RBA – Page 67 – Digital Finance Analytics (DFA) Blog

Household Cash Flows and Monetary Policy

The RBA released the September 2016 edition of the Bulletin today. The article “The Household Cash Flow Channel of Monetary Policy by Helen Hughson, Gianni La Cava, Paul Ryan and Penelope Smith is interesting, but possibly flawed.

It looks at the impact of households when the cash policy rate is changed. Lower interest rates can encourage households to save less and bring forward consumption from the future to the present (the inter-temporal substitution channel).

Lower interest rates can also lift asset prices, such as housing prices, and the resulting increase in household wealth may encourage households to spend more (the wealth channel). Additionally, lower interest rates reduce the required repayments of borrowing households with variable-rate debt, resulting in higher cash flows and potentially more spending, particularly for households that are constrained by the amount of cash they have available. At the same time, lower interest rates can reduce the interest earnings of lending households, which may, in turn, lead to lower cash flows and less spending for these households. These last two channels together are typically referred to as ‘the household cash flow channel’.

The analysis in this article focuses on a fairly narrow definition of the cash flow channel. It examines the direct effects of interest rates on interest income and expenses, but abstracts from monetary policy changes that have an indirect cash flow effect by influencing other sources of income, such as labour or business income.

Household disposable income, or cash flow, comprises wages and salaries, property income (including interest paid on deposits) and transfers, less taxes and interest payments on debt. The household sector in Australia holds more interest bearing debt than interest earning assets. Indeed, households have increased their debt holdings at a rapid pace since the early 1990s, mainly due to an increase in mortgage debt. For the household sector as a whole, the level of household debt now exceeds the level of directly held interest earning deposits by a significant margin. However, since the mid 2000s, slower growth in household debt and increases in interest-earning deposit balances (including balances held in mortgage offset accounts) has led to a decline in net interest bearing debt. This means that the household sector is a net payer of interest. Household net interest payments increased through the 1990s and early 2000s, mainly reflecting the rise in net household debt, but trended down from 2007 as interest rates and net debt declined.

The data shown above do not account for interest earning assets held in managed superannuation accounts, which have increased substantially since the early 1990s. The majority of these assets cannot be accessed until retirement.

This article finds evidence for both the borrower and lender cash flow channels, but the borrower channel is estimated to be the stronger channel of monetary transmission. One reason for this is that while there are roughly similar shares of borrower and lender households in the Australian economy, the average borrower holds two to three times as much net debt as the average lender holds in net liquid assets. Another reason is that the sensitivity of spending to changes in interest-sensitive cash flow is estimated to be larger for borrowers than for lenders based on statistical analysis using household-level data.

Overall, the estimates suggest that the cash flow channel is an important channel of monetary transmission; the central estimates indicate that lowering the cash rate by 100 basis points is associated with an increase in aggregate household income of around 0.9 per cent, which would, in turn, increase household expenditure by about 0.1 to 0.2 per cent through the cash flow channel.

We have a couple of issues with their analysis. First, recent events have shown that when the cash rate is cut, the benefit is not necessarily passed through to households, thanks to weak competition in the banking sector. When it is, the benefit is often not equally shared between borrowers and savers, and not all savers benefit equally. In fact, looking at the trends in recent years, savers have been taken to the cleaners, as banks repair and protect their margins. So benefits are overstated.

The second issue is households will be impacted by the confidence surrounding a rate move. If they become less confident, they will be less likely to spend, preferring to save for later. So a rate cut often lowers household spending – this is one of the significant reversals we have seen recently – and central banks are still trying to get to grips with the implications. The link between low interest rates and household spending, yet alone broader economic growth appears broken.

So, whilst the article is a good attempt, we think it overstates the benefits of cash rate cuts in the current cycle.

The New Regulatory Framework for Surcharging of Card Payments

“Where consumers see a card surcharge, they should check to see what non-surcharged methods of payment are available. Before paying a surcharge, they should think about whether any benefits from using that payment method outweigh the cost of the surcharge; if not they should consider switching to an alternative payment method. This will not only save them money, it will help keep costs down for businesses and will put pressure on card schemes to keep their charges low”. This was Tony Richards, Head of Payments Policy Department RBA, conclusion when he spoke at the 26th Annual Credit Law Conference and discussed the revised card payment surcharging regime.

In his speech he started by looking at data on average merchant service fees (or MSFs) show that there are very large differences in the cost of different card systems for merchants. These costs ranged from an average of just 0.14 per cent of transaction value for eftpos in the June quarter to about 2 per cent of transaction value for Diners Club. For MasterCard and Visa transactions, the average cost to merchants of debit cards was 0.55 per cent of transaction value, while the average cost of credit card transactions was 0.81 per cent. The average cost of American Express cards was 1.66 per cent of transaction value.

But these averages mask significant variation across different merchants. Many merchants pay up to 1–1½ per cent on average for MasterCard and Visa credit card transactions. And it is not unusual for merchants to pay 2–3 per cent to receive an American Express card payment.

Then he discussed five key elements of the new framework contained in the Bank’s new surcharging standard and the Government’s amendments to the Competition and Consumer Act.

First, the new framework preserves the right of merchants to surcharge for more expensive cards, but it does not require them to do so. Under the framework, a merchant that decides to surcharge a particular type of card may not surcharge above their average cost of acceptance for that card type.

For example, if on average it costs a merchant 1 per cent of the value of a transaction to receive a Visa credit card payment, the merchant may apply a surcharge of up to 1 per cent for that type of card. The merchant would not, however, be able to apply the same 1 per cent surcharge if the customer chose instead to pay with a debit card that was less costly to the merchant.

Second, the definition of card acceptance costs that can be included in a card surcharge has been narrowed. Acceptable costs will be limited to fees paid to the merchant’s card acquirer (or other payments facilitator) and a limited number of other documented costs paid to third parties for services directly related to accepting the particular type of card. A merchant’s internal costs cannot be included in a surcharge.

Third, a merchant that wishes to surcharge will typically have to do so in percentage terms rather than as a fixed-dollar amount. In the airline industry, this means that surcharges on lower-value airfares have been reduced significantly.

Fourth, the Government has given the ACCC investigation and enforcement powers over cases of possible excessive surcharging.

The Bank’s standard and the ACCC’s enforcement powers apply to payment surcharges in six card systems that have been designated by the Reserve Bank – eftpos, the MasterCard debit and credit systems, Visa’s debit and credit systems, and the American Express companion card system. However, Reserve Bank staff have been in discussions with other card systems that have not been designated and we expect that those systems will all be including conditions in their merchant agreements that are similar to the limits on surcharges under the Bank’s standard. This will mean that merchants that wish to surcharge on payments in these other systems will be contractually bound to similar surcharging caps to those that apply to the regulated systems.

Fifth, surcharging in the taxi industry – which is subject to significant regulation in many other aspects – will remain the responsibility of state taxi regulators. Until recently, surcharges of 10 per cent were typical in that industry. However, authorities in five of the eight states and territories have now taken decisions to limit surcharges to no more than 5 per cent. As new payment methods and technologies emerge, the Bank expects that it will be appropriate for caps on surcharges to be reduced below 5 per cent. The Government and the Bank will continue to monitor developments in the taxi industry with a view to assessing whether further measures are appropriate.

The first stage of implementation of the surcharging reforms took effect on 1 September and covers surcharging of card payments by large merchants. Merchants are defined as large if they meet certain tests in terms of their consolidated turnover, balance-sheet size or number of employees. The framework will take effect for other, smaller merchants in September 2017.

There are a few reasons for the delayed implementation for smaller merchants. Most importantly, these merchants are less likely to have a detailed understanding of their payment costs. Since the new framework involves enforcement by the ACCC, the Bank considered it important to ensure that such merchants have simple, easy-to-understand monthly and annual statements that show their average payment costs for each of the card systems subject to the Bank’s standard. Accordingly, as part of the new regulatory framework, acquirers and other payment providers must provide merchants with such statements by mid 2017. All merchants will be required to comply with the new surcharging framework from September 2017 and ACCC enforcement will apply also to smaller merchants from that point.

Given the new framework has only been effective for two weeks, it is too early to be definitive about how the new surcharging regime applying to large merchants has affected the surcharging behaviour of those merchants. However, based on some corporate announcements and an initial survey of some websites, I think it is possible to make six initial observations.

First, and most prominently, the major domestic airlines have moved away from fixed-dollar surcharges to percentage-based surcharging. This will result in a very significant reduction in surcharges payable on lower-value airfares. The two full-service airlines have introduced surcharges for on-line payments of 1.3 per cent for credit cards and 0.6 per cent for debit cards. A passenger wishing to pay for a $100 domestic airfare by card will now pay a surcharge of $1.30 or 60 cents, as opposed to a surcharge of up to $7-8 previously. Surcharges on some high-value airfares may rise with the shift to percentage-based surcharges. However, the airlines have implemented caps on surcharges of $11 for domestic fares and $70 for international fares, indicating that they continue to prefer to not pass on their full payment costs on purchases of more expensive tickets.

Second, there does not appear to have been any increase in the prevalence of surcharging. It remains the case that companies that face relatively low merchant service fees are tending not to surcharge, while those businesses which receive a high proportion of expensive cards are more likely to surcharge.

Third, the surcharge rates for credit cards that have been announced show significant variation, which is consistent with other evidence that there is a lot of variation in the merchant service fees faced by different businesses. In the case of the Qantas group, for example, Qantas is charging a credit card surcharge of 1.3 per cent while Jetstar – which presumably receives fewer high-cost cards – is charging a surcharge of 1.06 per cent.

Fourth, as required by the Australian Consumer Law, merchants that have announced changes to their surcharges are continuing to offer non-surcharged means of payment. In the face-to-face environment, this typically includes cash, eftpos and sometimes MasterCard and Visa debit cards. In the on-line environment, it typically includes payments via BPAY, POLi or direct debit, which are typically low-cost for merchants.

Fifth, while there are still many instances of ‘blended’ credit card surcharges, there are some early signs of greater discrimination in surcharges. Blending refers to the practice of charging the same surcharge across a number of systems regardless of their cost – say across the MasterCard, Visa and American Express credit systems.

The new framework allows merchants to set the same surcharge for a number of different payment systems, provided that the surcharge is no greater than the average cost of acceptance of the lowest-cost of those systems. For example, if a merchant accepts cards from two credit card systems, which have average costs of acceptance of 1 per cent and 1.5 per cent, it can set separate surcharges of up to 1 per cent and 1.5 per cent, respectively. If it wishes to set a single surcharge, it cannot average the costs and set a 1.25 per cent surcharge for both systems, since it would be surcharging one of those systems excessively. In this example, the maximum common surcharge that could be charged would be 1 per cent.

While I think we are already seeing some reduction in the practice of blended surcharging, it is likely that we will see this trend continue from mid 2017 when new rules on the interchange fees exchanged between banks for card transactions take effect. Without wishing to go into details, the Bank will for the first time be placing a cap on the maximum interchange fee that can be paid on any card transaction. This will significantly reduce the cost of MasterCard and Visa payments for those merchants which currently receive a high proportion of high-interchange cards.

The sixth change has been in the event ticketing industry, where it was previously very difficult to avoid a card surcharge in the on-line environment. Given this, the ACCC had already required the major ticketing companies to show their surcharges as a separate component within their headline, up-front pricing. Effective 1 September, the two major companies have now removed their card surcharges and are now quoting a simple, single price for all payment methods.

RBA’s View, “After the Boom”

RBA Assistant Governor (Economic) Christopher Kent, spoke at the Bloomberg Breakfast today and gave a comprehensive, if myopic, summary of the current Australian economic position though the boom years, and into the current realignments. There was no discussion of the high household debt and the rapid rise in home prices. He concluded:

The pattern of adjustment of the Australian economy to the decline in the terms of trade and mining investment is generally consistent with what we had anticipated. However, the decline in the terms of trade was larger than expected. In response, there has been significant adjustment in a range of market ‘prices’ – including wages and the nominal exchange rate, although the exchange rate has depreciated a little less than otherwise given global developments. Monetary policy has also responded, with interest rates reduced to low levels. So while mining investment and nominal GDP growth have both been weaker than the forecasts of a few years ago and, more recently, inflation has been a bit weaker than expected, growth in the non-mining economy has picked up and been a bit better than earlier anticipated. Indeed, of late, real GDP growth has been a bit stronger and the unemployment rate a little lower than earlier forecast.

In many respects, the adjustment to the decline in mining investment and the terms of trade has proceeded relatively smoothly. The Australian economy has performed well compared to other advanced economies (Graph 11). Moreover, the drag on growth from declining mining investment is now waning and the terms of trade are forecast to remain around their current levels.

Graph 11

Of course our forecasts are subject to the usual range of uncertainty. But, given that commodity prices have increased substantially over the course of this year, some stability in the terms of trade from here on seems more plausible than it has for some time. Developments in China are likely to continue to have an important influence on commodity prices, given China’s role as both a major producer and consumer of many commodities. For this reason the outlook for the Chinese economy is a key source of uncertainty for the Australian economy.

If commodity prices were to stabilise around current levels, that would be a marked change from recent years. Also, the end of the fall in mining investment is coming into view. The abatement of those two substantial headwinds suggests that there is a reasonable prospect of sustaining growth in economic activity, which would support a further gradual decline in the unemployment rate. There is also a good prospect that the growth in wages and the rate of inflation will gradually lift over the period ahead. That’s what’s implied by our central forecasts.

So Just How Much Are Home Prices Rising?

The statistical “fog of war” appears to have descended on Australian home prices, partly fueled by the RBA’s recent statements, and the latest chart pack data. Because of perceived issues with the CoreLogic data series, we see plots from a number of data providers, including the ABS (whose June 2016 data should be out later on – they are disgracefully slow on releasing their quarterly price data).

Now, we see there are some significant variations between the series, and of course in turn mask the significant differences between locations. CoreLogic has been tweaking their series, and the RBA specifically mentioned this in their recent report. These differences are driven by different methodologies, as well as some series breaks.

So, what is the truth about home price momentum? Of course the RBA wants to show prices growing more slowly despite the cut in the cash rate, thanks to their careful management; whilst others want to talk up the positive movements, to encourage more transactions. Our surveys suggest demand is still quite strong.

As best we can tell, price momentum did moderate in recent months, but now is on the rise again, thanks to low rates, and ongoing interest from investors. Somewhere between 2.5% and 7.5%! The high auction clearance rates appear to confirm this.

But, the real amount of the movement is uncertain. Yet another example of the problems we have getting meaningful, prompt and reliable statistics in Australia.

No Change to RBA Cash Rate Today

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

The global economy is continuing to grow, at a lower than average pace. Several advanced economies have recorded improved conditions over the past year, but conditions have become more difficult for a number of emerging market economies. Actions by Chinese policymakers have been supporting growth, but the underlying pace of China’s growth appears to be moderating.

Commodity prices are above recent lows, but this follows very substantial declines over the past couple of years. Australia’s terms of trade remain much lower than they had been in recent years.

Financial markets have continued to function effectively. Funding costs for high-quality borrowers remain low and, globally, monetary policy remains remarkably accommodative.

In Australia, recent data suggest that overall growth is continuing, despite a very large decline in business investment, helped by growth in other areas of domestic demand and exports. Labour market indicators continue to be somewhat mixed, but suggest continued expansion in employment in the near term.

Inflation remains quite low. Given very subdued growth in labour costs and very low cost pressures elsewhere in the world, this is expected to remain the case for some time.

Low interest rates have been supporting domestic demand and the lower exchange rate since 2013 is helping the traded sector. Financial institutions are in a position to lend for worthwhile purposes. These factors are all assisting the economy to make the necessary economic adjustments, though an appreciating exchange rate could complicate this.

Supervisory measures have strengthened lending standards in the housing market. Separately, a number of lenders are also taking a more cautious attitude to lending in certain segments. The best available information suggests that dwelling prices overall have risen moderately over the past year and growth in lending for housing purposes has slowed. Considerable supply of apartments is scheduled to come on stream over the next couple of years, particularly in the eastern capital cities.

Taking account of the available information, and having eased monetary policy at its May and August meetings, the Board judged that holding the stance of policy unchanged at this meeting would be consistent with sustainable growth in the economy and achieving the inflation target over time.

AU$ Forex and Derivative Volumes Down

In April 2016, the Reserve Bank conducted a survey of activity in foreign exchange and over-the-counter (OTC) interest rate derivatives markets in Australia. Using data from the BIS and the RBA summary, here is a snapshot. This was part of a global survey of 52 countries, coordinated by the Bank for International Settlements (BIS). Similar surveys have been conducted every three years since 1986.

Globally, the Australian dollar remains the fifth most traded currency, although its share of turnover decreased by 1½ percentage points to around 7 per cent.

The AUD/USD remains the fourth most traded currency pair, having also accounted for a slightly decreased share of global turnover.

Activity in Australia’s foreign exchange market has moderated since the previous survey in April 2013. Total turnover fell by around 25 per cent, compared with a 5 per cent decrease in global turnover over the same period.

Nonetheless, the Australian foreign exchange market remains the eighth largest in the world.

Activity in Australian OTC interest rate derivatives markets declined markedly over the three-year period, primarily reflecting a decline in turnover of forward rate agreements.

The BIS data highlights the high volume of US$ Swaps, relative to other currencies. AUD is in fourth position.

The USA and UK dominate the derivative markets, with Australia in seventh position.

The preliminary results of the global turnover survey and links to other participating jurisdictions’ results are available from the BIS website. More detailed results for the Australian market are available on the 2016 BIS Triennial Survey Results – Australia page.

The BIS will also publish global data on outstanding OTC derivatives as at June 2016 in November.

The Reserve Bank will publish Australian data on outstanding OTC derivatives at that time.

RBA Expects Inflation To Rise, Later

The RBA released their minutes today of the meeting where rates were cut to a record low 1.5% in August 2016.

They highlighted the property market and commented on both the slower rate of house price growth, and dwelling investment momentum.

Dwelling investment was expected to increase further, having grown strongly in recent years, although the contribution to output growth was expected to diminish over the forecast period. Building approvals had declined over the preceding year, but remained at high levels and had exceeded the amount of work completed. As a result, the number of dwellings under construction had increased to very high levels. Further, members noted that the pipeline of residential construction work, which included work that had not yet commenced, had increased the risk of oversupply in parts of the country. The outlook for the balance of supply and demand in the housing market was important for the inflation outlook because housing costs make up a significant share of the CPI basket.

Turning to the established housing market, members noted that most indicators pointed to an easing in conditions since late 2015. Recent data indicated that housing prices appeared to have grown modestly in the June quarter and had declined a little in most capital cities in July. Data on housing price growth from CoreLogic, which had been discussed at previous meetings, indicated that housing prices had increased very strongly in several cities in April and May. However, new information had revealed that these growth rates were overstated because of changes to CoreLogic’s methodology; data from other sources indicated that housing price growth had instead remained moderate in the June quarter. Other information showed that, while auction clearance rates had recently picked up a little in Sydney and Melbourne, the number of auctions was lower than in the preceding year and the average number of days that properties were on the market had increased. Housing credit growth had been little changed in recent months and remained below that of a year earlier. Rent inflation had declined to its lowest level since the mid 1990s and the rental vacancy rate had drifted higher to be close to its long-run average.

In addition, they think inflation will rebound, later. However there is significant uncertainty.

Members noted that there was little change in the forecast for underlying inflation. The central forecast was still for inflation to remain around 1½ per cent over 2016 before increasing to between 1½ and 2½ per cent by the end of the forecast period. The substantial depreciation of the exchange rate over recent years was expected to exert some upward pressure on inflation for a time and inflation expectations were assumed to return to longer-run average levels. The forecast increase in underlying inflation also reflected the expectation that strengthening labour market conditions would lead to a gradual rise in growth in labour costs. In particular, members noted that growth in average earnings had been low given the spare capacity in the labour market. Moreover, growth in average earnings had been affected by lower wage outcomes in sectors related to the mining industry as a part of the process of adjusting to the lower terms of trade and the end of the mining investment boom. Both of these effects were expected to wane over the forecast period. Members noted that there continued to be considerable uncertainty about momentum in the domestic labour market and the extent to which domestic inflationary pressures would rise over the next few years.

The exchange rate of course has remained pretty strong and is higher than this time last year. So, expect lower inflation for longer.

The legacy of Glenn Stevens in three lessons

From The Conversation.

On September 18 2016, Glenn Stevens will end his ten-year mandate as governor of the Reserve Bank of Australia (RBA). His experience in the top job provides a wealth of lessons for the next generation of policymakers; that’s arguably his most important legacy.

A graduate from the University of Sydney and the University of Western Ontario in Canada, Stevens worked in the RBA research department between 1980 and 1992. He then held positions as department head, assistant governor (economic) and deputy governor. In 2006, he was appointed governor.

Throughout his tenure as governor, Stevens has had to deal with a highly volatile and generally fragile global economic and financial landscape. Domestically, he has been confronted with the end of the mining boom and a prolonged contraction of gross domestic product (GDP) below its potential level.

It is probably not an exaggeration to say that the ten years from 2006 to 2016 have been some of the most difficult economic times in post-war history. But it is exactly this highly complicated environment that provides a valuable learning opportunity for policymakers and for the economics profession more generally.

The monetary policy framework

The first lesson concerns the need for a “risk management” approach to monetary policy in a time of crisis.

The RBA’s monetary policy framework centres on an inflation target of 2%-3% on average over the medium term.

This means that actual inflation may deviate from the target in the short term in response to the cyclical conditions of the economy. For instance, when a negative demand shock reduces GDP below potential and causes unemployment to increase, reduced inflationary pressures allow the RBA to stimulate the economy by reducing the cash rate moderately.

In September 2008, when the global financial crisis hit the world, Australian inflation had been above target and on the rise for three consecutive quarters. This should have made the RBA prudent in cutting interest rates.

Instead, conditions worldwide were such that a change in monetary policy thinking was needed. The risks were simply too large to be treated with a normal policy approach.

Accordingly, the RBA moved to a “risk management” approach that, while broadly consistent with the flexible inflation-targeting framework, allowed for a quick (and much-needed) response.

As a result, the cash rate was reduced from 7.25% to 4.25% in the period September to December 2008 and then to 3% in the course of the first half of 2009. Comparatively, only the Bank of England cut its interest rate by as much as Australia.

The cut in the cash rate largely passed through to commercial lending rates, resulting in an increase in disposable income for many individuals. This then contributed (together with other factors, including the fiscal stimulus) to maintaining the Australian economy out of a recession.

It is highly likely that without this risk-management approach to monetary policy, Australia would have been much more severely affected by the global financial crisis.

The limits of monetary policy

The second lesson is that policymakers ought to be realistic and pragmatic about what monetary policy can and cannot deliver.

Through changes to the cash rate, monetary policy can affect the pace of real economic activity in the short term. But, in the long term, growth and unemployment are driven primarily by supply-side factors and monetary policy only affects inflation.

Moreover, the extent to which monetary policy can affect growth in the short term decreases as interest rates get lower. During the GFC, monetary policy effectively contributed to shielding the Australian economy because higher interest rates gave the RBA more room to cut.

But when interest rates are already low, the monetary policy space is reduced and further cuts are unlikely to produce significant effects.

Understanding the limits of monetary policy is particularly important in the current economic context.

The Australian economy has been operating below potential for several years now, as data from the International Monetary Fund suggests.

In response to this prolonged contraction, the RBA has reduced the interest rate to record low levels. It has reached the point where further cuts would probably be more damaging than beneficial.

Now more than ever recovery becomes a matter of fiscal policy interventions.

How to use monetary policy

The third lesson is about the use of monetary policy.

The inflation-targeting framework requires the RBA to set the cash rate having consideration for a variety of factors and data, including qualitative information received from conversations with businesses, investors and stakeholders.

In making the best possible use of these data and information, the RBA follows two guiding principles.

First, policy should not be driven by conclusions drawn from short runs of data. This then implies that the cash rate should not be fine-tuned continuously in response to marginal developments occurring month by month.

In normal circumstances, the interest rate ought to move gradually and rather infrequently to provide individuals (businesses and households) with some certainty about the course of monetary policy.

Second, monetary policy in Australia ought to be both outward- and forward-looking. An outward look is required because, as a small and open economy, Australia’s inflationary dynamics are heavily affected by developments on international markets.

This does not mean that the RBA should passively mimic the behaviour of other central banks. However, it does mean that the importance of international factors for the Australian economy should be adequately taken into account.

Forward-looking refers to the fact that forecasts ought to play a central role in the monetary policymaking process. To express this in Stevens’ own words:

After all, if monetary policy takes some time – several years – to have its full effect on the economy and inflation, forecasts have to be at the centre of things, don’t they?

Author: Fabrizio Carmignani, Professor, Griffith Business School, Griffith University

How inflation is tied to the property market

Weak inflation has sent interest rates to historic lows, but new housing supply and APRA’s steps to rein in property investment will contain property prices according to an article in The Real Estate Conversation.

While many property owners around the country continue to enjoy strong capital growth, the national inflation rate dropped to 1% in the 12 months to June, according to the Australian Bureau of Statistics (ABS). For what it’s worth, this is below the Reserve Bank’s 2-3% target band and represents the weakest annual rate of inflation in 17 years.Such low inflation would typically mean the economy is weak and unemployment is high. But not in Australia, apparently. A number of commentators say that Australia’s unemployment rate (5.8% as per ABS) is at a stable level and that the economy is ticking along well, even though both company profits and wages are generally down. It’s a confusing mix of circumstances, for sure.

Adding to the complexity, low inflation has seemingly had little effect on the property market, which remains buoyant even after several years of high price growth in cities like Sydney and Melbourne. Prices aside, total housing credit has mostly been up this year (at least for owner-occupiers), and this usually means there are plenty of property buyers out and about and wanting to borrow money.

These buyers are often competing on a limited supply of homes, which is important because the supply-demand equation is central to our reading of the economy. One reason demand for property has so dramatically increased is because of the relatively cheap cost of home loans in recent years, which is due to record low interest rates – 1.5% as of August – implemented by the Reserve Bank (RBA).

The impact of rate cuts

Many media articles lead with the idea that RBA rate cuts are directly linked to the property market. Yet if you read past the headlines, it becomes clearer that the RBA is more concerned with low inflation.

“The RBA is trying to keep inflation at a certain level and the expected outcome from cutting interest rates is a lower dollar,” says BIS Shrapnel senior manager, Angie Zigomanis. “By lowering interest rates it means people will come here [to Australia] and the returns on their investments are lower, and the dollar starts falling on that basis because you’re competing for money.

“It means that the lower dollar starts stoking a lot of the import industries as well. It makes their products more competitive against exports.

“So rate cuts are part of a broader view to ward of inflationary pressures but also to lower the dollar to kick start some other industries that provide economic growth. The housing market is a bi-product [of this].”

Perception is reality

Much of this, of course, is about perception. In other words, high inflation means demand is seen to be strong, and this prompts businesses to invest more, consumers to spend and therefore price to go up.

There are several measures that help the government determine demand levels, like the consumer price index, which gives us that inflation rate figure. It simply measures the changing price consumers pay for goods and services. So in a high inflation environment, prices for the same goods and services are, well, much higher because the underlying demand is so strong.

Right now, CommSec says that price pressures are currently contained in Australia, largely due to greater competition in the market, including online sellers. This means consumers are the main beneficiaries of cheaper prices across all good and services – perhaps with the exception of property prices.

Find the balance

Over the past 20 years general price inflation has been low and stable, consistent with the inflation target since the early 1990s, according to an RBA paper published in 2015. However, such has been the level of property price growth that more recent prices have outstripped the rate of inflation in other parts of the economy, including inflation in the cost of new dwellings.

This has been a concern for the RBA because if property prices go up too high then most money will end up in housing and building instead of sustainable investment in industries, says Zigomanis.

This is why the Australian Prudential Regulation Authority (APRA) last year sought to limit the impact of property investors on the market by capping annual investor credit growth at 10%, which CoreLogic RP Data says has worked well to this point.