The RBA changed its tune on housing prices. Here’s what that means.

To borrow from the late Queen Elizabeth II, this has also been the RBA’s annus horribilis. Let’s take a walk through recent history.

Flashback to November 2021. The official Australian cash rate is 0.10%. RBA Governor Phillip Lowe is quoted saying it is fairly unlikely there will be any increases in the cash rate before 2024. Millions of Australian mortgage holders breathe a sigh of relief and continue on their merry way enjoying their new release from extensive COVID lockdowns.

Inflation is present but most central banks are hoping it will be transient. Except for the US Federal Reserve, which is getting a bit toey and soon indicates rate rises are coming in 2022.

Then everyone gets whiplash, while we race through six increases starting from May. The cash rate now stands at 2.60%. There’s more coming too.

Here’s where things get even more interesting – property prices

It starts here.

1. The cash rate and you
   The cash rate is the rate at which commercial banks like the big four can borrow money from the central bank. Commercial banks then align their own interest rates for customers with this. It’s not identical because commercial banks will also have other factors influencing their costs of borrowing but a basic rule of thumb follows. If the cash rate goes up, commercial bank interest rates go up. If the cash rate goes down, commercial bank interest rates go down.
   So, for a loan like a mortgage with a variable interest rate (around 60% of mortgages), this means your mortgage interest repayments will go up each time the cash rate increases.
   And what this means for property is…
2. Mortgage interest rates and property
   The size of the loan you are able to take out is affected by the combination of principal and interest. The bigger the interest repayments, the lower the principal you can borrow. This affects your ability to bid on properties. Everyone is in the same boat so this can affect property prices. Lenders typically estimate your borrowing power using a rate that is 3% above the current rate to factor increases.
   And…
   Those who already have mortgages are paying higher repayments. In some cases, people may find the repayments stretch beyond their capacity and they may default on their loans (or sell before they reach this point).

This, therefore, combines to depress property prices. It doesn’t happen instantly because it takes some time for interest rates pressure to flow through.

The above chart from the RBA maps the cash rate against housing price moves – you can see the pattern of growth in falling rate periods compared to declines in rising rates.

There’s a more detailed explanation from the RBA here. 

The RBA does care (somewhat) about property prices

The RBA’s primary job is really the stability of the economy – so managing inflation is a key part of that.

In making decisions about the cash rate, the central bank must consider a range of areas that influence the strength of the Australian economy. Property is a big part of that. Take, for example, the Australian dream of the quarter-acre block. This looks a little different now but the fact remains that Australians love to own residential property. 

Our retirement standards even centre on an expectation of property ownership. Australians are highly leveraged to property so it stands to reason that if property takes a hit, the economy will take a hit.

A turn for the scary

If you are a regular Livewire reader, you’ve probably read the recent article by Coolabah Capital’s Christopher Joye about the RBA’s forecasts on property prices. If not, you can revisit it here.

This is what you need to know in a nutshell.

The RBA’s research originally modelled a very modest dip of around 2-3% in property prices with cash rate increases of 100%. They expected falls of 15% over 2 years all up and recovery. By contrast, Coolabah Capital expected 20-30% falls with longer term implications.

In July this year, the RBA revisited their forecasts and compared them with the models from Coolabah Capital. They finally downgraded their forecast to a fall of 11% by mid-2023 and predicted the biggest fall in prices since the 1980s of up to 20% in the next two years. Information was finally released this month about how their latest modelling was completed (read here).

That property price falls exceeded the RBA's original expectations has come as little surprise to even the layman, but the central bank's recent recognition and adjustment has alarmed many.

How do we go from a modest fall prediction to the biggest drop since the 1980s in the space of months? What does this even mean?

• The RBA’s decisions to increase rates have been based on flawed data.
• The RBA was also taken by surprise by the falls in housing prices in June this year.
• This has huge implications for the direction of the economy.

What are the flow-on effects of a dramatic housing price fall?

Typically, when housing prices fall, consumers cut back on spending – in particular on discretionary and luxury items. Weaker consumption can flow through to weaker employment and economic activity.

Further to that, housing supply can drop too as people as less likely to sell their homes and buy new ones. This is bad news for lenders like banks and other associated industries like conveyancers who derive an income from people buying and selling.

The construction industry also takes a hit – this is likely to be significant given building costs have dramatically increased as a result of supply chain issues. Developers need to see a decent return on investment to build. If prices fall while costs remain high, they are less likely to go ahead with approvals. Once again, this affects employment numbers.

Usually, when housing prices fall, central banks start to drop the cash rate to support recovery and activity. The RBA is facing the battle between already falling housing prices and inflation that has remained persistent. It’s pretty clear that they will choose in favour of managing inflation based on previous statements.

It’s been said before that the RBA’s job is effectively to cut inflation by increasing unemployment and causing consumer pain. While Governor Lowe has said in the past that housing is not his focus, it’s hard to not look at the above and wonder if a hit to housing achieves exactly what the RBA wants anyway.

Either way, a bleaker housing outlook is bad news for the Australian economy. Investors should strap in. It could be a long ride ahead. 

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