The Problem with Property Doomsayers

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Jessica Irvine| Sydney Morning Heralds| 27 August 2017

The team at ABC’s Four Corners assembled a thrilling package about the Australian property boom last Monday.

It came replete with forecast of the “perfect storm” for property and an inevitable popping of the property “bubble”.

It’s true that the biggest threat to the housing market is the extent to which naive borrowers have been able to over-leverage on property portfolios.

If – and I stress “if”– some economic shock caused a rise in the jobless rate, these borrowers would no doubt be left high and dry. Their forced sales would no doubt create downward pressure on prices.

We are left to trust that banks and mortgage brokers have conducted the proper checks to weather inevitable rises in borrowing rates. But there are many reasons to be less concerned about all the dire warnings about property (much to the dismay of many would-be buyers).

Absent a rise in the jobless rate, which has been falling recently, it’s hard to see where the trigger for forced property sales would come from. In times of price weakness, home owners tend to just sit on their properties, keeping volumes low and price falls capped.

Australia has never seen a precipitous fall in house prices, as has occurred overseas. Price booms tend to be followed by period of price stagnation, rather than falls. Australian banks have never been willing to offer “no recourse” loans as in many other countries, like the US. If a mortgage holder can’t pay, their house is repossessed and the bank recoups its money. In other countries, many borrowers can just walk away, and do.

It doesn’t take as much to crimp household cash flows with even small interest rate increases.

Australian mortgage holders, by comparison, will keep paying the mortgage until it is absolutely impossible.

The other unique feature of our housing market is the degree to which people have variable interest rate loans. This makes us incredibly sensitive to changes in interest rates. Indeed, some of us make a very good living feeding Australian’s obsession with interest rates and house prices.

This sensitivity to interest rate changes makes monetary policy – the setting of borrowing rates by the central bank – a potent tool of economic management.

Perhaps the biggest reason to believe Australia’s property boom won’t go spectacularly bust is that the Reserve Bank won’t let it happen.

There is good reason to believe that future interest rates will remain lower than they have in the past.

Those who paid mortgage rates of about 10 per cent prior to the global financial crisis may yet earn the same sort of bragging rights over future generations that those who endured 20 per cent rates did.

To the extent borrowing rates are likely to remain lower, that just means people have had a rational reaction to borrow more, because they can afford to service higher debts. If borrowing rates returned to where they were, of course, there would be widespread misery.

The Reserve Bank shocked financial markets in July by releasing minutes of its July board meeting revealing board members had talked about the concept of the “neutral interest rate”.

That’s econo-speak for the interest rate at which monetary policy is neither expansionary or contractionary in its impact on the economy. The neutral rate is the rate consistent with full employment and maximum output growth without spiralling price pressures.

It’s the level you would expect interest rates to return to when the Reserve Bank feels its job of trying to stimulate the economy with record low borrowing rates is done.

Back in the early 2000s, then Reserve governor Ian Macfarlane estimated the neutral rate for the official cash rate was about 5.75 per cent. That’s a neutral real interest rate of 3.25 plus inflation of 2.5 per cent, plus a retail margin for the banks to get a headline mortgage rate – the rate people actually have to pay – of about 7.5 per cent.

According to the Reserve’s latest analysis, the neutral official cash rate had fallen from 5.75 per cent to just 5 per cent.

In the July minutes, it estimated the neutral official cash rate today has fallen to just 3.5 per cent.

Remember that the official cash rate today stands at 1.5 per cent, meaning interest rates would only have to rise 2 percentage points before the Reserve Bank could consider that its job of removing monetary stimulus was done. Game over.

That is less than has been required in the past and reason to believe that this tightening cycle – when it comes – will be more gentle, to avoid the very problem canvassed by Four Corners.

Why should we believe that the neutral level of interest rates has fallen?

Partly it’s because of the indebtedness of households. Because we’ve borrowed more, it doesn’t take as much to crimp household cash flows with even small interest rate increases.

The lower rate of productivity growth in the economy is also part of the reason. When economic growth is more sluggish anyway, you don’t have to do as much to pull on the reins.

Things could change and interest rates may need to rise by more. The Reserve’s minutes warn that “a reduction in risk aversion and/or an increase in the potential growth rate could see the neutral real interest rate rise again”.

But for now, it’s unlikely that a campaign of aggressive interest rate rises will be responsible for triggering the sort of property collapse that many fear.

There may be other external shocks that bring us undone. But the more likely scenario is a slow deflation of our property boom and prolonged high prices.

The majority of Australians, as homeowners, will still probably think that’s a good thing.



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