Expect rebound after RBA's bold decision, a game changer for housing

The net effect of yesterday’s decision by the RBA to normalise its official target cash rate back to 4.5% is to hand back to borrowers the large top-ups the major banks added to the RBA's November 2010 rate hike. Privately the RBA was surprised by the magnitude of these top-ups. 

On the 21st of October I anticipated that they would do exactly this should the third-quarter inflation data print less than 0.6%: 

“I suspect the RBA would not be opposed to "normalising" the level of interest rates… If the third-quarter inflation numbers print on the very low side, they will hammer the final nail in the coffin of the current inflation debate. There will be no evidence that price pressures are accelerating. With a still high currency, this will then denude the rationale for holding the cost of money at the RBA's "mildly restrictive" level (assuming that the RBA is able to revise down all of its currently-elevated inflation forecasts out to 2013). By bringing the price of money back to what the RBA considers to be a "neutral" level, it can signal to the community that it is not going to unnecessarily punish it on the basis of a misguided pursuit of inflation-fighting zealotry. In doing so, it builds up more goodwill with the public that can be expended when the RBA has a real inflation battle to fight. A genuinely low core inflation print next Wednesday…might give the RBA sufficient ammunition to justify a pleasant Melbourne Cup Day present.” 

As it turned out, we got a double surprise: while the third-quarter inflation results were much, much lower than economists or the market expected, the earlier ABS downgrade to the second-quarter numbers, from +0.9% to +0.6%, was revised back up again to +0.8%, which to the RBA’s mind is unacceptably high (since it annualises at over 3%). 

As I have been at pains to explain here before, this second revision to the June quarter inflation data eviscerated the argument that core inflation had been decelerating since March 2011. In fact, the ABS’s best guess at Australia’s underlying inflation track now looks like this (see chart).

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One of the more important remarks in the RBA's statement yesterday was a confirmation of this particular interpretation. More precisely, the RBA observed that "underlying inflation started to pick up in the first half of the year." Note the reference to the "first half of the year". There is no “first quarter”, or intimation towards disinflation over the second and third quarters. 

On the basis of the initial downward revision to the second quarter inflation data from 0.9% to 0.6%, which The Australian's David Uren described this week as a "bombshell", the RBA rather radically altered its inflation outlook. This was meant to be confirmed by the third-quarter data. Unfortunately, policymaking never seems to be that easy. Instead, the RBA got great news in the form of a downside surprise to price pressures over July, August and September, but bad news via yet another change to the ABS’s analysis of the inflation track in the first half of the year. 

Unfortunately, the decision the RBA made yesterday could only be justified by one lonely quarter of inflation data, which stands out as a striking anomaly when juxtaposed against the information contained in the preceding quarters, as illustrated in the chart above. This is positively ironic given the RBA had ignored very high, consecutive core inflation prints of +0.85% and +0.9% in the first and second quarters on the basis that it “needed more information”. It arguably tells us something significant about the way the institution operates: it would seem to find raising rates much more difficult than cutting them. 

An independent observer might respond that is a statement of the obvious. The extraordinary community resistance to the spectre of higher rates in the first half of 2011, when the level of rates was statistically indistinguishable from 15-year averages, highlights the obstacles this notionally “independent” organisation faces when trying to control the price of money. 

Yet RBA aficionados had thought that the bank had a forward-looking, so-called “inflation-targeting” approach to setting policy. What we learnt yesterday was that the RBA’s short-lived experiment with pre-emption, as exemplified by its November 2010 decision, has been abandoned. The RBA has more or less admitted that it is awfully difficult to forecast future inflation with any degree of accuracy. The change to its official forecasts out to 2013, which will be published on Friday, will underline this point. Yesterday’s decision to adjust policy in response to one quarter’s worth of data, when other contemporaneous information, such as the unemployment rate (ironically not materially different to where it was in October 2010), GDP growth-adjusted for the floods, domestic demand, retail sales, capex intentions, and so on, all imply the economy is chugging along at a trend-like rate. 

The question then becomes what the RBA thinks will happen in the future. The subtle message from yesterday is that the RBA is no longer going to take brave punts about what may or may not transpire. It will wait for historical data to guide policy into genuinely restrictive territory. 



So what then are the near-term implications of today's decision? The first will be a massive, and immediate, boon for Australia's highly interest rate sensitive housing market, which, as everyone knows, has been soft for most of the year. Over the nine months to end September, national dwelling values are down by 3.6%. After the RBA’s move, one should be able to find discounted variable home loan rates a tad higher than 6.5%, which is below the 6.9% average since the RBA started tracking this data. 

As previously explained, the housing market had been weighed down by consumer expectations of two to three more rate increases over the year ahead, which, of course, never materialised. Prior to the "double tap" in November 2010, we had been forecasting flat-to-negative capital growth in 2011 and more rate increases. We got a bit more than we bargained for in November. And it would seem that the conviction among Australian households that they would be slammed with another two to three hikes in 2011 did the RBA’s job for it. As Mark Bouris noted in his column yesterday, the de facto rate hikes in 2011 crushed consumer sentiment and housing demand. 

Now that the RBA has reversed course, I expect confidence to rise. We are not simply talking about a shift in rates from “mildly restrictive” to “more neutral” (in the RBA’s words), as I had predicted would happen following a low third-quarter inflation result. No, the RBA’s decision is much more important than that. While key media proxies, like Alan Mitchell and Terry McCrann, are confidently declaring today that this was a once-off adjustment to the RBA’s monetary policy settings and is not going to be followed by a sequence of cuts, the fact is that the community had been literally budgeting (i.e., saving and spending) as if they were certain to get several more rate increases. As late as August, an amazing 30% of Australians felt they would get four or more rate hikes over the ensuing 12 months. 

So the RBA’s decision will engender a substantial shift in consumer expectations. Quantitatively, the median expectation will move by around 50 basis points, or two rate cuts’ worth. This will be reinforced by “market pricing”, which is far more negative than either the RBA or the average economists’ forecast. At the time of writing, the interest rate futures market is pricing a remarkable 100% probability that the RBA will cut rates another 25 basis points in December. While this is conceivable, it would only occur if there were a very serious deterioration in conditions across the North Atlantic. 

The RBA will be especially loath to shift rates before it gets the vital fourth-quarter inflation data, which will be released in late January. This will be critical for both confirming the calendar year track of inflation, and, more specifically, that the low third-quarter result was not simply a once-off. That is, it will want to verify that there are no material revisions to the past data. It is possible, for example, that the third-quarter data is revised up a touch (as the December 2010 quarter data was from 0.4% to 0.6%), and that the ABS’s new “smoothing” methodologies generate a surprisingly high fourth-quarter number. 

The one thing we know with certainty is that no one, including the RBA, can reliably forecast Australia’s inflation data: neither the financial markets nor economists got remotely close to the first- and second-quarter outcomes, nor the ultra-low third-quarter numbers. Accordingly, I don't share Terry McCrann’s confidence that everything will be benign in January. It seems the one constant with Australia’s inflation rate is uncertainty. 

So, we have learnt that yesterday’s rate cut is perhaps more stimulatory than it might appear at first sight, because it will trigger a big change in consumer views of the future. It will also likely knock the wind out of the sails of the Aussie dollar, at least for the next three months. The Aussie dollar has plunged four US cents since before the RBA’s decision, and is currently trading at 1.029 US cents. 

Currencies ordinarily price off global interest rate differentials. The financial markets are punting on many more rate cuts, so it is hard to see how this is going to afford much support for our exchange rate given that peer economy rates have already hit their “lower bound”. 

This will be a tremendous relief to Australia’s exporters, who should benefit from a relative price cut, and import-competing industries, which will face more expensive substitutes. 

Another possible source of stimulation is the long-term price of money. On the back of the RBA’s decision and further global risk aversion, three year government bond rates (prices) have declined (risen) some 35 basis points. 

As I have explained before, the reduction in longer-term interest rates has been the motivating force behind the banks’ willingness to in turn cut the cost of three-year fixed-rate home loans to as low as 6.2% (cf. Suncorp today).

The average three-year fixed-rate home loan in Australia since January 1995 has been 7.41% (see chart below). So current three-year rates are probably around a full percentage point below the decade-and-a-half benchmark, which, in anyone’s books, is stimulatory.

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In summary, we had been expecting flat-to-negative house prices in 2011. Care of two rate hikes in November 2010, and two to three de facto increases in 2011, national dwelling prices are off by 3.6%. Once we accounted for consumer expectations of further rate hikes, our internal models did not project a genuine recovery in housing activity until mid-2012.  At the same time, the ABS reports that disposable household incomes have been expanding at a very rapid 8% per annum pace. This has led to a sharp fall in Rismark’s (and the RBA’s) estimate of the national dwelling-price-to-income ratio over 2010-11, and hence an improvement in affordability before we consider interest rates. 

Yesterday’s bold decision by the RBA to cut rates is a “game changer” for Australia’s housing market. Our models imply that we should see a rebound in activity one quarter earlier than expected (i.e., in the first three months of next year). Any further rate cuts will only embolden this dynamic. 

For over a year now we have argued that Australia’s housing market would be a good hedge against adverse economic outcomes. We believed that if the RBA’s terms of trade, or “Chindia”-driven, resources story did not play out as planned, then the bank will not hesitate to slash rates. The most direct and immediate beneficiaries of these cuts would be the four million-plus Australian households with fully adjustable rate mortgages that price off the RBA’s cash rate. That is, households that have been earning solid wages and solid disposable income growth, and have capitalised on a nearly fully employed labour market. 

In contrast to the extraordinarily volatile share market, a well-diversified portfolio of Australian housing has proven to be an exceptionally resilient store of wealth. Through the cycle, dwelling prices track disposable incomes closely. In fact, the cost of Australian housing has actually fallen slightly when deflated by disposable incomes since 2003. On a year-on-year-basis, there will be some inevitable variability. But over the medium term, the proposition that changes in purchasing power exert a very strong influence over prices tends to remain true. 

A final comforting thought for the housing market, is that, contrary to Steve Keen’s hysterical claims, there is absolutely no evidence of a catastrophic plunge in credit growth causing precipitous falls in dwelling prices. The hard empirical fact is that housing credit growth has stabilised at a rate in line with purchasing power, as we would expect. This point is illustrated by my final chart.

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Christopher Joye is a leading financial economist. The above article is not investment advice.


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