The rise and rise in Sydney house prices is causing much consternation in official circles. Ideally, the Reserve Bank of Australia would prefer house prices in our major city to be less frothy, as it would reduce the risk of a major house price crash later. That said, the RBA faces two dilemmas in trying to stem the property price rise, which suggest it is likely to retain an easing policy bias – and will still likely cut interest rates further this year.
DILEMMA ONE: HOUSES PRICES AND THE $A
The most widely recognised dilemma for the RBA is the trade-off between using interest rates to contain Sydney house prices and the likely effect of such a policy on the Australian dollar. Were the RBA to adamantly rule out further interest rate cuts – or even nudge them higher – it may well stem the speculative momentum developing in the Sydney property market. But the almost immediate effect of such a change in policy stance would be to add upward pressure on a still uncomfortably high $A. Indeed, the RBA’s apparent shift to a more neutral policy stance after this month’s rate cut has contributed to upward pressure on the $A, which is back around US80c. The $A is now in fact higher against the $US than after this year’s first rate cut in February.
Adding to the pressures on the RBA is the growing risk that US economic growth could disappoint over the rest of this year. Although March quarter US economic growth was held down by poor weather and industrial disputation, more recent June quarter economic data have also been mixed suggesting US growth may not rebound as strongly as the Federal Reserve has been hoping. If the Fed delays hiking interest rates – or retains a very dovish tone – upward pressure on the $A would intensify.
DILEMMA TWO: HOUSE PRICES AND THE ECONOMY
A less recognised dilemma facing the RBA is that, even if it were successful in stemming the rise in Sydney property prices without unduly pushing up the $A, any weakening in house prices would then risk undermining the key remaining near-term driver of economic growth – consumer spending.
With the long hoped recovery in non-mining investment stalled, both the RBA and Treasury are now counting on consumer spending picking up to an above-trend pace to support economic growth over the coming year. That’s despite the fact wage growth is expected to remain weak, and the unemployment rate expected to rise to 6.5% by June 2016.
Despite weak income growth, consumer spending is still expected to rise due to a fall in the savings ratio, caused by rising property and share market related household wealth. As seen in the chart below, officials are counting on a continuation of the broad negative relationship between household wealth and savings evident over recent decades – with the theory being households save less when they are feeling wealthier.
That said, as also apparent in the chart above, the decline in the household savings ratio over the past year has been much more muted – relative to the gains in wealth – than in the post-financial crisis era, likely reflecting already high household debt and greater consumer caution.
The dilemma faced by the RBA is that while it wants to avoid a house price bubble, should house prices soon start to flatten out – or even fall in nominal terms – it will be even less likely that the savings ratio will fall and consumer spending will rise. In turn that implies it will be even less likely that the economy will return to an above-trend pace of growth anytime soon, meaning the unemployment rate could remain uncomfortably high.
ON BALANCE THE RBA WILL LIKELY CUT FURTHER
Weighing up these competing issues is not easy, but on balance we continue to believe the RBA will err on the side of supporting the economy if need be with lower interest rates. In doing so, it will be comforted by the fact that house price gains outside of Sydney have been more moderate, and so-called macro-prudential controls – in consultation with the Australian Prudential Regulation Authority – could soon contain the “Sydney problem” without undue property price weakness.
The RBA will also be watching the United States closely, as signs of slower economic growth and further delay in raising US interest rates will add to the already uncomfortable recent upward pressure on the Australian dollar.