WEEKEND ECONOMIST: Don't bet the house
Glenn Stevens' warning on the housing market has been taken as a sure sign rates are going up next week. But the RBA is likely to wait and watch the impact of its previous hikes.
Markets are firmly of the view that the Board will raise rates by 25 basis points and for good reason. The RBA Governor took an extraordinary step this week to appear on free to air TV with a message that "...it is a mistake to assume a riskless easy guaranteed way to prosperity is just to be leveraged up into property."
This type of statement should not necessarily be interpreted as a signal for an immediate rate hike. Recall Mr Stevens' predecessor Governor McFarlane who wrote in April 2003: "For these reasons, we at the Reserve Bank have been concerned about investor housing for some time. We are concerned not only because it has been a very large factor in explaining the growth of household debt, but because the risks involved are greater than in borrowing for owner-occupation, and are unlikely to be fully understood by the many newcomers to this activity."
Rates were not increased until November of that year.
However, Governor Stevens' comments were reasonably assumed to indicate an imminent strike against excessive leverage. This focus on house prices is supported by the minutes from the last RBA Board meeting which note: "House prices had gained significant momentum and were continuing to rise strongly for all but the bottom segment of the market."
The attention being given to the housing market has its origins in the Bank's recent Conference marking its 50th Anniversary on February 6. At this, the Governor indicated a broader approach to monetary policy to try to take action in anticipation of asset bubbles rather than leaving it too late and needing to burst the bubble: "The potential instability of a well-developed boom means that for policy-makers, the least-harm policy is to make sure that their settings are not inadvertently fuelling the build-up." In effect, if rates were seen to be below neutral then such an expansionary setting could be "fuelling the build up".
Last week Assistant Governor Lowe expressed the same sentiment in a somewhat different way: "It would obviously be unhelpful if a speculative cycle were to emerge on the back of the recent strength in housing prices".
The story is therefore clear: there is no speculative boom at this stage but there is concern that the recent "significant momentum" in house prices could fuel one. The Bank should therefore not be holding rates below neutral since that risked fuelling a speculative cycle.
In another section of the TV appearance the Governor referred to "normal" cash rates as 4.5 per cent to 5 per cent. We know that no one really knows exactly where "normal" lies.
The logic behind the current estimates is that the average cash rate over the period January 1992 to December 2007 was 5.5 per cent and since the advent of the GFC the margins between private sector rates (mortgage rates and business rates) and the cash rate has increased by 1 per cent therefore lowering the effective cash rate.
For example, when the cash rate was at 5.25 per cent in December 2003 the variable mortgage rate was at 7.05 per cent. With the cash rate at 4 per cent the current variable mortgage rate is around 6.9 per cent.
Chairman Greenspan used to argue that you would only know "neutral" when you have actually reached it.
The data released on March 31 for retail sales and building approvals raises at least a doubt that "neutral" may have already been reached. These high-frequency series are generally released on the same day. Our scrutiny of the historical series (after revisions) shows that since the early 90's there has only been one month when the two series have both posted large falls (of more than 1 per cent for retail sales and more than 3 per cent for building approvals).
That was in July 2000 in the aftermath of the introduction of the GST. The RBA had raised rates at its August meeting prior to that data being made available and contrary to market expectations did not raise rates again in that tightening cycle.
Furthermore, these latest falls are not "one off" negatives which are contrary to underlying trends.
Our scrutiny of the retail sales data is consistent with our view that consumers will be much more conservative in this upswing than in previous cycles. Weakness was almost across the board. Of most concern was "household goods" – the segment that usually leads the recovery cycle particularly when the housing market is in an upswing – recorded a sizeable 1.3 per cent decline in February.
Spending in this category has recorded 10 per cent increases in the first year of previous upswings but has been flat in recent months in this "upswing". Monthly trend sales growth has moderated to just 0.1 per cent – with population growth at 2.1 per cent per capita and annualised trend growth of 2 per cent over the last three months spending per capita is falling.
For retail sales, trend growth for the three months to August was 1.3 per cent; to November was 1 per cent and to February had fallen to 0.5 per cent.
Building approvals have been losing altitude for two months. Three month growth in dwelling approvals is now at -4.0 per cent. That compares with the three months to November of 17.7 per cent and the three months to August of 16.7 per cent.
We are not arguing that this data should herald a premature end to the tightening cycle. We still expect rate hikes in May and July/August. However, we do believe that this data provides some early support for our view that a long pause in the tightening cycle is much closer than currently expected by the market which is close to expecting rates to be around 5.25 per cent by year's end.
Now, central banks are much more flexible on timing than markets. We saw that in February when the case for a rate hike was stronger than it is today but the Bank delayed due to requiring more information. For a central bank waiting another month to get more information is entirely reasonable.
There is also the risk in interpreting Reserve Bank "speak". Is it sometimes justifying previous action (as we saw in the Governor's speech in Perth in October – recall sentiment about not being too timid) or is it providing guidance for the future?
In a further warning about the sensitivity to interest rates we saw the most interest rate sensitive state (due to higher levels of household debt) NSW showing a fall in retail of 2.5 per cent; private sector houses of 10.4 per cent and private units of 18.2 per cent.
With this unusual coincidence of very weak high frequency data there is certainly a case for waiting another month to assess whether "neutral" is indeed lower than previously anticipated. If rates were a long way from assessed neutral then the decision would be easier.
Our expectation that rates will be on an extended hold is partly predicated on the view that Australia is not entering a period of speculative excess in the housing market. We expect that the recent increases in interest rates and the likely future extra 50 basis points of tightening will lead to an orderly slowdown in the pace of house price increases settling any concerns of a speculative boom.
The essential characteristics of a speculative boom is a sharp increase in leverage; aggressive competition amongst lenders; a relaxation of lending standards; dominance of investors; spruiking of excessively optimistic investment opportunities; and new types of mortgage products being introduced.
Banks are currently focussed on possible limits on lending as regulations and sharp increases in funding costs force them to balance growth on both sides of the balance sheet. These are not the preconditions for a speculative boom. The sharp increase in house prices in 2009 can be explained by shortages; population growth; improved affordability and not excessive leverage. With fundamentals driving prices, a new stable equilibrium can be attained without the likelihood of a massive speculative overshoot.
The RBA's preferred data analysts' for house prices, RP Data-Rismark, noted in a report on 31/3 supports this view that Australia is a long way from an overvalued housing market.
Over the last 12 months Australian capital city home values have increased by 12.7 per cent after values fell by 2-3 per cent in 2008.
Over the five years to December 2009 Australian capital city values increased by 6.2 per cent per annum compared to per capita disposable income increases of 6 per cent per annum.
In Sydney, dwelling values rose by only 1.3 per cent per annum while per capita disposable incomes grew by 5.7 per cent per annum.
As discussed last week there will be headwinds for the Australian economy in the next six to nine months that should justify an extended pause.
These include: the end of fiscal stimulus boosts; the lagged effect of 150 basis points of rate hikes in the previous nine months (including our forecast of a further 50 basis points); a disappointing pace of recovery in the developed world; China continuing to tighten policy; ongoing constraints in the availability of funding from the banks who are dealing with sharp increases in funding costs and regulatory uncertainty; a fundamentally more conservative household sector; likely falls in consumer confidence; and some easing in labour market pressures as the participation rate and population growth boost the supply of labour.
These are all real effects. On the other hand, policy will have to deal with the expected impact of the rise in the terms of trade. Our forecast is for gains of around 10 per cent in 2010 and 6 per cent in 2011.That compares with an average annual increase of 9.5 per cent over the 2003-2008 period. That will impact the economy through a boost to incomes; more fiscal flexibility; a continuation of the investment boom and rising asset prices.
But it will also exacerbate the two-speed economy – a dash to very contractionary monetary policy will only further widen that gulf. Furthermore, while all these positives sound great they are notoriously uncertain – how big will the leakage to incomes be? How will the government use its improving fiscal position given it will still be in deficit? Will adequate labour and capital resources be available to support the boom? Rising asset prices may also be limited to certain regions.
Despite strong market conviction we expect that the bank will take notice of the strong signal from the partial data released on March 31 and pause. With rates so close to neutral and rates having been increased at four of the last five board meetings, a decision to await further evidence on the cumulative impact of the last four rate hikes would make sense.
Alternatively, if there is a perceived need to immediately follow through on recent warnings about prospective excessive leverage then there will be a move.
Bill Evans is Westpac's chief economist