How will falling house prices impact the Australian consumer?

Chief Economists View

Early this month, we highlighted how the RBA continues to forecast much stronger growth for the Australian economy compared to the current market view (for more details see RBA expects Australian growth to remain at 6-year highs in 2019 and 2020). As we noted, the difference in view comes down to an assessment of the impact of falling house prices on consumer behaviour; the so-called wealth effect.

For the RBA, there is no wealth effect. For the market, there is. The wealth effect posits that rising house prices, and therefore rising housing wealth, boosts consumption growth above the rate of growth of disposable income. Conversely, when house prices fall, households tend to reduce their rate of spending relative to income growth.

The RBA, in its November Statement on Monetary Policy, and in various public speaking engagements of its senior staff, have argued that there is little evidence of an impact on consumer spending of house prices during the period of large price increases (from 2013 to 2017), and therefore, do not anticipate a significant impact on spending as prices fall.

So, who is right and who is wrong? It’s extremely difficult to understand the RBA’s denial of the wealth effect. Over the period from 2013 to 2017, when house prices increased by over 40%, the growth in real consumer spending outstripped the growth in real disposable income by a sizeable 1 percentage point per annum on average.

Of course, there were other factors at play driving a wedge between real disposable income and real consumer spending over much of that period other than house prices; uncertainty over job security being one of them. Nonetheless, the persistent outperformance of consumer spending relative to disposable income makes it difficult to deny the existence of the wealth effect. So, how much will the housing wealth effect be in a world where house prices are falling rather than rising?

QIC’s Principal Economist, Drew Klease, estimates that that every 10% fall in house prices leads to a 0.7% drop in real consumer spending, all else equal. However, this is just the first-round effect. As consumer spending falls, the pace of economic activity also falls leading to slower growth in employment, wages, disposable incomes, and hence, real consumer spending.

When Drew simulates a peak-to-trough fall in Australian house prices of 10% (the current market consensus) in the NiGEM model of the global and Australian economies, which picks up both the first and the second-round effects, he finds that the net cumulative fall in real consumer spending to be around 90 basis points by 2020; or a fall in the growth rate of about 45 basis point per annum in 2019 and 2020.

The 45 basis points hit to consumer spending approximately explains the difference between the experts’ forecasts of consumer spending over 2019 and 2020, i.e., 2.5% each year, and the RBA’s forecast of 3.0%. It also explains the difference between the experts GDP growth forecasts of 2.8% and the RBA’s forecast of 3¼% over both 2019 and 2020.

What does this mean for monetary policy? It seems to us that the market is pricing off the forecasts of experts. Currently, the market is not pricing in a rate hike until the June quarter of 2020 at the earliest. As Drew points out, even though the experts’ growth forecasts are not that pessimistic, it is a high hurdle for the RBA to tighten policy in the face of below-trend consumer spending. But if the RBA is right, and the economy is growing above trend, with trend growth in consumer spending and the housing price correction over, expect the RBA to go by the December quarter of 2019.

 

Table 1: Financial market movements, 22 – 30 November 2018

Equity index

Level

Change

10-yr government bond

Yield

Change

Foreign exchange

Rate

Change

S&P 500

2,737.8

3.3%

US

3.03%

-3.3 bps

US Dollar Index (DXY)

96.78

0.1%

Nikkei 225

22,262.6

2.8%

Japan

0.08%

-1.8 bps

USD-JPY

113.36

0.4%

FTSE 100

7,039.0

1.1%

UK

1.37%

-6.1 bps

GBP-USD

1.277

-1.0%

DAX

11,298.2

1.4%

Germany

0.32%

-4.9 bps

EUR-USD

1.135

-0.6%

S&P/ASX 200

5,758.4

1.2%

Australia

2.60%

-6.3 bps

AUD-USD

0.731

0.8%

Source: Bloomberg

For economic update by region, click here

 

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