The interest rate hike we never had

At first glance, an independent observer might think that the behavior of Australia’s housing market right now is a bit odd. Let’s reflect on the facts.

First, the unemployment rate has remained very low at around 4.9% since late last year. This is well below what we used to believe to be the so-called “non-accelerating inflation rate of unemployment” (or NAIRU), which in the 1990s was assumed to be 6% to 7%. Any falls in the unemployment rate beyond this point are typically accompanied by inflation breakouts. And while jobs growth has, to be sure, slowed considerably from its scorching 2010 pace, the leading indicators imply that the economy will continue to create new employment opportunities.

Second, wages growth is very firm, to say the least. Indeed, private-sector wages including bonuses are stomping along at a circa 4% plus pace, which, as the governor of the RBA recently observed, is above the average rate since the middle of the 1990s. If we then cast our eyes over disposable household income growth, which is reported by the ABS on a quarterly basis, we find an even rosier picture. Disposable incomes in Australia expanded at a remarkable 8.4% clip over the 12 months to March 2011 (see chart).

Source: RP Data-Rismark

Third, the cost of debt is still relatively modest. The headline mortgage rate in Australia today is 7.8%, which is only a smidgen higher than the average rate of 7.6% since the start of 1995 (see chart). Recall that in August 2008, the headline mortgage rate rose to a gut-wrenching 9.6%. Way back in January 1990 it was 17%. So, in terms of the interest rates households are paying on their loans, there is nothing really to complain about.


Source: RP Data-Rismark

Sure, the level of household debt held by households is much higher than it was 20 years ago. But even when we inspect debt-servicing costs, we find that things look fine. According to the RBA’s latest estimates, the median “debt servicing ratio” —that is, the share of disposable income used to service all repayments due on home loans — is just 21%. Indeed, the RBA finds that about 58% of all Australian borrowers are actually “ahead of schedule”, which means that they are paying down their debt more quickly than they have to. The chart below, which is excised from the RBA’s Financial Stability Review, shows the proportion of households that are ahead of schedule, and the median DSR, ranked by income “quintile” (which is fancy language for the five buckets of income, each representing 20% of the population, ranked from low to high).

Notwithstanding these encouraging facts, capital city and regional house prices in Australia have actually tapered in recent times. In the year to end April, capital city prices are off 1.5% while their regional counterparts are down by 1.8%, according to RP Data-Rismark.

The combination of healthy income growth and skinnier house prices has meant that Australia’s dwelling price-to-income ratio has fallen back to its lowest level since June 2003, as I previously reported here.

The question remains, though, if household incomes are rising rapidly, if the labour market is comparatively tight, and if interest rates are only slightly above average, what gives with lower dwelling prices?

The answer, I believe, is not something that has really been explained before: the phantom interest rate hikes. That is, the rate hikes we never had. Jonathon Chancellor alludes to this in a news report yesterday.

During 2011 Australian households have been very “hawkish” indeed. By hawkish we mean that they have expected a large number of interest rate hikes. We know this from a fascinating Westpac survey, which asks households every quarter where they think mortgage rates will be in a year’s time.

When Westpac carried out this survey in February, households said they were, on average, budgeting for more than three further rate increases. That suggests households were expecting to be paying 8.6% mortgage rates. Since that time, we have had no rate hikes despite a very high inflation outcome in the first quarter, which the RBA has thus far ignored, to the surprise of many.

In an update of the survey carried out in June, Westpac found that Australians remained exceedingly hawkish, forecasting more than two rate hikes in the coming year, albeit down from the three plus they anticipated in February. According to Westpac, households now, on average, believe that they will be paying an 8.4% mortgage rate by June next year.

Source: Westpac Red Book

Why are households seemingly so convinced that they are about to get whacked by the interest rate stick? Almost certainly because of the RBA’s and certain economists’ (including, notably, yours truly), sabre-rattling about the spectre of higher rates. Of course, this pain has yet to materialise, which is almost exclusively due to the impact of an unprecedented sequence of disasters.

The latter started with the east coast floods, followed by NZ’s earthquake, then the oil price shock induced by the rolling Middle Eastern political turmoil (which continues to this day), the extraordinary earthquake-cum-nuclear calamity in our second-largest trading partner, Japan, and now a resurgence of European sovereign debt woes.

The natural and man-made turbulence in 2011 has conspired to disrupt both Australian and global growth and pushed the RBA to the sidelines. Some, such as Macquarie Bank, take a harder line, and contend that the RBA is starting to sound like “the boy who cried wolf”.

For the time being, however, the RBA’s jawboning has paid off (a subtle pun in this sentence for the central bank enthusiasts). That is, its so-called “open-mouth operations” have had the effect of de facto rate hikes.

Notwithstanding robust income growth, households are saving more than they have in 25 years, and they are avoiding taking out new debt. This is reflected in another intriguing suite of statistics published by Westpac and the Melbourne Institute, which document where households believe they should be putting their hard-earned savings. The chart below tells the story. There has been a structural shift away from shares and real estate towards cash, super and paying back debt.


Source: Westpac-Melbourne Institute

As I predicted many years ago, this means credit growth will move in lock-step with incomes, not the double-digit rates that persisted during the 1990s and 2000s. Contrary to what the notorious doomsayer, Dr Steve Keen, would have us believe, it does not portend a cataclysmic, 40% fall in house prices, or a precipitous drop in the rate at which credit is extended.

It does, however, mean that the handful of institutions that dominate our banking sector will have to get used to much lower returns on equity, given that they have now effectively become the system, and cannot, by definition, grow faster than it (a point well-made in this landmark speech on the subject late last year).

Christopher Joye is a leading financial economist and works with Rismark International. Rismark and RP Data provide house price analytics products, and solutions that enable investors to go long and/or short the housing market. The above article is not investment advice. You can follow Christopher on twitter at @cjoye or read his blog.


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