Balancing an economy is undoubtedly a tough ask for anyone. Our inflation targeting Reserve Bank looks to maintain inflation within a range of 2% to 3% on an annual basis over the cycle. Too much inflation is not ideal, nor is deflation, so the RBA tries to tweak monetary policy to stimulate the economy in order to see some inflation but not too much. If inflation runs too high consumption slows down as consumers simply can’t afford to purchase goods and services because they don’t have enough buying power. If deflation occurs consumers are also likely to stop spending because the value of any debt they have increases (as opposed to reduces when there is inflation). Consumer buying power may increase during times of deflation; however the weak economic conditions that have caused prices to deflate are likely to also result in higher unemployment, a contraction in the number of jobs and a pessimistic consumer mindset.
With the currently high levels of inflation in housing prices it stands to reason that the purchasing power of many consumers has diminished. When you think about the Australian housing market as a whole I don’t think anyone could argue that shelter in Australia is particularly affordable. In fact over the last two decades home values have increased at a rate much higher than inflation meaning that some in the community don’t have enough buying power to purchase shelter. As a result, many of these people are likely to rent.
I am constantly surprised about articles and comments which seem to believe that a significant decline in Australian home values would be the preferred cure to housing affordability and a good outcome for the economy. If we look purely at the inflation and deflation argument some people would say we have had too much inflation of home values however, the solution to that problem is not to aim for deflating current home values.
The Australian Bureau of Statistics (ABS) estimated that as at June 2014, the total value of Australia’s dwelling stock was $5.2 trillion and there were an estimated 9,366,800 dwellings across the country (note that RP Data we estimate the total value of residential dwellings to be somewhat higher at $5.5 trillion as at June 2014). To put this $5.2 trillion in dwellings into perspective, over the 12 months to June 2014, GDP, or the total output of the national economy, was recorded at $1.57 trillion. What this means is that the value of residential dwellings was more than three times greater than the annual output of the economy.
According to data released by the Australian Prudential Regulation Authority (APRA), Australian authorised deposit-taking institutions (ADIs) held $1.225 trillion in loans against these dwellings across 5,079,800 mortgages. So what do these figures tell us? 54.2% of dwellings across Australia have a mortgage to an Australian ADI and 23.6% of the total value of Australian dwellings is outstanding to Australian ADIs. The ratio of debt held against the total value of the housing asset class is very low however, this ratio includes all dwellings (not just those where a mortgage is held). In the event of a downturn those with high leverage are likely to be much more significantly impacted. It also probably reflects that quite a lot of dwellings have no mortgage (the 2011 Census indicated that roughly one third of Australia dwellings were owned outright) while a proportion will also have mortgages sourced from non ADI lenders or offshore banks.
Australian’s choose to hold a large proportion of their wealth in residential property; this is highlighted by the $5.2 trillion total value of residential dwellings. Data published quarterly by the Reserve Bank shows that while the typical household’s ratio of housing debt to disposable income in 137.1%, the typical household’s ratio of housing assets to disposable income is a much larger 433.6% making up 54% of the typical households assets. Over the past couple of decades Australian ADIs have shown a preference for lending to housing as opposed to lending for personal loans or to business. Of course, the ADIs have had good reason to preference housing lending; it has generally performed well with low mortgage arrears, the return on equity is strong, earnings from mortgages are consistent, higher risk loans are generally insured via lender’s mortgage insurance (LMI), home values have generally trended higher and Australian’s tend to prioritise repayments of their mortgage. But this does not mean that home owners and the economy could withstand a significant deflation in home values. Nor does it mean that a significant deflation in housing values would be a tonic for those that can’t afford to own a house to finally achieve home ownership. Why would deflation in an asset which is more than three times larger than the annual output of the economy play out any better than deflation in an economic sense? In fact, were home values to deflate it could be argued that the whole economy would suffer as consumers stopped consuming. As consumers stop spending unemployment would likely rise, ADIs would stop lending and there is a high likelihood the Australian economy would enter a recession. Remember, it isn’t only those with a mortgage which would face the prospect of unemployment, so too would all those people who are yet to purchase a home waiting for the collapse to enter into the market at rock bottom prices.
A more desirable solution to improve housing affordability in my opinion is to look for a more moderate level of growth in home values while improving both the supply and demand side of the equations. A sustained period in which home values grow at a rate below inflation would be an ideal way in which to improve affordability rather than a large-scale bust. Interestingly, as we showed in last week’s blog a number of cities have recorded value growth below the rate of inflation over a number of years now (although this hasn’t been the case in Sydney and Melbourne).
Housing booms make it harder for prospective home owners to enter into home ownership, however I would argue that busts are much worse. Furthermore the level of exposure to the housing market by ADIs and residents would mean a housing bust has much more far reaching repercussions for the economy. Although stress tests indicate that most ADIs could cope with a significant decline in home values the impact on households and the Australian economy as a whole would likely send Australian into a recession. This is why rapid deflation in home values is just as, if not more undesirable than rapid inflation and why the goal should be moderate growth in home values with a growth rate that broadly trends in line with household income growth over the cycle. If we want to reduce the cost of housing from its current level with minimal overall economic damage, home value appreciation below the rate of inflation for a number of years is what I see as an ideal solution. Of course achieving this means that governments need to address the factors that drive a high level of housing demand and those which constrain the overall supply of housing and drive the cost of this new supply higher.