RBA hike, and the $500 billion fixed mortgage rate reset is also looming.
That’s minus $1.5 trillion of wealth and, in any normal cycle, would weigh on household consumption enough to slow the economy down to somewhere around 1% growth.
However, Australia faces a very unusual and potentially more destructive round this time around.
Inflation is higher than it has been for many years. So, the RBA is raising rates more steeply with a higher goal in mind.
Moreover, this situation has been considerably aggravated by the East Coast energy crisis. Although wage growth is still quite weak, its role in stimulating late-cycle inflation has instead been played by energy prices.
Due to the war profits of Australian gas and coal companies, which impose uncontrollable international prices on Australia despite extracting the materials for near-free on the road, we are going to see a much stiffer CPI than when from previous monetary tightening cycles.
To current coal and gas prices, energy bills will approximately double over the next year. This will add 3% to the CPI plus whatever companies are trying to pass on.
This raises the distinct possibility that the critical components of underlying inflation are not falling at the pace the RBA is accustomed to during cyclical downturns and that it is continuing to drive interest rates higher beyond the levels the RBA is accustomed to. political-housing economic model structure can take. This weighed heavily after the recent RBA meeting.
Inflation is expected to rise further, but then decline back to the 2-3% range next year. Higher electricity and gas prices and recent increases in gasoline prices mean that in the near term, inflation is likely to be higher than expected a month ago.
As global supply issues are resolved and commodity prices stabilize, even at a high level, inflation should moderate. Today’s increase in interest rates will help inflation return to target over time.
In short, if we see a cash rate of 2%, with the next 100 basis points being the direct result of energy prices, then the house price correction will double in magnitude to 30%. The wealth affected by households will be $3 trillion, half of which is attributable to the energy shock.
The magnitude of these losses exceeds the contemporary Australian experience and may therefore represent a structural adjustment to the economic model itself.
For more than two decades, Australia has operated a “house and hole” economy that earns income by selling land to the world. Our banks then leverage that revenue in global markets and turn the debt into mortgages to inflate real estate prices that drive demand for services.
This will be replaced by the “holes and dips” economy that pays the world to take our land, while making us pay more and more to borrow, driving down property prices and deflating demand. services on a permanent basis.
David Llewellyn-Smith is chief strategist at MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economics editor of The Diplomat, Asia-Pacific’s leading geopolitical and economic portal. He is co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.
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