It's probably time for the RBA to do some analysis on what happens to spending levels when home prices are falling

  • Australian home prices are falling and household spending is weak.
  • In a speech this week, RBA Governor Philip Lowe discussed the impact of home prices on spending levels.
  • His speech included analysis on what happens when home prices are rising, not falling.
  • Given household spending is the largest part of the economy, some analysis on the impact of falling home prices on spending would be useful information.

Household spending is the largest part of the Australian economy at around 55%, depending on the quarter.

That means it’s important for what happens in the broader Australian economy. As such, the factors that impact spending are, as a consequence, of equal importance.

One obvious one is household income, mainly reflecting what people get paid for the vast majority of households. So too is population growth when you measure spending on an aggregate national level.

The housing market, or, more specifically, home prices, is also another important driver of spending.

When prices go up, it makes those who own their home feel more wealthy. Hey, my house is now worth a lot more than it was last year, so I might as well splash out at the shops, or take an overseas holiday.

This feeling is known as the wealth effect.

According to the Reserve Bank of Australia, when home prices go up, Australians tend to spend more than what they otherwise would.

In a speech delivered this week, RBA Governor Philip Lowe put a figure on how much higher home prices boost household spending.

RBA

“My colleagues at the RBA have examined how changes in measured housing wealth affect household spending,” told the AFR Business Summit in Sydney.

“They estimate that a 10% increase in net housing wealth raises the level of consumption by around 0.75% in the short run and by 1.5% in the longer run.

“They have also examined how this wealth effect differs by type of spending.

“They find that it is highest for spending on motor vehicles and household furnishings and that for many other types of spending the effect is not significantly different from zero.”

So home prices tend to boost car and household furniture sales the most when they’re going up, but not much else, at least in the RBA’s opinion.

However, the chart above suggests that spending levels in other categories also tends to get a boost, albeit on a far smaller scale.

We’re now in a scenario where home prices are falling in many parts of the country, especially in the largest and most expensive capital cities, Sydney and Melbourne.

So does that mean the wealth effect that provided tailwinds for spending in the past when prices were soaring in many locations will now turn into a stiff headwind, an outcome that would likely crimp spending and lead to slower economic growth?

In the RBA’s opinion, the answer is no, not really.

It says the wealth effect is not the most important factor in explaining why household spending has been slowing in recent quarters, outside of car sales, that is.

Instead, it’s largely due expectations about household incomes will evolve in the future.

“The more important influence… is what is happening with household income,” Lowe told the AFR Business Summit in Sydney.

“As I have discussed on previous occasions, growth in household income has been quite weak for a while. It is plausible that, for a time, this didn’t affect people’s expectations of their future income growth; that is the value of their human capital. So they didn’t change their spending plans much, despite their current income growth being weak, and the saving rate fell.

“However, as the period of weak income growth has persisted, it has become harder to ignore it.”

So persistently weak income growth, driven by a variety of factors such as low productivity growth, low inflation and still elevated levels of labour market underutilisation, is why, according to the RBA, household spending has slowed quite noticeably.

That may be so, but it is curious that this has occurred at a time when the headlines have been dominated by ever-increasing negative headlines about just how far home prices will fall.

Motor vehicle sales have cratered in recent months. Broader retail sales have also been weak, growing by just 0.1% in real, inflation adjusted terms, in the December quarter last year.

While growth in household incomes is undoubtedly an important factor in determining spending levels, what was missing from Lowe’s otherwise interesting speech was some analysis about how much falling home prices impact spending levels.

Prices nationwide, from an average weighted basis, are now down close to 10% from their cyclical peak, making this question all the more relevant, particularly for similar scenarios in the future and the expected impact on the wider economy.

Is the wealth effect symmetrical in both directions, implying that households behave in the exact opposite manner when prices rise or fall by the same amount, or is there an asymmetrical relationship where spending is highly skewed in one direction, depending on what home prices are doing?

That would be useful information to know, even if based on modeling and past trends, but Lowe’s speech — at a time when home prices are falling — had analysis about what happens when prices are rising.

As Gareth Aird, Senior Economist at the Commonwealth Bank, noted following the speech, part of the reason the RBA is currently uncertain about the outlook for spending is because it’s a complex relationship to measure.

“It’s very hard to disentangle wealth, income and spending since the spending of one household is the income to another,” Aird said.

“In other words, the wealth, income and spending nexus is interconnected which makes quantifying the magnitude of the wealth effect problematic.

“There are other factors that matter too. We believe that job security fears are a key component of consumer confidence and household spending.”

Given the complexity and level of uncertainty that currently exists from the combination of high levels of household debt, falling home prices and weak income growth, hopefully there’ll be some analysis from the bank shortly to help avoid a possible policy mistake, both now and in the future.

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