Tag: RBA

Credit Suisse says the RBA will need to cut multiple times

From Business Insider.

The Reserve Bank of Australia will need to cut interest rates multiple times as the labour data understates the slack in the economy, according to Credit Suisse.

While jobs growth in April surpassed expectations and the unemployment rate fell to a four month low, full-time jobs fell and the weakness in the detail would have been bigger if not for another month of bias from the sample rotation, Credit Suisse analysts, led by Damien Boey, said in a note to investors.

The Credit Suisse call for cuts is in contrast to the collective market wisdom, which expects the RBA to stay pat at a record low cash rate of 1.5% for the rest of the year.

“The output gap is at levels historically consistent with another cash rate cut,” Credit Suisse said. “We believe there is a case for multiple cuts, because our measure of the output gap is based on upwardly-biased labour market data, and probably understates the degree of slack in the economy.”

That said, Credit Suisse felt the positive headline data means the RBA is yet to get a trigger to change its policy stance.

This chart from Credit Suisse shows the sample bias

Data on Thursday shows Australia added 37,400 jobs, smashing expectations for an increase of 5,000.

However, full-time employment fell by 11,600 over the month, while part-time employment surged by 49,000.

Credit Suisse explains the quality of the data thus:

Employment quality was even more questionable considering statistical distortions. For yet another month, the ABS rotated its sample in favour of cohorts with higher full-time employment to population ratios. There is a notable net upward bias to the full-time employment data since late 2016. In our view, this means that if we were to remove upward statistical biases, the decline in full-time employment in April would have been even greater than officially reported.

Employment leading indicators, based on business and consumer confidence, as well as trend growth in loan approvals point to a near-term bottoming out in the labour market, Credit Suisse said.

However, the official data, thanks to the statistical problem, has stolen the march and shows the jobs market has already bottomed out and when the sample bias reverses, it could start throwing out some ugly numbers.

Credit Suisse is not alone in blaming the data. Commonwealth Bank of Australia economists said the jobs report left them scratching their heads: “Once again the ABS has published an employment report that has left us scratching our heads. Employment is reported to have lifted by a very strong 37,400 in April after increasing by a massive 60,000 in March. To put these numbers in perspective, it’s the equivalent of a 1.2 million increase in US non farm payrolls over two months! To further add to our concerns over the data, total hours worked is reported to have fallen by 0.3% in April and is down by 0.1% over the past two months despite employment having risen by 97,400”.

This chart shows Credit Suisse’s cash rate model

“our cash rate model currently points to one further cut,” Credit Suisse analysts said.

“However, because of our belief that full-time employment gains have been significantly overstated, we think that our output gap proxy understates the amount of slack in the economy. We remain of the view that the RBA needs to cut rates multiple times this year.”

Latest RBA Minutes Warn On Household Balance Sheets

The RBA minutes really tell us little more about the economy, but the did talk about household balance sheets.

“Growth in housing credit had continued to outpace growth in household incomes, which suggested that the risks associated with household balance sheets had been rising” .

See my highlights below.

Domestic Economic Conditions

Members commenced their discussion of domestic economic conditions by noting that inflation outcomes for the March quarter had been in line with forecasts presented in the February Statement on Monetary Policy. As such, the March quarter inflation data had generally increased confidence in the forecast that underlying inflation would pick up to around 2 per cent by early 2018. Both headline and underlying measures of inflation had been ½ per cent in the March quarter. In year-ended terms, headline inflation had been a little above 2 per cent and underlying inflation had increased to around 1¾ per cent. Higher petrol prices and the increase in tobacco excise had both made sizeable contributions to headline inflation; increases in tobacco excise were expected to continue adding to headline inflation over the forecast period. Members noted that the ABS would issue revised expenditure weights for the Consumer Price Index (CPI) in the December quarter 2017 CPI release, which would reflect changes in consumption behaviour over the preceding six years in response to factors including large changes in relative prices.

Prices of tradable items (excluding volatile items) had been little changed in the March quarter but fell over the prior year. Strong competitive pressures in the retail sector had helped keep retail inflation low and there were signs that these pressures were affecting a broader range of consumer goods, such as furniture and household appliances. The appreciation of the exchange rate over the prior year is likely to have weighed on consumer prices.

Non-tradables inflation (excluding tobacco) had stabilised over preceding quarters. There had been signs of stronger price pressures in a few components, including an increase in new dwelling construction costs, which largely reflected a rise in the cost of materials. Utilities prices had also increased strongly in some cities in the March quarter, reflecting the pass-through to consumers of higher wholesale costs for gas and electricity. Members noted that utilities prices in other cities were likely to increase in the next few quarters and that there could be second-round effects on the CPI through upward pressure on business costs.

Working in the other direction, low wage growth and strong competition in the retail sector had contributed to domestic cost pressures remaining subdued. Rent inflation had remained persistently low and was around its lowest level in over 20 years, partly because rents had fallen significantly in Perth. Inflation in a range of administered prices, such as those for education, child care and pharmaceuticals, had been lower than usual, largely reflecting changes in government policy and the benchmarking of some administered prices to the CPI.

GDP growth over 2016 had been around 2½ per cent. Data that had become available over April suggested that the domestic economy had continued to expand at a moderate pace in the March quarter. Members noted that growth in domestic output was still expected to pick up to be a little above 3 per cent by the first half of 2018, as the drag from declining mining investment waned and as resource exports continued to pick up.

The impact of Cyclone Debbie had been most apparent in the spot price of coking coal, which had increased sharply after damage to key infrastructure affected coking coal exports from the Bowen Basin. Coking coal export volumes were expected to be significantly lower in the June quarter before returning to their previous levels over the remainder of 2017 as the damaged infrastructure is restored. Iron ore and liquefied natural gas exports were expected to make significant contributions to growth over the forecast period. Iron ore prices had fallen over the prior month, as had been expected for some time, and oil prices had been lower.

Although Australia’s terms of trade were expected to be higher in the near term than had been forecast at the time of the February Statement, much of the increase in the terms of trade since mid 2016 was expected to unwind over the next few years. As such, the recent rise in the terms of trade was not expected to result in materially more mining investment. However, members noted that the recent boost to mining profits could have other spillover effects, such as higher dividend payments, wage outcomes or government revenues, which represented an upside risk to the forecasts.

Recent data on retail sales growth and households’ perceptions of their personal finances suggested that consumption growth had moderated somewhat in early 2017. Further out, consumption was still forecast to expand at a bit above its average rate of recent years, consistent with the forecasts made at the time of the February Statement. Members noted that if the upside risks to household income growth from the higher terms of trade were realised, consumption growth could be stronger. On the other hand, if households were becoming more focused on paying down debt, this would imply some downside risks to the outlook for household consumption growth. A fall in housing prices could also weigh on consumption growth.

The large amount of residential construction still in progress was expected to support dwelling investment in the near term. Building approvals had been lower over prior months, particularly for higher-density dwellings, suggesting that this pipeline of construction work would continue to be worked off in coming quarters. Members noted that changes in the rate of home-building lag changes in population growth and that this had affected housing prices in some markets in the preceding few years. Growth in housing prices had remained brisk in Sydney and Melbourne, where population growth had been relatively strong, but had been weak in Perth, where population growth had fallen significantly following the end of the mining investment boom. At the same time, there had been some indications that the large increase in supply in the inner-city Melbourne and Brisbane apartment markets had weighed on prices, particularly in the case of Brisbane.

Members noted that surveys of business conditions had continued to improve and that some survey measures of investment intentions had picked up. However, other measures of investment intentions, including those recorded in the ABS capital expenditure survey, suggested that it could be some time before a stronger and more broadly based pick-up in non-mining business investment growth occurs. Other recent indicators of non-mining business investment, including non-residential building approvals and the pipeline of non-residential construction work, were still quite soft. The pipeline of outstanding public infrastructure work, however, had increased further.

Members observed that the unemployment rate had edged slightly higher in recent months to 5.9 per cent, but was expected to decline gradually over the forecast period. Members noted that this suggested spare capacity would remain in the labour market, although there was significant uncertainty about how to measure the degree of spare capacity, particularly given the higher levels of underemployment in recent years. An increase in labour demand could, in the first instance, be met partly by increasing hours worked by part-time employees, which would reduce measures of underemployment but represent an upside risk to the unemployment rate forecasts. The participation rate was slightly higher than had been forecast three months earlier and was assumed to remain around current levels throughout the forecast period.

Employment growth over the March quarter had increased and full-time employment had continued to rise. Members noted that this was in contrast to 2016, when all of the growth had been in part-time employment. Forward-looking indicators of labour demand, including data on vacancies and surveyed employment intentions, indicated that employment growth would pick up a little. Wage growth was expected to increase gradually as labour market conditions improved and the adjustment to the lower mining investment and terms of trade drew to an end.

Members had an in-depth discussion about changes in the composition of employment in recent decades. They discussed the implications of the secular upward trend in the share of part-time employment for labour market spare capacity. The share of part-time employment in Australia, which had increased from around 10 per cent in the early 1970s to over one-third at present, was relatively high by international standards, especially for younger workers; one driver is that students in Australia are more likely to combine their studies with part-time jobs. Data from the Household, Income and Labour Dynamics in Australia Survey suggested that the majority of part-time workers worked part-time as a matter of choice given their personal circumstances, which vary across their lifecycle. People aged between 15 and 24 years are more likely to work part-time at the same time as studying, while a significant share of women between the ages of 25 and 44 years cite child-caring responsibilities as their main reason for working part-time. Furthermore, some older workers indicate a preference for working part-time, possibly as part of their transition to retirement. The survey also indicated that some part-time workers cite a lack of full-time opportunities or that their work requires part-time hours as the main reason for working part-time.

Members observed that growth in part-time employment had become more cyclical over time because businesses had been more able to respond to changes in demand by adjusting the hours worked by employees rather than the number of employees. This increase in labour market flexibility had been enabled by a range of factors including labour market deregulation, technological change and the shift towards a more service-based economy. As a result, the distinction between full-time and part-time work had become less important in assessing labour market conditions. In addition, understanding the degree of spare capacity in the economy required an assessment of the additional hours part-time workers were willing and able to contribute as well as the number of unemployed people.

International Economic Conditions

Members noted that GDP growth in Australia’s major trading partners had picked up since mid 2016 and most forecasters had revised up their outlook for global growth. Recent data had generally confirmed this improved outlook. The stronger activity had been evident in a pick-up in various indicators, including industrial production and measures of business and consumer sentiment, as well as in a broad-based rise in global trade. For some countries, including the United States, Japan and Korea, this had been reflected in an increase in the growth of business investment.

Economic growth in China had retained momentum in early 2017. Property construction and government spending on infrastructure had been among the important drivers of growth and had supported Chinese demand for Australian iron ore and coal as inputs into steel production. The share of investment in nominal GDP had fallen in recent years, while the share of consumption had been rising. Members observed that as economies matured, the share of services in consumption generally increased, which was consistent with the rising share of services in Chinese economic output. Risks around rapid housing price growth had remained a source of concern for the authorities and some ratcheting up of tightening measures had been needed to contain housing price inflation and speculative activity. Members noted that the outlook for the Chinese economy, particularly the residential property market, was an ongoing source of uncertainty for Australian exports and the terms of trade. Another source of uncertainty was how the Chinese authorities might balance achieving their growth targets with the risks associated with high and rising leverage in the Chinese economy.

In the United States, consumption growth had slowed in the March quarter, although this was likely to have been temporary. At the same time, there had been an increase in business investment growth, some of which was related to the energy sector. Survey measures had suggested that the prospects for further growth in business investment were favourable. The unemployment rate had fallen to a level consistent with full employment, while GDP growth was still expected to be above potential over the next couple of years.

Members noted that growth in the euro area was expected to continue at around its recent pace in early 2017. Business credit had increased since late 2016, having declined for a number of years, and the unemployment rate had fallen to its lowest level in nearly eight years. Members noted that the unemployment rate was particularly low in Germany, but had been persistently high in some other countries in the euro area, including France. The Japanese labour market had tightened further and economic growth had exceeded estimates of potential growth in Japan over recent years. Wage growth in Japan had increased a little, but core inflation had remained close to zero and inflation expectations were low.

Core inflation in the major advanced economies had generally remained low. Headline inflation had risen in recent quarters, but was likely to fall back because the effect of the earlier increase in oil prices had started to dissipate. Core inflation was expected to rise gradually in the major advanced economies as spare capacity in labour markets declined further.

Financial Markets

Members noted that financial markets had been relatively stable over recent months and global financial conditions generally remained very favourable. Heightened geopolitical tensions and various political developments had had little effect on financial markets.

Members noted that the widening of the yield spread between French government bonds and German Bunds ahead of the French presidential election had partly unwound following the result of the first round of voting. Members observed that long-term sovereign bond yields in the major markets had remained higher than in the preceding year, but were still low in a historical context.

The Bank of Japan left monetary policy unchanged at its April meeting, but stated that more quantitative easing would be undertaken if needed to reach the inflation target. The European Central Bank also left policy unchanged at its April meeting. Market participants did not expect the US Federal Open Market Committee (FOMC) to change monetary policy at its May meeting. Market expectations were for three increases in the federal funds rate by the end of 2018, compared with five increases implied by the median projections of FOMC members.

Chinese financial market conditions had tightened following the announcement of regulatory measures aimed at reducing leverage in financial markets. Short-term money market rates had risen and corporate bond financing had declined since the end of 2016.

Share prices in major markets had risen over the prior month and equity market valuations remained at high levels. Corporate bond yields generally remained very low, with spreads to government bonds having narrowed over the prior year. Corporate bond yields had mostly moved in line with sovereign bond yields over the prior month, except in China, where yields had increased following announcements by the authorities aimed at addressing high and rising leverage.

Members noted that the cost of borrowing US dollars in short-term foreign exchange swap and bank funding markets had declined from the high levels of 2016, reflecting both demand and supply factors.

There had been relatively little change in major exchange rates over the prior month. The Australian dollar had been little changed against the US dollar and on a trade-weighted basis over the prior month, but had depreciated slightly over the previous few months, which was consistent with the decline in commodity prices.

Australian government and corporate bond yields had generally moved in line with global bond markets over preceding months. Corporate bond issuance had remained relatively subdued, with resource-related corporations using their higher cash flows to reduce debt.

Australian share prices had increased a little over the prior month, with the exception of resource stocks, which had fallen in response to lower iron ore prices.

Members observed that housing credit growth had steadied in early 2017. Growth in investor housing credit had been rising for a time, but had stabilised in preceding months, consistent with the decline in loan approvals to investors. Household credit overall had grown at an annualised rate of 6 per cent over the six months to March. Variable housing interest rates had increased since late 2016, particularly for investors and interest-only lending. As a result, the average estimated interest rate on major banks’ outstanding housing lending had increased slightly, while the average cost of funding was estimated to have been little changed.

Financial market pricing indicated that market participants expected the cash rate to remain unchanged at the May meeting and over the remainder of the year.

Considerations for Monetary Policy

In considering the stance of monetary policy, members noted that the outlook for the global economy remained positive. The broad-based nature of the data supporting this outlook provided some confidence that the expansion could become self-reinforcing. At the same time, the improved conditions and ongoing accommodative stance of monetary policy globally had not, to date, led to a sustained increase in inflation. Members noted that various policy, financial and geopolitical risks to the ongoing expansion in the global economy were still present. The improvement in global economic conditions had helped to support commodity prices, although recent commodity price movements had also been affected by commodity-specific supply factors, such as disruptions to Australian coking coal exports following Cyclone Debbie.

Domestically, inflation outcomes had been as expected in the March quarter. The central forecast for headline inflation was that it would be above 2 per cent over the forecast period; underlying inflation was expected to increase gradually from its current rate of 1¾ per cent. Subdued growth in labour costs and strong competition in the retail sector had continued to have a dampening effect on aggregate inflation. Working in the other direction, rises in utilities prices and the cost of new dwelling construction had increased inflationary pressures.

Members noted that, although it seemed unlikely that wage growth would slow much further, wage pressures were expected to rise only gradually as the effects of structural adjustment following the mining investment and terms of trade boom, which had weighed on aggregate wage growth, continued to wane. Data on the labour market had been somewhat mixed, but forward-looking indicators continued to suggest that employment growth would maintain its recent pace and spare capacity in the labour market would decline gradually.

Recent data suggested that the Australian economy had grown at a moderate pace at the beginning of 2017. The outlook was little changed from three months earlier and continued to be supported by the increase in the terms of trade and the low level of interest rates, although lenders had announced increases in mortgage rates, particularly those paid by investors and on interest-only loans. The pick-up in non-mining business investment had been modest and forward-looking indicators of investment remained mixed. The drag from the fall in mining investment (and the spillover effects of this on non-mining investment and activity) had continued to ease. Recent data had provided further signs that the downswings in the Western Australian and Queensland economies were coming to an end. The depreciation of the exchange rate since 2013 had assisted the economy through this transition; an appreciation of the exchange rate would complicate this adjustment process.

Conditions in the housing market continued to vary considerably across the country. Conditions in established housing markets in Sydney and Melbourne remained robust, but housing prices had been falling in Perth. The additional supply of apartments scheduled to be completed over the next couple of years in the eastern capital cities was expected to put some downward pressure on growth in apartment prices and on rents, particularly in Brisbane.

Growth in housing credit had continued to outpace growth in household incomes, which suggested that the risks associated with household balance sheets had been rising. Recently announced supervisory measures were designed to help mitigate these risks by reinforcing prudent lending standards and ensuring that loan serviceability was appropriate for current financial and housing market conditions. However, it would take some time to assess the full effects of recent increases in mortgage rates and the additional supervisory focus.

The Board continued to judge that developments in the labour and housing markets warranted careful monitoring. Taking into account all the available information and the updated forecasts, the Board’s assessment was that maintaining the current accommodative stance of monetary policy would be consistent with achieving sustainable growth and the inflation target over time.

The Decision

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

Housing Finances Under The Microscope

The latest RBA Quarterly Statement on Monetary Policy says low wages growth will cramp growth, and also includes information on household finances and mortgage lending.  They say that interest only investors have seen an average rise of 35 basis points since Nov 2016, and a principal and interest investor of 28 basis points. Personal loan rates have also risen by 25 basis points since April 2016 (despite cash rate cuts). Major banks have a lower share of the home loan market as more business to the non-banks and other lenders.

Housing credit growth was stable in recent months at an annualised rate of around 6½ per cent. Growth in credit extended to investors has steadied at an annualised pace of around 8 per cent, after accelerating through the second half of 2016. This stabilisation in investor credit growth is consistent with the slight reduction in investor loan approvals and may have been partly driven by the increases in interest rates for investors in late 2016 along with further tightening in lending standards by lenders around that time.

The decline in loan approvals in recent months has been driven by a decline in approvals in Victoria, while loan approvals in New South Wales have remained near record highs (Graph 4.11).

Housing finance for new dwellings has been little changed recently following rapid growth through 2016; housing finance for the construction of new homes has remained stable (Graph 4.12). Overall, loans for new dwellings or dwellings under construction are estimated to have contributed more than half of credit growth over the past year. This contribution is expected to rise, based on the pipeline of residential construction work under way.

The major banks’ share of housing loan approvals has fallen in recent months to its lowest level since 2008. Most of this reduction appears to have been absorbed by other Australian and foreign banks (Graph 4.13). Housing credit issued by entities that are not licensed by APRA as authorised deposit-taking institutions (ADIs) is estimated to have increased slightly in recent quarters, but at around 3 per cent remains a very small share of housing credit.

The further increases in housing interest rates announced by some lenders in March and April and prudential guidance from APRA and ASIC regarding interest-only lending can be expected to affect housing credit growth over the months ahead.

As outlined in the April Financial Stability Review, the Council of Financial Regulators (CFR) has been monitoring and evaluating the risks to household balance sheets. APRA announced further measures in March 2017 to reinforce sound housing lending practices. ADIs will be expected to limit new interest-only lending to 30 per cent of total new residential mortgage lending and, within that, to tightly manage new interest‑only loans extended at loan-to-value ratios above 80 per cent. APRA also reinforced the importance of banks: managing their lending so as to comfortably meet the existing investor credit growth benchmark of 10 per cent; using appropriate loan serviceability assessments, including the size of net income buffers; and continuing to exercise restraint on lending growth in higher risk segments. APRA also announced that it would monitor the growth in warehouse facilities provided by ADIs. These facilities are used by non-bank mortgage originators for short-term funding of loans until they are securitised.

In addition, the Australian Securities and Investments Commission (ASIC) announced in April further steps to ensure that interest‑only loans are appropriate for borrowers’ circumstances and that remediation can be provided to borrowers who suffer financial distress as a consequence of shortcomings in past lending practices.

Since February, the major banks have announced an average cumulative increase to their standard variable rates of around 25 basis points for investors and a few basis points for owner‑occupiers. Also, borrowers will pay an additional premium for interest-only loans of around 15 basis points for investors and 20 basis points for owner-occupiers (Graph 4.14).

The rates actually paid on new variable rate loans are likely to differ from the major banks’ standard variable rates. The major banks and other lenders offer discounts to their standard variable rates, which can vary through time particularly for new borrowers; for example, in 2015, increases in interest rates on existing borrowers were reportedly accompanied by larger unadvertised discounts for new borrowers.

Overall, the increases that have been announced to date by lenders are expected to raise the average variable rate paid on outstanding housing loans by around 15 basis points. The average outstanding rate on all housing loans is expected to increase by slightly less than the variable rate since interest rates on new fixed-rate loans remain below those on outstanding fixed-rate loans.

As has been the case for some time, there is considerable uncertainty around the timing and extent to which domestic cost pressures will rise over the next few years. As wages are the largest component of business costs, the outlook for wage growth is particularly important for the inflation outlook. The recovery in wage growth could be stronger than anticipated if conditions in the labour market tighten by more than assumed, or if employees demand wage increases to compensate for the sustained period of low real wage growth. However, it could be the case that some of the factors currently weighing on wage growth, such as underemployment in the labour market or structural forces such as technological change, are more persistent or pervasive than assumed.

The path of inflation will also depend on whether the heightened competitive pressures in the retail sector continue to constrain inflation. On the other hand, the earlier increases in global commodity prices and increases in domestic utilities prices could flow through to domestic inflation (through higher business costs) by more than assumed.

Another factor affecting the outlook for CPI inflation is that the weight assigned to each expenditure class in the CPI will be updated in the December quarter 2017 CPI release. Measured CPI inflation is known to be upwardly biased because the weight assigned to each expenditure class is fixed for a number of years.

This means that the CPI does not take into account changes in consumer behaviour in response to relative price changes (known as ‘substitution bias’). As a result, the forthcoming re-weighting is expected to reduce measured inflation, although it is hard to predict by how much because the effects of past re-weightings have varied significantly and are not necessarily a good guide to future episodes. The ABS plans to re-weight the CPI annually in future, which will reduce substitution bias on an ongoing basis.

The crash the RBA fears: it’s not housing and banks, it’s you

From The New Daily.

In a landmark speech, Reserve Bank of Australia governor Philip Lowe has outlined his nightmare scenario of a property market crash, as well as his favourite solution to the affordability crisis.

The RBA is not overly concerned that a “severe correction in property prices” would trigger a banking collapse, as happened in the US in 2008-09, Dr Lowe said on Thursday.

No, he said he was far more worried that Australians would bring the economy to a grinding halt by curbing their spending.

“The Australian banks are resilient and they are soundly capitalised. A significant correction in the property market would, no doubt, affect their profitability. But the stress tests that have been done under APRA’s eye confirm that the banks are resilient to large movements in the price of residential property,” Dr Lowe told the Economic Society of Australia.

house prices household debt“Instead, the issue we have focused on is the possibility of future sharp cuts in household spending because of stretched balance sheets.”

Household debt is “high” relative to incomes, making it likely that many Australians would respond to a market correction with a “sharp correction in their spending”, in an attempt to pay down debt.

“An otherwise manageable downturn could be turned into something more serious.”

The golden solution

Dr Lowe’s speech contained a comprehensive answer to what has caused house prices to skyrocket, at least in Sydney and Melbourne, and what should be done to fix it.

The answer was unlikely to be comforting for either the Liberals or Labor, as it touched on both supply and demand-side fixes.

He dismissed allowing young Australians to use their superannuation for a deposit. “You don’t address affordability by adding to demand.”

But he also downplayed the importance of tax policies. “The best housing policy is really a transport policy,” he said during a question-and-answer session at the end.

In the speech itself, the Governor blamed the house price explosion on an encyclopaedic list of factors, including an increased ability to borrow via financial liberalisation and lower interest rates; supply constrained by zoning issues, geography and, crucially, inadequate roads and trains to link outer suburbs to the inner city.

He also pointed to Australians’ preference for big houses in the big cities; slow income growth; stronger-than-expected population growth; and the rise of investors.

While much has been made of the crackdown of APRA and ASIC on bank lending to investors — indeed, constraining investor demand is the centrepiece of Labor’s solution — Dr Lowe placed far more emphasis on supply issues.

“This borrowing [by investors] is not the underlying cause of the higher housing prices. But the borrowing has added to the upward pressure on prices caused by the underlying supply-demand dynamics. It has acted as a financial amplifier in some cities, adding to the already upward pressure on prices.”

The Governor noted in passing that tax policies (presumably negative gearing and the 50 per cent capital gains tax discount) would “have an effect”, but he was more optimistic about faster rates of home-building, better transport infrastructure, and an eventual rise in the RBA’s cash rate.

“Increased supply and better transport could be expected to help address the ongoing rises in housing prices relative to incomes. These changes and some normalisation of interest rates over time might also reduce the incentive to borrow to invest in an asset whose price is rising strongly.”

Household Debt, Housing Prices and Resilience

RBA Governor Philip Lowe spoke at the Economic Society of Australia (QLD) Business Lunch. Of note is the data which shows one third of households with a mortgage have little or no interest rate buffer, and that the Reserve Bank does not have a target for the debt-to-income ratio or the ratio of nationwide housing prices to income.

This afternoon I would like to talk about household debt and housing prices.

This is a familiar topic and one that has attracted a lot of attention over recent times. It is understandable why this is so. The cost of housing and how we finance it matters to us all. We all need somewhere to live and for many people, their home is their largest single asset. Real estate is also the major form of collateral for bank lending. The levels of debt and housing prices also affect the resilience of our economy to future shocks. Beyond these economic effects, high levels of debt and housing prices have broader effects on the communities in which we live. The high cost of housing is a real issue for many Australians and can have serious side-effects. High levels of debt and high housing costs can also reinforce the existing distribution of wealth in our society, making social and geographic mobility more difficult. So it is understandable why Australians are so interested in these issues.

At the Reserve Bank, we too have been focused on these issues in the context of our monetary policy and financial stability responsibilities. Our work has been in three broad areas. First, understanding the aggregate trends and their causes. Second, understanding how debt is distributed across the community. And third, understanding how the level of debt and housing prices affect the way the economy operates and its resilience to future shocks.

This afternoon, I would like to make some observations in each of these three areas.

This first chart provides a good summary of the aggregate picture (Graph 1). It shows the ratios of nationwide housing prices and household debt to household income. Housing prices and debt both rose a lot from the mid 1990s to the early 2000s. The ratios then moved sideways for the better part of a decade – in some years they were up and in others they were down. Then, in the past few years, these ratios have been rising again. Both are now at record highs.

Graph 1
Graph 1: Housing Prices and Household Debt

 

Although the debt-to-income ratio has increased over recent times, the ratio of debt to the value of the housing stock has not risen. This reflects the large increase in housing prices and the growth in the number of homes. Over recent times, there has also been a substantial increase in the value of households’ financial assets, with the result that the ratio of household wealth to income is at a record high (Graph 2). So both the value of our assets and the value of our liabilities have increased relative to our incomes.

Graph 2
Graph 2: Household Assets and Liabilities

 

Turning now to why the ratios of housing prices and debt to income have risen over time. A central factor is that financial liberalisation and the lower nominal interest rates that came with the lower inflation of the 1990s increased people’s ability to borrow. These developments meant that Australians could take out larger and more flexible loans. By and large, we took advantage of this new ability, as we sought to buy the housing we desired.

We could, of course, have used the benefit of lower nominal interest rates in the 1990s and the increased ability to borrow for other purposes. But instead we chose to borrow more for housing and this pushed up the average price of housing given the constraints on the supply side. The supply of well-located housing and land in our cities has been constrained by a combination of zoning issues, geography and inadequate transport. Another related factor was that our population was growing at a reasonable pace. Adding to the picture, Australians consume more land per dwelling than is possible in many other countries, although this is changing, and many of us have chosen to live in a few large coastal cities. Increased ability to borrow, more demand and constrained supply meant higher prices.

So we saw marked increases in the ratios of housing prices and debt to household incomes up until the early 2000s. At the time, there was much discussion as to whether these higher ratios were sustainable. As things turned out, the higher ratios have been sustained for quite a while. This largely reflects the choices we have made as a society regarding where and how we live (and how much at least some of us are prepared to spend to do so), urban planning and transport, and the nature of our financial system. It is these choices that have underpinned the high level of housing prices. So the changes that we have seen in these ratios are largely structural.

Recently, the ratios of housing prices and debt to household income have been increasing again. Lower interest rates both in real and nominal terms – this time, largely reflecting global developments – have again played some role. But there have also been other important factors at work over recent times.

One of these is the slow growth in household income. During the 2000s, aggregate household income increased at an average rate of over 7 per cent (Graph 3). In contrast, over the past four years growth has averaged less than half of this, at about 3 per cent. Slower growth in incomes will push up the debt-to-income ratio unless growth in debt also slows. This partly explains what has happened over recent years.

Graph 3
Graph 3: Nominal Household Disposable Income

 

A second factor is that some of our cities have become major global cities. Reflecting this, in some markets there has been strong demand by overseas investors.

A third factor has been stronger population growth. Population growth picked up during the mining investment boom and, although it subsequently slowed, it is still around ½ percentage point faster than it was before the boom (Graph 4). For some time the rate of home-building did not respond to the faster population growth; indeed, the response took the better part of a decade. The rate of home-building has now responded and we are currently adding to the housing stock at a rate not seen for more than two decades. Over time, this will make a difference.

Graph 4
Graph 4: Dwelling and Population Growth

 

It is Melbourne and Sydney where population growth has been the fastest over recent times. Not surprisingly, it is these two cities where the price gains have been largest, and these price gains have helped induce more supply. Indeed, Victoria and New South Wales account for all of the recent upward movement in the national housing price-to-income ratio (Graph 5). In the other states, the ratio of housing prices to income is below previous peaks. So there is not a single story across the country. This is despite us having a common monetary policy for the country as a whole. Factors other than the level of interest rates are clearly at work.

Graph 5
Graph 5: Housing Price-to-income Ratios

 

In summary then, the supply-demand dynamics have been pushing aggregate housing prices in our largest cities higher relative to our incomes. With interest rates as low as they have been, and prices rising, many people have found it attractive to borrow money to invest in an asset whose price is increasing. The result has been strong growth in borrowing by investors, with investors accounting for 30 to 40 per cent of new loans.

This borrowing is not the underlying cause of the higher housing prices. But the borrowing has added to the upward pressure on prices caused by the underlying supply-demand dynamics. It has acted as a financial amplifier in some cities, adding to the already upward pressure on prices. The borrowing by investors is also obviously contributing to the rise in the aggregate debt-to-income ratio. Just like in the early 2000s, there is again a discussion as to whether these increases will continue and whether they are sustainable.

The Distribution of Debt

I would now like to turn to the distribution of housing debt across households. This is important, as it is not the ‘average’ household that gets into trouble. At the Reserve Bank we have devoted considerable resources to understanding this distribution. One important source of household-level information is the survey of Household Income and Labour Dynamics in Australia (HILDA).

If we look across the income distribution, it is clear that the rise in the debt-to-income ratio has been most pronounced for higher-income households (Graph 6). This is different from what occurred in the United States in the run-up to the subprime crisis, when many lower-income households borrowed a lot of money.

Graph 6
Graph 6: Household Debt-to-income Ratios - Income quitile, median

 

It is also possible to look at how the debt-to-income ratio has changed across the age distribution. This ratio has risen for households of all ages, except the very youngest, who tend to have low levels of debt (Graph 7). Borrowers of all ages have taken out larger mortgages relative to their incomes and they are taking longer to pay them off. Older households are also more likely than before to have an investment property with a mortgage and it has become more common to have a mortgage at the time of retirement.

Graph 7
Graph 7: Household Debt-to-income Ratios - Age of household head, median

 

We also look at the share of households with a debt-to-income ratio above specific thresholds. In 2002, around 12 per cent of households had debt that was over three times their income (Graph 8). By 2014, this figure had increased to 20 per cent of households. There has also been an increase, although not as pronounced, in the share of households with even higher debt-to-income ratios.

Graph 8
Graph 8: Household Debt-to-income Ratios - share of households

 

Another dataset that provides insight into distributional issues is one maintained by the Reserve Bank on loans that have been securitised. This indicates that around two-thirds of housing borrowers are at least one month ahead of their scheduled repayments and half of borrowers are six months or more ahead (Graph 9). This is good news. But a substantial number of borrowers have only small buffers if things go wrong.

Graph 9
Graph 9: Mortgage Repayment Buffers

 

At the overall level, though, nationwide indicators of household financial stress remain contained. This is not surprising with many borrowers materially ahead on their mortgage repayments, interest rates being low and the unemployment rate being broadly steady over recent years. At the same time, though, the household-level data show that there has been a fairly broad-based increase in indebtedness across the population and the number of highly indebted households has increased.

Impact on Economy and Policy Considerations

I would now like to turn to the third element of our work: the implications of all this for the way the economy operates and its resilience.

It is now commonplace to say that housing prices and debt levels matter because of financial stability. What people typically have in mind is that a severe correction in property prices when balance sheets are highly leveraged could make for instability in the banking system, damaging the economy. So the traditional financial stability concern is that the banks get in trouble and this causes trouble for the overall economy.

This is not what lies behind the Reserve Bank’s recent focus on household debt and housing prices in Australia. The Australian banks are resilient and they are soundly capitalised. A significant correction in the property market would, no doubt, affect their profitability. But the stress tests that have been done under APRA’s eye confirm that the banks are resilient to large movements in the price of residential property.

Instead, the issue we have focused on is the possibility of future sharp cuts in household spending because of stretched balance sheets. Given the high levels of debt and housing prices, relative to incomes, it is likely that some households respond to a future shock to income or housing prices by deciding that they have borrowed too much. This could prompt a sharp contraction in their spending, as they try to get their balance sheets back into better shape. An otherwise manageable downturn could be turned into something more serious. So the financial stability question is: to what extent does the higher level of household debt make us less resilient to future shocks?

Answering this question with precision is difficult. History does not provide a particularly good guide, given that housing prices and debt relative to income are at levels that we have not seen before, and the distribution of debt across the population is changing.

Given this, one of the research priorities at the Reserve Bank has been to use individual household data to understand better how the level of indebtedness affects household spending. The results indicate that the higher is indebtedness, the greater is the sensitivity of spending to shocks to income. This is regardless of whether we measure indebtedness by the debt-to-income ratio or the share of income spent on servicing the debt. If this result were to translate to the aggregate level, it would mean that higher levels of debt increase the sensitivity of future consumer spending to certain shocks.

The higher debt levels also appear to have affected how higher housing prices influence household spending. For some years, households used the increasing equity in their homes to finance extra spending. Today, the reaction seems different. This is evident in the estimates of housing equity injection (Graph 10). In earlier periods of rising housing prices, the household sector was withdrawing equity from their housing to finance spending. Today, households are much less inclined to do this. Many of us feel that we have enough debt and don’t want to increase consumption using borrowed money. Many also worry about the impact of higher housing prices on the future cost of housing for their children. As I have spoken about previously, higher housing prices are a two-edged sword. They deliver capital gains for the current owners, but increase the cost of future housing services, including for our children.

Graph 10
Graph 10: Housing Equity Injection

 

This change in attitude is also affecting how spending responds to lower interest rates. With less appetite to incur more debt for current consumption, this part of the monetary transmission mechanism looks to be weaker than it once was. There is, however, likely to be an asymmetry here. When the interest rate cycle turns and rates begin to rise, the higher debt levels are likely to make spending more responsive to interest rates than was the case in the past. This is something that we will need to take into account.

In terms of resilience, my overall assessment is that the recent increase in household debt relative to our incomes has made the economy less resilient to future shocks. Given this assessment, the Reserve Bank has strongly supported the prudential measures undertaken by APRA. Double-digit growth in debt owed by investors at a time of weak income growth cannot be strengthening the resilience of our economy. Nor can a high concentration of interest-only loans.

I want to point out that APRA’s measures are not targeted at high housing prices. The international evidence is that these types of measures cannot sustainably address pressures on housing prices originating from the underlying supply-demand balance. But they can provide some breathing space while the underlying issues are addressed. In doing so, they can help lessen the financial amplification of the cycle that I spoke about before. Reducing this amplification while a better balance is established between supply and demand in the housing market can help with the resilience of our economy.

There are some reasons to expect that a better balance between supply and demand will be established over time.

One is the increased rate of home-building. As we are seeing here in Brisbane and some parts of Melbourne, increased supply does affect prices. This increase in supply is also affecting rents, which are increasing very slowly in most markets.

A second reason is the increased investment in some cities, including in Sydney, on transport. Over time, this will increase the supply of well-located residential land, and this will help as well.

And a third reason is that at some point, interest rates in Australia will increase. To be clear, this is not a signal about the near-term outlook for interest rates in Australia but rather a reminder that over time we could expect interest rates to rise, not least because of global developments. Over recent years, the low interest rates in Australia have helped the economy adjust to the winding down of the mining investment boom. They have helped support employment and demand through a significant adjustment in the Australian economy. We should not, though, expect interest rates always to be this low.

It remains to be seen how the various influences on housing prices play out. Other policies, including tax and zoning policies, also have an effect. But increased supply and better transport could be expected to help address the ongoing rises in housing prices relative to incomes. These changes and some normalisation of interest rates over time might also reduce the incentive to borrow to invest in an asset whose price is rising strongly. To the extent that, over time, a better balance is established, we will be better off not incurring too much debt, and having housing prices go too high, while this is occurring.

I want to make it clear that the Reserve Bank does not have a target for the debt-to-income ratio or the ratio of nationwide housing prices to income.

As I spoke about earlier, there are good reasons why these ratios move over time. My judgement, though, is that, in the current environment, the resilience of our economy would be enhanced by an extended period in which housing prices and debt outstanding increased no faster than our incomes. Again, this is not a target or a policy objective of the Reserve Bank, but rather a general observation about how we build resilience.

Many of you will be aware that these issues have figured in the deliberations of the Reserve Bank Board for some time. This is entirely consistent with our flexible medium-term inflation targeting framework. With a medium-term target, it is appropriate that we pay attention to the resilience of our economy to future shocks. In the current environment of low income growth, faster growth in household debt is unlikely to help that resilience.

We have also been watching the labour market closely. The unemployment rate has moved up a little over recent months and wage growth remains subdued. Encouragingly, employment growth has been a bit stronger of late and the forward-looking indicators suggest ongoing growth in employment. We will want to see a continuation of these trends if the overall growth in the economy is to pick up as we expect. Stronger growth in incomes would of course also help people deal with the high levels of debt and housing prices. Overall, our latest forecast is for economic growth to pick up gradually and average around 3 per cent or so over the next few years.

To conclude, I hope these remarks help provide some insight into the Reserve Bank’s thinking about housing prices and household debt. As household balance sheets have changed, so too has the way that the economy works. Both from an individual and an economy-wide perspective, we need to pay attention to how the higher level of debt affects our resilience to future shocks.

Mortgage Reclassification Still An Issue

The RBA said recently, when they released their credit aggregates to end March, that $51 billion of loans have been switched from investor to owner-occupier, with $1.2bn in March.

Following the introduction of an interest rate differential between housing loans to investors and owner-occupiers in mid-2015, a number of borrowers have changed the purpose of their existing loan; the net value of switching of loan purpose from investor to owner-occupier is estimated to have been $51 billion over the period of July 2015 to March 2017, of which $1.2 billion occurred in March 2017. These changes are reflected in the level of owner-occupier and investor credit outstanding. However, growth rates for these series have been adjusted to remove the effect of loan purpose changes.

With the current balance of investor loans sitting at a record $577 billion, nearly 10% of the book has been switched to lower owner occupied rates. We of course cannot tell if this switching is legitimate, or opportunistic to get a lower interest rate and helpfully reduce the bank exposure to investor loans. The RBA data shows strong “corrected” investor growth of 7.1%, higher than owner occupied loans.

According to a report in the Australian today:

Responding to questions on notice from a Senate economic committee hearing, APRA said the switching “highlighted that some (lenders) have not had ­sufficiently robust practices” for monitoring the status of their borrowers and the data previously submitted to the regulator was “incorrect”.

APRA forced several banks to upgrade their reporting capabilities and, as a result, “some have strengthened their procedures”.

Tasmanian senator Peter Whish-Wilson, who asked APRA if its data was accurate, said the ­reclassification of loans was “concerning, whether it’s deliberate or not”.

He said: “I’d be loathe to see if any sort of systemic changes by the banks to loan classification were made to continue to grow loans to investors when it’s clear APRA is trying to crack down on what is potentially a very serious issue.”

RBA Holds Again

The RBA left the cash rate unchanged again today.

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

There has been a broad-based pick-up in the global economy since last year. Labour markets have tightened further in many countries and forecasts for global growth have been revised up. Above-trend growth is expected in a number of advanced economies, although uncertainties remain. In China, growth is being supported by increased spending on infrastructure and property construction, with the high level of debt continuing to present a medium-term risk. The improvement in the global economy has contributed to higher commodity prices, which are providing a significant boost to Australia’s national income. Australia’s terms of trade have increased, although some reversal of this is occurring.

Headline inflation rates have moved higher in most countries, partly reflecting the higher commodity prices. Core inflation remains low. Long-term bond yields are higher than last year, although in a historical context they remain low. Interest rates have increased in the United States and there is no longer an expectation of additional monetary easing in other major economies. Financial markets have been functioning effectively.

The Bank’s forecasts for the Australian economy are little changed. Growth is expected to increase gradually over the next couple of years to a little above 3 per cent. The economy is continuing its transition following the end of the mining investment boom, with the drag from the decline in mining investment coming to an end and exports of resources picking up. Growth in consumption is expected to remain moderate and broadly in line with incomes. Non-mining investment remains low as a share of GDP and a stronger pick-up would be welcome.

Indicators of the labour market remain mixed. The unemployment rate has moved a little higher over recent months, but employment growth has been a little stronger. The various forward-looking indicators still point to continued growth in employment over the period ahead. The unemployment rate is expected to decline gradually over time. Wage growth remains slow and this is likely to remain the case for a while yet.

The outlook continues to be supported by the low level of interest rates. Lenders have announced increases in mortgage rates, particularly those paid by investors and on interest-only loans. The depreciation of the exchange rate since 2013 has also assisted the economy in its transition following the mining investment boom. An appreciating exchange rate would complicate this adjustment.

Inflation picked up to above 2 per cent in the March quarter in line with the Bank’s expectations. In underlying terms, inflation is running at around 1¾ per cent, a little higher than last year. A gradual further increase in underlying inflation is expected as the economy strengthens.

Conditions in the housing market continue to vary considerably around the country. Prices have been rising briskly in some markets and declining in others. In the eastern capital cities, a considerable additional supply of apartments is scheduled to come on stream over the next couple of years. Rent increases are the slowest for two decades. Growth in housing debt has outpaced the slow growth in household incomes. The recently announced supervisory measures should help address the risks associated with high and rising levels of indebtedness.

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.

Investor Loan Growth Outpaces Owner Occupied In March

The latest data from the RBA, the credit aggregates, shows that loan growth was strongest for investment home loans, at an annualised rate of 7.1% compared with owner occupied loans at 6.2%. Business lending fell again, and personal credit continues to fall.

The proportion of lending to business fell to 32.8% (a record low) and the proportion of home lending for investors sat at 34.9%

Total credit grew $9.7 billion (up 0.4%), owner occupied lending rose $6.7 billion (up 0.6%), investment loans rose $2.5 billion (up 0.4%) and lending to business up $1 billion (up 0.1%).

However, the RBA adjusts these numbers to take account of $1.2 billion restatement between owner occupied and investment loans. Overall housing rose 6.5% in the past 12 months, way above income growth, so higher household debt once again.

Comparing the RBA and APRA data, it looks like the share of non-bank investor home lending is rising, and of course these lenders are not under the APRA regulatory control, but fall under ASIC (and they are not required to hold capital, as they are not ADIs). This is a loophole.

The RBA notes:

Following the introduction of an interest rate differential between housing loans to investors and owner-occupiers in mid-2015, a number of borrowers have changed the purpose of their existing loan; the net value of switching of loan purpose from investor to owner-occupier is estimated to have been $51 billion over the period of July 2015 to March 2017, of which $1.2 billion occurred in March 2017. These changes are reflected in the level of owner-occupier and investor credit outstanding. However, growth rates for these series have been adjusted to remove the effect of loan purpose changes.

Commodities rally putting pressure on RBA

From InvestorDaily.

A commodity-driven spike in Australia’s nominal GDP is putting the Reserve Bank of Australia under increased pressure to hike interest rates, says Nikko Asset Management.

Australia has seen strong growth in nominal GDP in the past year, thanks largely to the strong rally in commodities prices, according to Nikko Asset management fixed income portfolio manager Chris Rands.

The commodities rally is likely to continue for the next two quarters, Mr Rands said – but whether it continues longer than that will be down to Chinese demand.

Either way, the bright outlook for Australian economy over the next two quarters could potentially give rise to a more hawkish RBA than the market expects, he said.

Few economists are expecting the RBA to hike interest interest rates in the near future given the bank’s fears about further stoking domestic house prices.

But the sharp divergence between nominal GDP and the official cash rate (which have traditionally moved in lockstep) suggests it will be weighing on the RBA’s mind.

“In a strong nominal GDP environment, the RBA is typically either hiking rates or keeping them on hold,” said Mr Rands.

“Over the past five years, the cash rate has been moving in only one direction, and this new information could see the RBA taking a more hawkish tone than what the market is expecting,” he said.

The question for investors (and the RBA) is whether the rally in commodities that is driving nominal GDP growth is sustainable, Mr Rands said.

“If the commodity sector has been driven by Chinese fiscal expansion, this momentum could begin to run out during the second half of this year,” he said.