Why the RBA is unlikely to cut interest rates despite a slowdown in Australia's housing market

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Australia’s housing market is cooling after years of rollicking price growth.

Annual price growth has halved since May, auction clearance rates sit at multi-year lows in Sydney and Melbourne and investor housing credit is declining, coinciding with tougher restrictions on interest-only lending from APRA, Australia’s banking regulator, introduced in March.

The slowdown in the housing market, coming on top of weakness in Australia’s household sector seen in Australia’s recent GDP report, has got many people questioning whether the Reserve Bank of Australia (RBA) should hike interest rates given the current set of circumstances, especially with inflationary pressures close to non-existent.

Rather than hiking interest rates, some have even floated the idea that the RBA may consider cutting interest rates given the sharp deceleration in the housing market.

George Tharenou and Carlos Cacho, Economists at UBS, played devils advocate on that front earlier this month, pointing to the chart below to show that when house prices weakened by a similar amount in the past, it has almost always resulted in the RBA cutting official interest rates.

Source: UBS

The pair note that national price growth on a six-month annualised basis is currently running at just 0.7%, an important consideration given that over the past 30 years “when house prices over a 6-month period weakened towards flat or negative, the RBA cut within a few months in 7 of 9 cycles”.

While that’s not UBS’ official call, forecasting instead that the RBA will hike rates in late 2018 with the risks slanted towards a later move, it does pose the question as to whether the current weakness in the housing market will see history repeat.

To ANZ Bank’s Australian economics team, led by David Plank, the answer to that question is almost certainly no.

“There has been quite a lot of focus on the current downturn in house price inflation, with some commentators pointing out that similar downturns in the past have been followed by RBA rate cuts,” the bank says.

“While this might be true, it ignores the key differences between this cycle and previous downturns.

“In particular, previous downturns in house prices followed a succession of RBA rate increases, which pushed mortgage rates sharply higher. Given that RBA tightening cycles typically impact a lot more across the economy than just house prices, we think it is difficult to argue that the slowdown in house price inflation was the primary reason for eventual rate cuts.

“We think a rising unemployment rate was far more important,” it says.

One look at the charts below adds credence to that view.

The first looks at the relationship between annual house price growth and mortgage rates. The latter, shown in orange, has been inverted and advanced by six months.

Source: ANZ

As opposed to what has been seen previously when house prices tended to decline following a series of interest rate hikes, in recent times, price growth has slowed despite mortgage rates remaining near the lowest levels on record, coinciding with tighter macroprudential restrictions on investor and interest-only lending from APRA.

“The current downturn in house prices has not come after a tightening cycle. Instead we think the most likely cause was the tightening in credit, though with a lag and interrupted by the impact of RBA rate cuts in 2016,” ANZ says.

In comparison, this next chart shows the relationship between the annual change in Australia’s unemployment rate to movements in the cash rate.

Source: ANZ

While not perfect by any stretch, when unemployment starts to lift, the RBA tends to cut the cash rate, and vice versus.

Australia’s unemployment rate has recently fallen to 5.4%, leaving it at the lowest level in close to five years, going someway to explaining why ANZ is forecasting that the RBA will lift the cash rate to 2% by the end of next year despite the slowdown in the housing market.

“In our view, a [housing] cycle driven by credit is likely to play out very differently from one driven by higher interest rates,” it says.

“Expecting the current housing cycle to play out like those caused by movements in interest rates, strikes us as likely to end in disappointment.”

Indeed, outside of the recent price deceleration caused by credit rather than mortgage rates, ANZ points to a variety of other housing market indicators that suggest there’s little need for the RBA to cut rates.

“The most recent data on auction clearance rates suggest some stability after a period of decline. If this broadly continues then we would expect house annual price inflation to stabilise in the low-to-mid single digits in 2018,” it says.

“Our forecasts have nationwide house price inflation slowing to zero in 2018, but this also includes the impact of the two RBA rate hikes we expect in 2018. If these don’t take place then we would expect less of a slowdown in housing inflation, probably to the low-to-mid single digits mentioned above.”

ANZ says recent strength in Australian building approvals data, supporting the view that credit cycles play out differently from rate hike cycles, provides further evidence why RBA rate cuts are not required on this occasion.

“In late 2016, when approvals were falling sharply, there were a number of dire predictions about what that would mean for housing construction and employment. But it has been clear for some time that the downturn in building approvals was shallower than in previous cycles,” it says.

“We think this is because this cycle was not triggered by higher interest rates. Instead, we think a more likely cause was the tightening in credit that began in 2015.”

Source: ANZ

According to the ABS, Australian building approvals rose by 0.9% to 19,074 in seasonally adjusted terms in October, leaving the increase on a year earlier at 18.4%. Private sector approvals for houses and other dwellings stood at 10,063 and 8,683, up 6.2% and 37.6% respectively from 12 months earlier.

Given the absence of weakness in other areas of the housing market, differing it from periods in the past when interest rates were cut, it helps explain why ANZ and the vast majority of forecasters believe that the next move in the cash rate will be higher, albeit not for many months.

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