If you’ve been watching Australian house prices over the past two decades, you may be struggling to reconcile why you kept getting told that inflationary pressures are low.
Housing costs — that is to buy a house — have surged by over 300% since 1998, according to the ABS residential property price index, some five times faster than CPI which has increased by a far smaller 63% over the same period.
Given many see CPI as a cost of living measure, it’s easy to understand why many think it’s piffle that inflationary pressures are low.
However, there’s a good reason why the official CPI rate — currently sitting at just 1.5% — is so far below the stonking gains recorded in house prices across many parts of the country over.
The cost to buy a house isn’t included in the CPI.
“For all intents and purposes, dwelling prices are excluded from the CPI,” says Gareth Aird, senior economist at the Commonwealth Bank.
“In a technical sense, ‘new dwelling purchase by owner-occupiers’ is included. But this is simply the cost of new homes excluding land. In reality it’s not a representative measure of dwelling prices because it doesn’t take into account the primary driver of changes in the price of a dwelling which is, of course, the price of land.”
Despite being hardly reflective of changes in housing costs, Aird says that the ABS’ new homes ex-land component of the CPI basket is worth a non-trivial 8.7% of the total basket.
Essentially, a significant chunk of the CPI basket measures the cost to build a new house, not the land it sits on or changes in house prices, helping to explain why CPI is currently so low while house prices have been soaring.
“The reason why the ABS excludes the change in land prices is because they don’t fit the definition of a consumption good,” says Aird. “The ABS does not consider dwelling price rises to be ‘inflation faced by households’.”
In order to determine what impact housing costs would have if they were included in CPI, Aird constructed a model where 10% of the CPI basket captured movements in house prices.
Unsurprisingly, it was significantly higher than what the official reading would have you believe.
“The inclusion of dwelling prices, even just accounting for 10% of the basket, pushes up the annual change significantly since 1998,” he says. “The annual change is, on average, 55 basis points higher than the annual change in CPI”.
This chart from the CBA shows the difference in the annual CPI rate to that which includes the impact of house prices based on its modelling.
That result is not only interesting, it also goes someway to explaining the current conundrum faced by the RBA.
Labour market conditions are weak with unemployment elevated, underemployment at record-highs and wage growth at record lows, but instead of delivering further rate cuts to help reverse this, the bank has had to sit on its hands, fearful of further stoking house prices and household debt accumulation.
Perhaps the inclusion of house prices in the CPI basket could have avoided such a scenario.
Not only would its inclusion have boosted CPI, making it easier for the RBA to reach its inflation target, it would probably have meant that the bank wouldn’t have reduced interest rates as low as it did.
And that would have probably meant that household debt wouldn’t have grown as much as it has, and probably would have stopped some of the enormous house price increases seen over that period.
Instead, as an inflation-targeting central bank, the RBA kept cutting rates to boost a measure of inflation that didn’t capture housing prices, merely resulting in rapid debt accumulation and strong house price growth.
While some may disagree, it was looking to solve one problem but merely created another, resulting in not only one problem but two that it now needs to address.
“The hangover in Australia from pushing interest rates lower over an extended period of time to hit an inflation target has been a huge accumulation of debt and very high dwelling prices,” says Aird.
As a result of that outcome, financial stability risks have increased and there’s even some evidence that high levels of household indebtedness are impacting household spending, an outcome that does little to boost economic growth nor inflationary pressures.
While monetary policy has not been solely responsible for sending property prices in Australia’s southeastern corner skyrocketing — a slow supply response, high immigration levels, increased foreign investment and the current tax mix on housing have all played a part — it’s indisputable that lowering borrowing costs for households has been a major factor.
“Interest rates have needed to be on a long-run downward trend for the RBA to meet its inflation target as the neutral rate has fallen,” Aird says.
“Throughout that period, Australia’s stock of debt has risen as a share of income, mainly driven by the household sector. Most of that debt has been going into bricks and mortar and dwelling prices have therefore risen faster than income but, as discussed above, none of this has been captured in CPI.”
Perhaps that needs to change given the current set of circumstances.