Tag: RBA

RBA’s Luci Ellis, Assistant Governor (Economic) spoke yesterday “What’s Up (and Down) With Households?“. We examined the conundrum that labour markets are strong, yet the economy is weaker. The disconnect is the household sector – which of course DFA examines closely in our surveys.

One of the most interesting comments relates to household spending slowing, especially on cars and household goods. We regard this as an important indicator. Income of course is under pressure in real terms, costs are rising, and home prices are falling. Households are hunkering down. As the RBA says ” at some point they might conclude that this is not temporary and that low income growth will persist. At that point they would be likely to adjust their spending plans. Consumption growth would then slow“.

This is what she said:

For a little while now, the team at the Bank has been grappling with how one might reconcile apparently weak national accounts figures with the noticeably stronger labour market data.

The disconnect can be traced to the household sector. Many other parts of the national accounts measure of output – gross domestic product (GDP) – are actually doing reasonably well. Outside the mining sector, where some large projects are still winding down, business investment is growing at a solid pace. Transport and renewable energy projects have been quite important. Public demand, both consumption and investment, is supporting growth.

There are also some areas of weakness outside the household sector, such as the drought-affected rural sector, which is weighing on exports at the moment. Droughts and other recent natural disasters clearly pose difficulties for those directly affected. But the underlying trends in the broader economy are not determined by these events. So in the main, outside the household sector, the economy is not doing too badly.

The Labour Market has Unambiguously Improved

This makes sense, because employment has been strong and someone must be hiring all those extra workers. Over the past year, total employment has increased by more than 2 per cent. The unemployment rate declined by ½ percentage point over 2018, reaching the level of 5 per cent before our forecasts implied it would (Graph 1). This is a good outcome. Youth unemployment has declined and most measures of underemployment have also come down a bit.

Some industries are doing better than others, but overall the strength in employment has been across a diverse range of sectors (Graph 2). We can see this either by looking at the industry that people say they work in, or we can use the ABS’s new Labour Account to triangulate this information with what firms say their industry is. Either way, we see jobs being added in a range of industries. Employment in health care and social assistance has been increasing for a while; the rollout of the NDIS is an important driver of this, but not the only one. More recently, we have also seen employment increase in a number of business services industries. Construction employment had also been strong for a while, reaching the highest share of total employment in more than a century of records.

One can be reasonably confident in the steer the labour market data are giving us, because it is coming from multiple, independently collected data sets. The employment and unemployment data come from the ABS’s survey of households. But a survey of businesses, also from the ABS, tells us that the number of job vacancies has been a very high share of the total jobs available. Separate private-sector surveys of businesses tell us that many firms plan to hire more workers. Many of our own liaison contacts also tell us that they are hiring.

And as the labour market gradually tightens, we are beginning to see the effects in wages growth. This has been low for some time, but is gradually trending up now, especially in the private sector (Graph 3). Part of this shift is that fewer workers are subject to wage freezes than was the case a year or so ago. Minimum and award wage rises have also increased. Along with other countries, it’s taking longer and a lower unemployment rate to start seeing faster wages growth than historical experience might have suggested. Indeed, we still think Australia is a little way off the levels of the unemployment rate that would induce materially faster wages growth. But as the experience of other countries has also shown, if the labour market tightens enough, wages growth does eventually pick up.

Household Consumption Spending is Slowing

In contrast to the positive picture implied by the labour market, growth in household income has been slow, and growth in consumption has weakened recently (Graph 4).

If we drill down to see which kinds of spending have slowed the most, we can see that spending on cars and household goods has been particularly affected (Graph 5). Spending on less discretionary items like food has been less affected.

There has been a deal of talk about the possibility that ‘wealth effects’ from declining housing prices might be weighing on spending. It’s important to remember, though, that people’s reaction to a fall in prices is likely to depend partly on how far prices had increased previously.

Some recent work by colleagues at the Bank suggests that the link is a bit more subtle than simply that increases in wealth boost spending directly (May, Nodari and Rees 2019). It isn’t so much that people wake up one morning, realise their home is worth more, and decide to go out shopping. Rather, if their home is worth more, they can borrow more against it, which matters for some people’s decisions to buy a car. And because rising housing prices usually occur in the context of high rates of transactions in the market, spending on home furnishings tends to rise and fall with housing prices. So when housing prices decline, turnover also declines. This means there are fewer people moving house and realising their old couch doesn’t fit or they need new furnishings in the extra bedroom.

Slow Income Growth is a Drag on Household Spending

Beyond this specific link to housing turnover, some slowdown in consumption spending is not entirely unexpected. For several years now, we have been calling out the issue of weak income growth and how it might test the resilience of household consumption spending. This is a particular issue in the context of high household debt and the need to service that debt.

One aspect of economic theory that actually works in practice is the observation that people try to smooth their consumption in the face of fluctuating incomes. Income growth is noticeably more volatile than consumption growth. So the usual pattern is that gaps between the two resolve with shifts in income growth, not shifts in consumption growth.

But there might be limits to how long households can continue expanding their consumption faster than their income is rising. People are still saving, and they can do so at a slower rate. But at some point they might conclude that this is not temporary and that low income growth will persist. At that point they would be likely to adjust their spending plans. Consumption growth would then slow.

So we need to establish how household income growth might indeed return back towards current rates of consumption growth or even higher. To do that, we need to understand why it has been so weak.

Labour Income Growth Has Recovered Somewhat

For some time, part of the story had been that labour income growth was weak. This has been true across several dimensions. First, the growth of wage rates for particular jobs has been slow (Graph 6). This is the measure of wages growth captured by the ABS’s Wage Price Index (WPI). It captures changes in wages paid for a fixed pool of jobs. As I already mentioned, growth in this measure has started increasing, though only gradually. It is still well below what one might expect in the longer run, if inflation is to average between 2 and 3 per cent and if productivity maintains a similar average growth rate to its average over the past decade or so.

People’s actual incomes include bonuses and other non-wage labour income, and average labour income depends on whether the mix of jobs in the economy is changing. For a number of years, these factors combined to make average earnings per hour, as recorded in the national accounts, increase much more slowly than the mix-adjusted WPI measure. It isn’t unusual for growth in this measure of earnings to differ from growth in the WPI. They are compiled on different bases. But in the years following the end of the mining investment boom, this gap was persistently negative, and quite large.

Some of the compositional change might have been because people were moving out of higher-paid jobs in mining-related activity, and had gone back to lower-paying work. It’s hard to pinpoint how important this effect was, because the weakness in average earnings growth was seen in some industry-level data as well. So at least some people would have had to be switching to lower-paid jobs in the same industry. Another factor that might have been at work was that fewer people were actually switching jobs than in the past. Surveys that track people through time, such as the HILDA survey, show that people who change jobs often see faster income growth in the year they switched, than people who didn’t change jobs (Graph 7).

This lower rate of job churn accords with some of the evidence we see in business surveys and the messages coming out of our business liaison program. Many firms report that they find it hard to find suitable labour, at least for some roles, and that this is a constraint on their businesses, though usually not a major one (Graph 8). But when we ask our contacts what they are doing about this problem, paying people more is not the first solution they think of. Even poaching someone from another firm by enticing them with higher pay is not that common. The evidence from our liaison program suggests that it has long been the case that firms first resort to other strategies to deal with labour shortages, and only turn to faster wage increases when the shortages are severe and persistent (Leal 2019).

But whatever the underlying drivers, the gap between the growth rates of the WPI and average earnings has closed more recently. Slow wages growth is still a concern, but in terms of its contribution to income growth, it is less of a puzzle than it was a few years ago. Instead we need to seek the source of the more recent weakness elsewhere.

Non-Labour Income Remains Weak

If we break household disposable income growth into its components, we can see the drivers of the more recent weakness (Graph 9). Labour income is not especially strong, but it no longer seems at odds with growth in employment and other information about wages growth. Rather, growth in other sources of income has been weak for some time, and this has continued more recently.

Within non-labour income, the main components are social assistance, rental income, other investment income, and the earnings of unincorporated businesses. It turns out that a confluence of factors has resulted in growth in most of these categories of income being weak recently. In some cases, this is a trend change that is likely to persist. Some others are driven by shorter-term factors that could reverse in coming years.

Social assistance payments have been relatively flat for a number of years (Graph 10). As the labour market has strengthened and unemployment has come down, it is not surprising that some forms of social assistance have not been growing. But there are a few other things going on at the same time. Firstly, the rate of growth of age pension payments has slowed, though it is still positive. There are a number of probable drivers of this, including the increase in the eligibility age, as well as more people above the (higher) eligibility age remaining in the workforce rather than drawing a pension. It is also possible that, as time goes on and the people who are retiring have had longer to accumulate superannuation balances, more people are receiving a part-pension together with an income stream from their superannuation.

Secondly, in recent years, growth in social welfare spending by the government has come from new programs (like the NDIS) that are counted as government consumption, not household income, in the national accounts. So while both disability payments and other payments to families with children have been broadly constant in dollar terms for several years, government consumption has been growing strongly over the same period. If we adjusted for this, the growth in the social assistance component of household income would look much closer to its average over the past, rather than well below average.

These factors all relate to the design of programs assisting households, and how they are classified in the national accounts. So we would not expect them to reverse all of a sudden. This implies that we should also not expect that measured household income from this source will bounce back strongly any time soon.

Rental income has also been a bit weak (Graph 11). This is not surprising considering that rents have been rising only slowly in most cities, and falling for a few years in Perth. But rental income is only earned by 15 per cent of taxpayers, and lower cash rental income for landlords is also lower rent paid by renters, leaving them with more money to pay for other things.^[1] So the weakness in rental income is unlikely to be a large driver of any slowdown in consumer spending. Income from other kinds of investments has also been a bit weak, but has recovered a bit lately.

Unincorporated business income has also been weak of late. This can be a volatile type of income and sensitive to conditions in particular sectors. The farm sector represents a large share of unincorporated business income, compared with their share of the economy. So one reason this type of income has fallen has been the effect of the drought on farm incomes. A recovery here will depend on how soon normal seasonal conditions return. Much of the rest of unincorporated business income comes from sectors related to the property market, including building tradespeople and real estate agents. They are also seeing lower incomes, as both construction activity and the volume of sales of existing homes decline. Again, it can be envisaged that these sources of income might recover at some point, but not in the very near term.

Tax and Other Payments are Dragging on Disposable Income

When we think about household income available for consumption and saving, economists usually talk about household disposable income. This is income net of taxes, net interest payments and a few other deductions like insurance premiums. Income payable – the things deducted from gross income to calculate disposable income – increased by nearly 6 per cent in 2018. This was significantly faster than growth in gross household income.

Despite the relatively weak picture for household income growth, the tax revenue collected from households has grown solidly in recent years. It’s normal for growth in tax revenue to outpace income growth a bit: that is how a progressive tax system works. A useful rule of thumb is that, in the absence of adjustments to tax brackets to allow for bracket creep, for every one percentage point of growth in household income, taxes paid by households will on average increase by about 1.4 percentage points. That’s an on-average figure, though. The actual ratio can vary quite a bit.

In the past year, taxes paid by households increased by around 8 per cent, more than double the rate of growth in gross household income of 3½ per cent. So the ratio is more like a bit over two-to-one at the moment, rather than 1.4 to one. That is at the high end of the range this ratio reaches, but as this graph shows, it is not unprecedented (Graph 12). But this effect has cumulated over time, so that the share of income that is paid in tax has been rising (Graph 12, bottom panel).

What is noteworthy is that for all of the past six years, growth in tax paid has exceeded income growth by an above-average margin, at a time when income growth itself has been slow (Graph 13).

There are likely to be several things going on here. Aside from the usual bracket creep, some deductions and offsets have declined, boosting the overall tax take. Interest rates on investment property loans are now higher than for owner-occupiers, but overall the interest rate structure on mortgages is lower than it was a few years ago. So landlords will have lower tax deductions for interest payments on loans on investment properties. At the same time, the significant run-up in housing prices in some cities over the past decade will have increased the capital gains tax liability paid by investors selling a property. Turnover in the housing market has declined. But as best we can tell, the price effect has dominated the effect of declining volumes, and total capital gains tax paid has increased.

Compliance efforts and technological progress in tax collection have boosted revenue collected from a given income. The Tax Office reports that its efforts to raise compliance around work-related deductions have boosted revenue noticeably (Jordan 2019). The next wave of this effort, focused on deductions related to rental properties, could result in further boosts to revenue.

Some of these drivers boosting tax paid could persist for a while, but they aren’t permanent. For example, the earlier period of strong housing price growth will only increase capital gains tax revenue if the asset was owned during that period. It can be expected to become less important, the further into history it passes. Similarly, increased compliance increases the level of tax paid on a given level of income. It is not a change in the trend growth rate in tax paid. That said, the effect could last for a while as efforts shift to different aspects of compliance.

Some Recent Policy Changes Might Mitigate the Drag on Consumption

The net of all these effects is that household income growth has remained slow even as labour market conditions have been improving. Unlike slow wages growth, though, it is less clear how much weak non-labour income growth will weigh on consumer spending. As I already noted, slow growth in rental income for landlords means that tenants have more money to spend on other things. Some of the weakness in social assistance payments is because new programs are being delivered differently from existing ones, and so they are classified as government consumption. The net benefit to the recipients could be the same or higher.

So there might be reasons to think that weak non-labour income growth is less worrisome than weak wages growth. But you would not want to rely on that possibility to underpin your views on the outlook for consumption. So this is an area we need to watch closely. Household consumption spending is a large part of economic activity. A significant retrenchment there would lower growth and feed back into a weaker labour market, as well as into decisions to purchase housing.

Parting Thoughts

My talk today has deliberately not overlapped with what the Bank has recently said about the housing market. But I think it’s clear that conditions in the household sector more broadly are highly consequential for the housing sector and thus this audience. Whatever other forces might be affecting housing market developments, fundamentally demand for housing rests on the household sector’s confidence and capacity to take on the financial commitments involved in the purchase or rental of a home. Without enough income, and so without a strong labour market, that confidence and capacity would be in doubt. This is not the only reason we are watching labour market developments closely. But the nexus between labour markets, households and housing are crucial to our assessment of the broader outlook.

Thank you for your time.

The RBA released their minutes today relating top the March 2019 meeting. They called out the market’s view that policy rates would be lower in 2020 (a turn around), lower retail, and slowing housing momentum, despite strong employment.

In considering the stance of monetary policy, members observed that growth in the global economy had been above trend in 2018, although it had slowed over the second half of the year and timely indicators suggested that this moderation had extended into 2019. Nonetheless, output growth had remained sufficient in most advanced economies for labour markets to remain tight, putting upward pressure on wages. Members noted the tension in a number of economies between slower GDP growth and resilient labour markets. The transmission of tighter labour market conditions to inflation pressures was taking longer than might be expected, based on historical experience.

The authorities had responded to slowing growth in China by putting in place policies to increase the flow of credit to the private sector and easing fiscal policy in a targeted way to support growth, while continuing to pay close attention to risks in the financial sector. Slowing growth in China and ongoing trade tensions had led to lower growth in global trade, and continued to be a source of uncertainty for the outlook for global growth.

The tightening of global financial conditions, associated with higher risk premiums required by investors around the turn of the year, had eased. Members assessed that global financial conditions remained accommodative, with financial market pricing indicating that little change to the accommodative stance of monetary policy in the advanced economies was expected over the following year or so. The terms of trade for Australia were expected to have remained above their trough in early 2016 and the Australian dollar had remained within its narrow range of recent times.

Domestically, there continued to be tension between the ongoing improvement in labour market data and the apparent slowing in the momentum of output growth in the second half of 2018. Leading indicators of conditions in the labour market, such as vacancies and hiring intentions, pointed to further tightening in the labour market in the near term. Private sector wages growth had picked up further in the December quarter, consistent with the Bank’s forecasts and survey evidence that a significant share of firms were finding it difficult to attract suitable labour.

Although output growth had slowed in the second half of 2018, the outlook for business investment and spending on public infrastructure had remained positive. Growth in consumption was expected to be supported by an increase in growth in household disposable income. However, there continued to be considerable uncertainty around the outlook for consumption given the environment of declining housing prices in some cities, low growth in household income and high debt levels. Dwelling investment was expected to subtract from growth in output over the forecast period and, unless pre-sales volumes started to increase, this decline could be sharper than currently expected.

The process of adjustment in the housing market had continued. Housing prices in Sydney, Melbourne and Perth had declined further, and turnover in the housing market had fallen significantly. Rent inflation had remained low across most of the country despite declines in rental vacancy rates over the previous year, except in Sydney, where rental vacancy rates had been increasing. Credit conditions had tightened for some borrowers and the demand for housing credit had slowed noticeably as conditions in the housing market had changed. Mortgage rates had remained low and there was strong competition for borrowers of high credit quality.

Members noted that the sustained low level of interest rates over recent years had been supporting economic activity and had allowed for gradual progress to be made in reducing the unemployment rate and returning inflation towards the midpoint of the target. While the labour market had continued to strengthen, less progress had been made on inflation. Looking forward, the central forecast scenario was still for growth in GDP of around 3 per cent over 2019 and a further decline in the unemployment rate to 4¾ per cent over the next couple of years. This further reduction in spare capacity underpinned the forecast of a gradual pick-up in wage pressures and inflation. Given this, members agreed that developments in the labour market were particularly important.

Taking account of the available information on current economic and financial conditions and how they were expected to evolve, members assessed that the current stance of monetary policy was supporting jobs growth and a gradual lift in inflation. However, members noted that significant uncertainties around the forecasts remained, with scenarios where an increase in the cash rate would be appropriate at some point and other scenarios where a decrease in the cash rate would be appropriate. The probabilities around these scenarios were more evenly balanced than they had been over the preceding year.

Members agreed to continue to assess the outlook carefully. Given that further progress in reducing unemployment and lifting inflation was a reasonable expectation, members agreed that there was not a strong case for a near-term adjustment in monetary policy. Rather, they assessed that it would be appropriate to hold the cash rate steady while new information became available that could help resolve the current tensions in the domestic economic data. Members judged that holding the stance of monetary policy unchanged at this meeting would enable the Bank to be a source of stability and confidence, and would be consistent with sustainable growth in the economy and achieving the inflation target over time.

The Decision

The Board decided to leave the cash rate unchanged at 1.5 per cent.

Interesting speech from the RBA Governor today, in which he explains why home prices are falling, and says its all manageable. No mention of too loose credit and too low interest rates. Or the substantial credit tightening of recent times as the credit impulse slows!

Just remember they banked on the household sector to spend big to support the economy after the mining boom faltered, and that housing credit growth was the centre piece. This is a neat piece of misdirection in my view!

The Current State of the Housing Market

Australians watch housing markets intensely, perhaps more so than citizens of any other country. Over the five years to late 2017, they saw nationwide housing prices increase by almost 50 per cent (Graph 1). Since then, prices have fallen by 9 per cent, bringing them back to their level in mid 2016.

Declines of this magnitude are unusual, but they are not unprecedented. In 2008 and 2010, prices fell by a similar amount, as they did on two occasions in the 1980s. In the 1980s, the rate of CPI inflation was higher than it is now, so in inflation-adjusted terms, the declines then were larger than the current one.

These nationwide figures mask considerable variation across the country (Graph 2). The run-up in prices over recent years was most pronounced in Sydney and Melbourne, so it is not surprising that the declines over the past year have also been largest in these two cities. In Perth and Darwin, the housing markets have been weak for some time, affected by the swings in population and income associated with the mining boom. By contrast, the housing market in Hobart has been strong recently. In Adelaide, Brisbane, Canberra and many parts of regional Australia, conditions have been more stable. Given these contrasting experiences, it is pretty clear that there is no such thing as the Australian housing market. What we have is a series of separate, but interconnected, markets.

Another important window into housing markets is provided by rental markets. Over recent times, the nationwide measure of rent inflation has been running at a bit less than 1 per cent, the lowest in three decades (Graph 3). As with housing prices, there is a lot of variation across the country. Rents have been falling for four years in Perth and are now around 20 per cent below their previous peak. By contrast, in Hobart rents have been rising at the fastest rate for some years.

As is well understood, shifts in sentiment play an important role in housing markets. When prices are rising, people are attracted to the market in the hope of capital gains. At some point, though, valuations become so stretched that demand tails off and there is a shift in momentum. When prices are falling, it’s the reverse. The prospect of capital losses leads buyers to stay away or to delay purchasing. At some point, though, the lower prices draw more buyers into the market. First home owners find it easier to buy a home, investors are attracted back into the market, and trade-up buyers take the opportunity to upgrade to the home they have always wanted. These shifts in sentiment and momentum are seen in most housing cycles, but their precise timing is difficult to predict.

Some of these shifts in sentiment are evident in consumer surveys (Graph 4). Over recent times, the number of people reporting that an investment in real estate is the wisest place for their savings has fallen significantly. So, it is not surprising that there are fewer investors in the market. At the same time, the number of people saying it is a good time to buy a home has increased. Lower prices draw more people in and, eventually, this helps stabilise the market. So it is worth closely watching these shifts in sentiment.

Explaining the Recent Cycle

An obvious question to ask is what are the underlying, or structural, drivers of the large run-up in housing prices and the subsequent decline?

There isn’t a single answer to this question. Rather, it is a combination of factors.

Before I discuss these factors, it is worth pointing out that the current adjustment is unusual. Unlike the other four episodes in which housing prices have declined in recent decades, this one was not preceded by rising mortgage rates. Nor has it been associated with a rise in the national unemployment rate. Instead, in New South Wales, where the recent decline in housing prices has been the largest, the unemployment rate has continued to trend down. It is now at levels last seen in the early 1970s. The unemployment rate has also trended lower in Victoria.

So, the origins of the current correction in prices do not lie in interest rates and unemployment. Rather, they largely lie in the inflexibility of the supply side of the housing market in response to large shifts in population growth.

It is useful to start with the national picture (Graph 5). Australia’s population growth picked up noticeably in the mid 2000s and it took the better part of a decade for the rate of home building to respond. It took time to plan, to obtain council approvals, to arrange finance and to build the new homes. Not surprisingly, housing prices went up. Eventually, though, the supply response did take place. Over recent times, the number of dwellings in Australia has been increasing at the fastest rate in more than two decades. Again, not surprisingly, prices have responded to this extra supply.

The population and supply dynamics are most evident in Western Australia and New South Wales (Graph 6).

During the mining investment boom, population growth in Western Australia increased from around 1 per cent to 3½ per cent. This was a big change. The rate of home building was slow to respond. When it did finally respond, it was just at the time that population growth was slowing significantly, as workers moved back east at the end of the boom. This explains much of the cycle.

In New South Wales it is a similar story, although it is not quite as stark. The recent rate of home building in New South Wales is the highest in decades. At the same time, population growth is moderating, partly due to people moving to other cities, attracted by their lower housing prices and rents. By contrast, in cities where population patterns and the rate of home building have been more stable, prices, too, have been more stable.

Another demand-side factor that has influenced prices is the rise and then decline in demand by non-residents.

One, albeit imperfect, way of seeing this is the number of approvals by the Foreign Investment Review Board (Graph 7). In the middle years of this decade, there was a surge in foreign investment in residential property, particularly from China. This was apparent not just in Australian cities, but also in ‘international’ cities in other countries. In Australia, the demand was particularly strong in Sydney and Melbourne, given the global profiles of these two cities and their large foreign student populations. More recently, this source of demand has waned, partly as a result of the increased difficulty of moving money out of China as the authorities manage capital flows.

The timing of these shifts in foreign demand has broadly coincided with – and reinforced – the shifts in domestic demand. However, making a full assessment of their impact on prices is complicated by the fact that international property developers were also adding to supply in Australia at a time of very strong demand. More recently, these developers have scaled back their activity.

Domestic investors have also played a significant role in this cycle. This is especially the case in New South Wales, which was the epicentre of strong investor demand (Graph 8). At the peak of the boom, approvals to investors in New South Wales accounted for half of approvals nationwide, compared with an average of just 30 per cent over the five years to 2010. More than 40 per cent of the new dwellings built in New South Wales recently have been apartments, which tend to be more attractive to investors.

The strong demand from investors had its roots in the population dynamics. Low interest rates and favourable tax treatment added to the attraction of investing in an appreciating asset. The positive side to this was that the strong demand by investors helped underpin the extra construction activity needed to house the growing population. But the rigidities on the supply side, coupled with investors’ desire to benefit from a rising market in a low interest rate environment, amplified the price increases.

As I discussed earlier, there is an internal dynamic to housing price cycles, and this one is no exception. By 2017, the ratio of the median home price to income had reached very high levels in Sydney and Melbourne (Graph 9). Finding the deposit to purchase a home had become beyond the reach of many people, especially first home buyers if they did not have others to help them. At the same time, the combination of high prices and weak growth in rents meant that rental yields were quite low. So, naturally, momentum shifted. Given the big run-up in prices and the large increase in supply, a correction at some point was not surprising, although the precise timing is nearly impossible to predict.

No discussion of housing prices is complete without touching on interest rates and the availability of finance. The low interest rates over the past decade did increase people’s capacity to borrow and made it more attractive to borrow to buy an asset whose price was appreciating. But the increase in housing prices is not just about low interest rates. The variation across the different housing markets indicates that city-specific factors have played an important role.

Recently, much attention has also been paid to the availability of credit. This attention has coincided with a noticeable slowing in housing credit growth, especially to investors (Graph 10).

It is clear there has been a progressive tightening in lending standards over recent years. The RBA’s liaison suggests that, on average, the maximum loan size offered to new borrowers has fallen by around 20 per cent since 2015. This reflects a combination of factors, including more accurate reporting of expenses, larger discounts applied to certain types of income and more comprehensive reporting of other liabilities. Even so, only around 10 per cent of people borrow the maximum they are offered. Sensibly, most people borrow less than what they are offered, so the effect of this reduction in borrowing capacity has not been particularly large.

It has also been apparent through our liaison that some lenders became more cautious last year. There was a heightened concern by some loan officers about the consequences to them and their career prospects of making a loan that might not be repaid if the borrower’s circumstances changed. So, lenders became more risk averse. This, along with greater verification of expenses and income, led to an increase in average loan approval times, although some lenders have invested in people and technology to address this. Our liaison suggests that application approval rates are largely unchanged.

Overall, the evidence is that a tightening in credit supply has contributed to the slowdown in credit growth. The main story, though, is one of reduced demand for credit, rather than reduced supply.

When housing prices are falling, investors are less likely to enter the market and to borrow. So too are owner-occupiers for a while. Consistent with this, the number of loan applicants has declined over the past year. There is also strong competition for borrowers with low credit risk, which is not something you would expect to see if it were mainly a supply story. This competition is evident in the significant discounts on interest rates on new loans compared with those on outstanding loans.

Even though the slowing in credit growth is largely a demand story, we are watching credit availability closely. It is perhaps stating the obvious to say that we want lenders who are both prudent and who are prepared to take risk. As lenders recalibrated their risk controls last year, the balance may have moved too far in some cases. This meant that credit conditions tightened more than was probably required. Now, as lenders continue to seek the right balance, we need to remember that it is important that banks are prepared to take credit risk. And it’s important that they have the capacity to manage that risk well. If they can’t do this, then the economy will suffer.

Impact on the Macroeconomy

This brings me to the issue of how developments in the housing market affect the broader economy.

Movements in housing prices affect the economy through multiple channels. They influence consumer spending, including through the spending that occurs when people move homes. They also influence the amount of building activity that takes place. Changes in housing prices also have an impact on access to finance by small business by affecting the value of collateral for loans. And finally, they can affect the profitability of our financial institutions.

Today, I would like to focus on the effect of housing prices on household consumption. My colleagues at the RBA have examined how changes in measured housing wealth affect household spending.^[1] They estimate that a 10 per cent increase in net housing wealth raises the level of consumption by around ¾ per cent in the short run and by 1½ per cent 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 (Graph 11). Part of the effect on spending on furnishings is likely to come from the fact that periods of rising housing prices are often associated with higher housing turnover, and turnover generates extra spending.

Over recent years, spending by households has risen at a faster rate than household income; in other words, the saving rate has declined (Graph 12). The results that I just spoke about suggest that rising housing wealth played a role here. If so, falling housing prices, and a decline in measured household wealth, could have the opposite effect.

The more important influence, though, is what is happening with household income. For many people, the main source of their wealth is their human capital; that is, their future earning capacity. 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. Expectations of future income growth have been revised down and it is likely that this is affecting spending.

My conclusion here is that wealth effects are influencing consumption decisions, but they are working mainly through expectations of future income growth. Swings in housing prices and turnover in the housing market are also having an effect, but they are not the main issue. This assessment is consistent with the data on housing equity injection (Graph 13). Over recent years, households have been injecting substantial equity into housing and have not been using the higher housing prices to borrow to support their other spending. This is in contrast to the period around the turn of the century, when households were withdrawing equity.

Given this assessment, developments in the labour market are particularly important. A further tightening of the labour market is expected to see a gradual increase in wages growth and faster income growth. This should provide a counterweight to the effect on spending of lower housing prices.

Taking these various considerations into account, the adjustment in our housing market is manageable for the overall economy. It is unlikely to derail our economic expansion. It will also have some positive side-effects by making housing more affordable for many people.

A related issue that the RBA has paid close attention to is the impact of lower housing prices on financial stability.

In 2017, APRA assessed the ability of Australian banks to withstand a severe stress scenario, in which housing prices declined by 35 per cent over three years, GDP declined by 4 per cent and the unemployment rate increased to more than 10 per cent.^[2] The estimated impact on bank profitability was substantial, but importantly, bank capital remained above regulatory minimum levels. This provides reassurance that the adjustment in our housing market is not a financial stability issue. We have not experienced the very loose lending practices that were common in the United States before the housing crash there a decade ago. Nor have we seen significant overbuilding around the country.

Non-performing housing loans in Australia have risen recently, but they remain low at less than 1 per cent (Graph 14). The increase is most evident in Western Australia, where the unemployment rate has risen.

The national experience has been that low levels of unemployment and low interest rates allow most people to service their loans, even if weak income growth means that household finances are sometimes strained. Our estimate is that currently, less than 5 per cent of indebted owner-occupier households have negative equity, and the vast bulk of these households continue to meet their mortgage obligations. One factor that has helped here is that the share of new loans with high loan-to-valuation ratios (LVRs) has declined substantially (Graph 15). The nature of Australian mortgages – in which there is an incentive to make prepayments – has also helped.

Monetary Policy

I would like to conclude with some words about monetary policy and highlight some of the issues we focused on at yesterday’s Reserve Bank Board meeting.

As you are aware, the current setting of monetary policy has been in place for some time. A cash rate of 1.5 per cent is very low historically and it is clearly stimulatory. It is supporting the creation of jobs and progress towards achieving the inflation target.

Looking forward, a key issue is the labour market. Achieving full employment is an important objective in its own right. But, in addition, a strong labour market is the central ingredient in the expected pick-up in inflation. We are expecting that as the labour market tightens, wages growth will increase further. In turn, this should boost household income and spending and provide a counterweight to the fall in housing prices. The pick-up in spending is, in turn, expected to put upward pressure on inflation. Of course, it is possible that inflation could move higher for other reasons, although the likelihood of this at the moment seems low. This means that a lot depends upon the labour market.

The recent data on this front have been encouraging. Employment growth has been strong, the vacancy rate is very high and firms’ hiring intentions remain positive. The latest reading of the wage price index also confirmed a welcome, but gradual, pick-up in wage growth, especially in the private sector.

Other indicators of the economy, though, paint a softer picture. We will receive another reading on GDP growth later this morning, but growth in the second half of 2018 was clearly less than in the first half. This is similar to the picture internationally. In a number of countries, including our own, there is growing tension between strong labour market data and softer GDP data. We are devoting significant resources to understanding this tension.

At its meeting today, the Board decided to leave the cash rate unchanged at 1.50 per cent.

The global economy grew above trend in 2018, although it slowed in the second half of the year. The slower pace of growth has continued into 2019. The outlook for the global economy remains reasonable, although downside risks have increased. The trade tensions remain a source of uncertainty. In China, the authorities have taken further steps to ease financing conditions, partly in response to slower growth in the economy. Globally, headline inflation rates have moved lower following the earlier decline in oil prices, although core inflation has picked up in a number of economies. In most advanced economies, unemployment rates are low and wages growth has picked up.

Overall, global financial conditions remain accommodative. They have eased recently after tightening around the turn of year. Long-term bond yields have declined, consistent with the subdued outlook for inflation and lower expectations for future policy rates in a number of advanced economies. Also, equity markets have risen, supported by growth in corporate earnings. In Australia, short-term bank funding costs have moderated, although they remain a little higher than a few years ago. The Australian dollar has remained within the narrow range of recent times. While the terms of trade have increased over the past couple of years, they are expected to decline over time.

The Australian labour market remains strong. There has been a significant increase in employment and the unemployment rate is at 5 per cent. A further decline in the unemployment rate to 4¾ per cent is expected over the next couple of years. The vacancy rate is high and there are reports of skills shortages in some areas. The stronger labour market has led to some pick-up in wages growth, which is a welcome development. The improvement in the labour market should see some further lift in wages growth over time, although this is still expected to be a gradual process.

Other indicators suggest growth in the Australian economy slowed over the second half of 2018. The central scenario is still for the Australian economy to grow by around 3 per cent this year. The growth outlook is being supported by rising business investment, higher levels of spending on public infrastructure and increased employment. The main domestic uncertainty continues to be the strength of household consumption in the context of weak growth in household income and falling housing prices in some cities. A pick-up in growth in household income is nonetheless expected to support household spending over the next year.

The adjustment in the Sydney and Melbourne housing markets is continuing, after the earlier large run-up in prices. Conditions remain soft in both markets and rent inflation remains low. Credit conditions for some borrowers have tightened a little further over the past year or so. At the same time, the demand for credit by investors in the housing market has slowed noticeably as the dynamics of the housing market have changed. Growth in credit extended to owner-occupiers has eased further. Mortgage rates remain low and there is strong competition for borrowers of high credit quality.

Inflation remains low and stable. Underlying inflation is expected to pick up over the next couple of years, with the pick-up likely to be gradual and to take a little longer than earlier expected. The central scenario is for underlying inflation to be 2 per cent this year and 2¼ per cent in 2020. Headline inflation is expected to decline in the near term because of lower petrol prices.

The low level of interest rates is continuing to support the Australian economy. Further progress in reducing unemployment and having inflation return to target is expected, although this progress is likely to be gradual. Taking account of the available information, the Board judged that holding the stance of monetary policy unchanged at this meeting would be consistent with sustainable growth in the economy and achieving the inflation target over time.