The unwelcome home sign

House prices are falling despite favourable affordability, low interest rates and rising wages. If weakness gains momentum, the central bank may have to react.

House prices are falling again. If these falls are the start of a new trend lower rather than just a bit of a blip, it could be a very unpleasant signal that will require a policy reaction from the Reserve Bank.

According to data compiled by RP Data, house prices have fallen 1.5 per cent in less than two months since the end of March to take a chunk out of the 2.6 per cent rise that was recorded in the first three months of 2013. House prices are up just 1.2 per cent in net terms since the start of the year.

Since early 2011, for every few months there has been a bit of an increase, the next few months have shown a reverse and so on. That said, house prices are now approximately 5 per cent down from the peak around two years ago to register one of the longest periods of flat to falling house prices.

The recent dip is surprising given the extremely favourable housing affordability at present with low interest rates and rising wages helping to support housing demand. Falling prices are of course the other component of improved affordability.

While it is not clear what is behind the recent house price dip, in the last few months there has been a slide in consumer sentiment which might be seeing potential buyers hold off entering the market. Perhaps more fundamentally, the updrift in the unemployment rate over the past year or so has impacted on consumers’ willingness and ability to bid prices higher. The unemployment rate was around 5 per cent in the middle of 2012 and it is now around 5.5 per cent.

For the central bank, there is nothing yet in lower house prices that would see it losing sleep. But it knows only too well from the experience in the US, the UK, Ireland, Spain and elsewhere that a house price collapse is economic poison and should be avoided if the local banks are to remain solvent and keep the real economy growing.

Indeed, if it were not for the collapse in house prices in those countries, what ended up as the most severe economic crisis since the 1930s Great Depression may have only been a slow-down or mild recession.

The Australian housing market is also fundamentally different from the likes of the US, Ireland and Spain, where the house price bubbles were accompanied by a housing construction boom. If anything, housing construction in Australia is in the doldrums, with new construction bouncing along at very low levels.

Perversely, perhaps, this weakness in new housing construction is good news for now as it means there is little risk of a glut of property coming on to the market should there be a more worrying house price fall in the months ahead.

Obviously, the Reserve Bank does not target house prices as it has objective target changes in consumer prices. That said, any large and sustained falls in house prices matter from an inflation targeting perspective because a destruction of household wealth and severely damaged balance sheets for most banks in the event of a house price dive would unleash a deflationary bias into the local economy, much in the way it has in many overseas markets.

The chances of a sharp fall in house prices in Australia remains remote, not least because of the policy actions already from the Reserve Bank to cut interest rates but also because of the still extremely favourable demographics, especially strong population growth, that will continue to underpin housing demand for many years to come.

And of course, the central bank has plenty more it can do on interest rates. With the backdrop of around 90 per cent of mortgages having floating interest rates – that is, they move more or less in line with changes in official interest rates – signs of a troubling house price fall would inevitably see the Reserve Bank cut interest rates again and again and again.

This is why the recent Reserve Bank policy bias to further cut interest rates will only be reinforced by the recent house price declines. If the price falls gain momentum, there could even be a scenario when the central bank drops the cash rate more than the futures market is currently pricing – say to around 2 per cent. In a worst case, official interest rates could be 1-point-something per cent, which I suspect would be enough to underpin house prices and fend off the nasty effects of a house price bust. 

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