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Friday, May 25, 2012

The RBA's own-goal on housing supply (column)

To be published by Property Observer and Business Spectator...

The RBA’s own-goal on housing supply

A couple of weeks ago the Deputy Governor of the RBA, Dr Phil Lowe, revealed that the “biggest surprise” for the central bank in 2011 had been the very low level of “home building.” I laughed when I read this because I had debated exactly this issue with the RBA in 2009 and 2010. It was entirely predictable.

Pondering how the RBA had misjudged the level of new building activity over 2011, Lowe said he thought that “a lowering of expected capital gains on housing…has made developers, financiers and households less willing to commit to new construction despite rising rental yields, lower prices relative to income and ongoing growth in population.”

In 2009 and early 2010 I publicly and privately expressed anxiety that high-profile “jaw-boning” of house price rises by Glenn Stevens, Phil Lowe, and Tony Richards would exacerbate the supply-side problems that these same individuals claimed they were concerned about. I also warned economist buddies of mine that there was no way building approvals would recover to the levels they forecast while the RBA left the community with the impression there was a house price bubble. Here’s what happened to building approvals after the RBA’s “open mouth operations.”

On the one hand, the Bank has frequently argued via its bi-annual Financial Stability Review that the housing market’s fundamentals are solid, with an inelastic supply-side (something I had highlighted back in 2003), internationally low default rates, healthy population growth, a reasonable price-to-income ratio, and low vacancy rates. The Bank has also regularly said it would welcome more developer activity.

On the other hand, the Bank was worried that the rapid house price appreciation in 2009-10 could lead to future financial stability complications. It was a forward-looking critique: if asset price growth continued it could feed back into credit growth, which is something the Bank wanted to avoid. In March 2010 the Governor, Glenn Stevens, famously gave an unprecedented, and widely covered, interview to Sunrise’s David Koch warning home buyers that house prices were not a one-way bet.

Several months earlier, the RBA’s Tony Richards had offered the argument, which also got wide media airtime, that “[A]s a nation, we are not really any richer when the price of housing rises, but the more vulnerable tend to be hurt.”  

The net result of the RBA’s posturing was that many commentators reported that the central bank thought Aussie housing was expensive. In truth, the RBA was trying to deliver more nuanced messages. One of these was that we should not expect to see a repeat of the 7-8% capital gains home owners realised over the last 30 years. A second was a reminder that house prices can go up and down.

In abstract, this was wise advice. Indeed, I had myself regularly argued that the risk of an individual family home was much higher than many people understood.  In this May 2010 column, I revealed research by Rismark that had, for the first time in Australian history, quantified precisely how risky an individual home is.

Before diving further into this issue, it is useful to get some context. After three years of relatively low house price growth in 2004, 2005, and 2006, capital gains accelerated by 13% in 2007. The coincidence of rising variable mortgage rates, which peaked at a scorching 9.6% in August 2008, and the onset of the GFC saw prices drop by about 4% that year (see chart below).

Yet the unwinding of the RBA’s tight monetary policy in 2008 together with fiscal stimulus from the government helped the market recover quickly in 2009. That year prices rose 13.7%.

In October 2009 the RBA started to normalise monetary policy again with four quick rate hikes. The Bank was keen to do so in part because of worries it had about the effects of leaving rates too low for too long.

It was clear to Rismark in the first half of 2010 that there was no risk of a repeat of the previous year’s boom. In fact, we forecast zero capital growth in the second half of 2010, and started warning prices could fall if the RBA kept on pushing rates into restrictive territory. In November 2010 the RBA complied with a de facto double rate hike, which was amplified by a barrage of RBA rhetoric in the first half of the following year implying more hikes were coming. Unsurprisingly, prices fell by 3-4% in 2011.

Since the end of 2007 Australian house prices have risen by 2.5% per annum. That is, they have tracked the RBA’s inflation target. Notwithstanding two years in which house prices deflated, they are still around 8-10% higher than their early 2008 peak.

This is awkward news for the University of Western Sydney’s assistant professor, Steve Keen. Many will recall that Keen sensationally predicted a 40% drop in Aussie house prices. As my next chart shows, the gap between Keen’s 2008 prediction and current house price levels is over 80%.

 With the 2009-10 rate hikes neutralising the relief bequeathed by the RBA during the GFC, I thought the high-profile jaw-boning of prices by RBA officials was fraught with danger. Specifically, I warned that these actions could end up stifling the supply-side. I outlined this thinking in April 2010:

“Back in 2008 and 2009 we had the RBA enthusiastically defending the integrity of housing market conditions and casting doubt on the many predictions for steep price falls.

What is problematic here is that Stevens and Lowe's statements [about the cost of housing] are only going to seriously spook lenders. Rightly or wrongly every credit officer in the country thinks the RBA believes Australia is suffering from an unproductive house price bubble. (We even had NAB’s Chairman criticising CBA and Westpac for ramping up mortgage finance.) The headlines on the front pages of newspapers conveyed the story this week: "RBA worried about bubble risks".

The RBA’s jaw-boning is going to exacerbate the supply-side problems. Ironically, rising prices are the best possible thing to stimulate investment in new supply. This is, after all, what free markets are there to do: signal where scarce economic resources should be allocated via the price mechanism.

It also pays to remember that property "investors" provide rental accommodation for lower income families. According to the RBA, rental vacancy rates are currently very tight. So surely we want to be encouraging, not discouraging, investment in new rental shelter?

Finally, if people are going to argue that fundamentals-based house price rises are bad for society, they also have to explain to us why rising share prices are bad too. Rising house prices simply reflect an increase in the value of productive assets that supply 10.9 million Australian workers with shelter. It is usually the market signaling that we need more investment in shelter. Likewise, the rise in the value of, say, farms that produce food for us to consume (food and shelter are the two essential inputs for a functioning economy) reflects an increase in the market value of its assets.

For clarity's sake, I am a big opponent of individual consumers gearing heavily into residential property or shares, which, contrary to popular opinion, have similar levels of risk at the individual asset level. It makes little economic sense. And I have argued longer and harder than anyone that we need to deleverage household balance-sheets [via greater use of “equity” as opposed to “debt” finance] and elastify the supply-side.”

In addition to jaw-boning house prices in 2009 and 2010, the RBA regularly signaled via its media proxies that it was prepared to put a break on housing returns if it deemed them to be problematic from a financial stability viewpoint.

Given these interventions, one wonders whether it really was that “surprising” that investors have downgraded their return expectations with direct ramifications for the amount of capital being committed to producing new housing supply.