In previous periods of falling house prices, such as 2008/09 and 2010/12, the Reserve Bank cut the cash rate materially to boost the economy and, in the process, lifted housing affordability.
Up until recently, the challenge with this housing cycle was that the RBA appeared absolutely committed to the next move in rates being up. Thus, after strong price rises since 2012, particularly in Sydney and Melbourne, and ongoing weak wages growth and soft demand, it appears that prices – rather than rates and incomes – will represent most of the required adjustment to restore equilibrium and attract new participants into the market.
But the decision this month by the RBA to signal that interest rates could fall further, despite the current record low level of 1.5 per cent, was profoundly important and suggested that some relief on interest rates may occur.
Prior to this, the RBA’s view appeared to be that the adjustment in the housing market was necessary, with limited spill over effects to the rest of the economy, and that lowering rates would only disrupt the adjustment at a time when further stimulus elsewhere wasn’t needed.
However, following recent weak data across consumer spending, residential housing construction and new lending, it appears the spill over effects are real and the “adjustment” process more substantial than anticipated. Certainly, the collapse in new lending – down 14.9 per cent in the second half of 2018 -- and sharp falls in house prices would be attracting considerable attention.
As such, it wasn’t surprising to see the RBA recently revise down its growth forecasts for 2019 and 2020 from 3.25 per cent and 3 per cent, to 3 per cent and 2.75 per cent, respectively.
Despite our forecasts being below the RBA’s for some time, the nature of the slowdown, particularly in consumer spending, through the second half of 2018 has been confirmed to be quite dramatic: annualised GDP growth went from 4 per cent in the first half to our estimate of 1.5 per cent in the second half. Moving from a 1.5 per cent pace to a 3 per cent pace in 2019, as forecast by the RBA, seems a very large stretch.
Even our GDP growth forecast in 2019 and 2020 of 2.6 per cent in each year now appears too high and we have reduced our forecasts to 2.2 per cent for each year.
There are a few key considerations to our forecasts.
In particular, while we had been expecting only a modest impact on consumer spending from the likely negative “wealth effect” associated with falling house prices, it is likely households will lift their savings rate in 2019 from 2.4 per cent to 3.5 per cent, and towards 5 per cent in 2020.
Those savings rates imply consumer spending growth around just 2 per cent, below the RBA’s expectations.
Our estimates of the required improvement in affordability point to falls of around 5-10 per cent in Sydney and Melbourne over the course of 2019 complemented by softness in other housing markets.
Further weakness is likely in 2020, absent any policy response from the RBA.
As seen in credit data, demand has weakened from both investors and owner occupiers due to concerns around falling prices and stretched affordability, while supply eased in the wake of prior regulations and caution from some lenders in a falling market. We expect these trends, albeit at a much slower pace, to continue through 2019, representing a negative feedback loop to prices.
The negative wealth effect is therefore likely to persist through 2020 with a further extension of the soft profile for consumer spending, which has been recently made clear during Christmas retail spending.
Other important dynamics will be around the sharp downturn in residential housing construction, which we have revised down in 2019 to negative 10 per cent from negative 7 per cent, and softer business equipment investment amid greater caution.
With this expected growth slowdown, we see the unemployment rate lifting to 5.5 per cent in the second half of 2019 and further by end 2020. It’s worth noting this should not be severe since unit labour costs are contained and labour enjoys a relative cost advantage over capital. However, it will be contrary to the RBA’s expectations and prompt a significant revision to its 4.75 per cent forecast for 2020.
The question then becomes would the RBA act?
We think the August Board meeting is a good estimate. Recognition of these softening trends is likely to take some time, but not too long. Also, a full explanation of the reasons behind the decision can be set out in the August Statement on Monetary Policy, and it allows for two more inflation prints to confirm muted pressures.
A second 25 basis point cut at the November Board meeting is likely to follow.
Unlike in 2016, we do not expect these cuts to immediately stabilise housing markets. However, there will be sufficient progress for the RBA to resume its cautious stance while further adjustments in the economy may be accommodated by a lower Australian dollar.
There are risks to our forecasts.
Housing markets and the savings rate may stabilise more quickly than we anticipate, the labour market may hold up more strongly, wages growth may lift more quickly, China may boost its own growth and we may be overestimating the appetite of the RBA to respond.
There is also mixed evidence around wealth effects in other countries, although the scale of the adjustment in house prices in Sydney and Melbourne is too large to downplay.
Despite RBA, markets and most economists expecting higher rates, since 2016 we’ve consistently held the line that the cash rate would remain on hold for the foreseeable future due to our less upbeat growth and inflation forecasts, and a perception that the RBA was comfortable with adjustments in the housing market.
But the recent change of rhetoric from the Bank on that issue is important and our revised growth, inflation and unemployment forecasts now make a convincing case for lower rates.
This material contains general commentary, and market colour. This material does not constitute investment advice. This information has been prepared without taking account of your objectives, financial situation or needs. We recommend that you seek your own independent legal or financial advice before proceeding with any investment decision. Whilst every effort has been taken to ensure that the assumptions on which the forecasts are based are reasonable, the forecasts may be affected by incorrect assumptions or by known or unknown risks and uncertainties. The ultimate outcomes may differ substantially from these forecasts. Except where contrary to law, Westpac and its related entities intend by this notice to exclude liability for this information.
By Peter King
Acting Chief Executive Officer, Westpac