For a more comprehensive round up of the week, listen to Stephen’s full report here.
Spending on new and existing housing has started to make a material contribution to Australian economic growth. In Q1 2014, the volume of spending on new and existing housing rose by 6.4% quarter-on-quarter (qoq) and added a further 5.7% in Q2. The contribution to GDP growth from housing was 0.2 percentage points in both Q1 and Q2 after zero quarterly contribution each quarter through 2013. Moreover, the material quarterly contributions from housing to growth look set to keep coming through Q3 and Q4 2014 and through 2015 on the basis of reports of strong home buying activity extending to still mostly strong monthly reports of home building approvals.
Much of what is happening in terms of strong home buying activity is positive in terms of the economic outlook, boosting household wealth, providing one area of relatively strong employment growth, adding much needed new housing supply (especially in Sydney) and potentially improving the prospects of retail spending on major household goods down the track. Other aspects of booming housing activity are starting to present concerns, such as the continuing rapid escalation in house prices in some areas, the dominance of investment housing purchases, the quality of lending for housing and potential damage to spending in the economy down the track if some housing investors have not prepared adequately for the negative change in housing market conditions that will inevitably and eventually follow from the rapid lift in supply of residential properties to rent.
The RBA has started to “think aloud” about issues relating to the housing boom and its initial response is similar to the way it is dealing with the over-valued Australian – keep reminding the market that there are compelling fundamental reasons why it should be trading lower. In the case of housing, the RBA is also starting to think and talk aloud reminding investors that there are reasons to be cautious – house prices can fall and interest rates will not always be as low as they are now. As far as housing investors are concerned there is also the issue that the burgeoning supply of homes to rent implies little if any escalation in housing rental yields. Indeed the risk is rising that the supply could even place downward pressure on rents and worse rental vacancies could rise.
As housing yields come under pressure and vacancies rise, the pressure from investors bidding house prices higher could fade very quickly at some point. That would probably be the best outcome. A worse outcome would be if investors keep bidding up house prices regardless, inflating a true housing price bubble that, when it collapses, will present risks not only to the investors involved, but also to the financial institutions that have leant them money. Comments from the RBA seem to indicate that they are closely monitoring developments in housing, but are not yet unduly concerned about the possibility that a housing price bubble is starting to develop.
Differences in the various Australian capital city housing markets indicate that excessive house price escalation is really only a potential problem in Sydney and, to a lesser degree, Melbourne. The least likely policy action by the RBA would be a hike in the cash rate. Even though low interest rates have contributed to the power of the boom in the Sydney and Melbourne housing markets, housing activity elsewhere is either showing modest improvement or struggling. Non-housing activity, of course, is growing far from strongly enough from the RBA’s point of view and would be damaged by higher interest rates. There is also no evidence of untoward general inflation pressure requiring the RBA to lift interest rates.
Instead of using interest rates, the RBA might be tempted to impose so-called “macro-prudential” controls. For example, the RBA might require lenders to limit loan size to no more than say 80% of property valuation. The RBA has not indicated a great deal of enthusiasm for macro-prudential controls, and probably for several reasons. One of which is the same reason that applies to using higher interest rates; while housing activity may need containing in some parts, for much of the country it is more likely that stronger housing activity is needed and it would be difficult to restrict loan size in one area (for example, Sydney) and leave loan size unrestricted in others (for example, Hobart and Perth).
Greater problems with macro-prudential controls, however, are that they distort useful market signals and tend to become ineffective over time (key reasons why the majority of such controls were removed in the 1980s). Sydney’s booming house prices are providing useful signals that the supply of housing has been constrained by inefficient and unnecessarily costly practices developing new housing for too long. There is nothing the RBA can do with the policy tools at its disposal to deal with undersupply of new homes at reasonable price, but the price pressure keeps highlighting the need for root and branch reform of local government building codes and requirements.
In terms of macro-prudential controls losing their effectiveness over time, it is not too hard to imagine that a set loan-to-valuation ceiling could lead to pressure on housing valuers to inflate prices and lenders to manufacture cocktail loan arrangements with a principal loan for housing, plus an additional loan for a non-housing purpose.
The issue of what to do about housing is a tricky one. In the near-term, it is probably best that the RBA continues to keep talking in public about how residential property investment in Sydney and Melbourne at current prices is increasingly likely to end in tears.