Thursday, May 19, 2022

House prices looking vulnerable

Anyone in the rural community wanting to cap the rise in interest rates or see the New Zealand dollar fall needs to be eyeing house prices.

Some, including the Reserve Bank, predict a modest fall in house prices over 2022 of 5%, but the supply and construction of houses to remain buoyant.

Anyone in the rural community wanting to cap the rise in interest rates or see the New Zealand dollar fall needs to be eyeing house prices.

The sharper the turn in the residential property market, the less pressure the Reserve Bank will be under to keep lifting interest rates, provided it flows into some key areas of inflation pressure.

The housing market has turned, yet market expectations are we are going to see even larger rises in the Official Cash Rate over 2022.

We look headed for a showdown between inflation that could prove sticky, but house prices that look vulnerable to very sharp declines.

Inflation is more broad-based than housing alone and much of it beyond the Reserve Bank’s control. However, the tentacles of the residential property market spread widely across the economy both in terms of house prices, building activity and employment.

Residential property is a key pro-cyclical part of the economy. It moves up sharply in booms and can quickly reverse. Taming inflation is not growth, asset price or housing friendly. 

Housing is a sizable component of the consumer price index. Purchase of housing is 9% of the consumer price index and rent’s another 10%. Housing and household utilities are more than 28%.

Home ownership inflation increased 15.7% in the past year. The finger is being pointed at covid supply chain issues, but the story is simpler than that; it is a function of a booming housing market where demand for materials and labour is outstripping supply.

Falling house prices are an inevitable part of a receding inflation equation. House prices lead construction costs by almost a year. Falling house prices also remove the wealth effect, or positive impact of rising wealth on spending. When your wealth recedes, people tend to spend less too.

House prices are falling. National house prices are down 2.3% in the past three months. Auckland has seen a 5.5% decline.

It is still early days in the housing cycle, but indications are it is turning fast. The number of days to sell a house is rising and jumped from a seasonally-adjusted 32 days in January to 37 days in February. Volumes sold in the month of February 2022 were down 32% versus February 2021. The level of inventory is rising. Rising days to sell and less sales volumes typically lead house prices. 

Some, including the Reserve Bank, predict a modest fall in house prices over 2022 of 5%, but the supply and construction of houses to remain buoyant.

This is one reason the Reserve Bank is projecting the Official Cash Rate needs to head above 3% and market expectations are the same. House prices fall a bit, but activity generally holds up, keeping inflation cooling, but a bit sticky.

Indications are the housing market is turning more aggressively. Building consents fell 9.2% in the month of January and have fallen for three of the past five months. Fifteen percent construction cost inflation, challenges getting credit, rising interest rates, signals some areas such as Auckland may now be building too many houses and negative migration (a driver of demand) are changing the landscape for housing supply. 

Activity is coming from an extreme level of strength with 48,700 consents issued in the past year and monthly data can be volatile. But turning points can occur quickly.

Financial markets are ramping up expectations the Reserve Bank will start raising the Official Cash Rate faster. A further 185 basis points of increases in the Official Cash Rate are priced into 2022 and 85 basis points in the next two meetings, implicitly betting the odds are high we could see two 50 basis point rises.

The current and expected inflation picture can be argued to validate this. Expectations for inflation two years ahead are above 3% and outside the policy band.

Things could soon get very awkward if the housing market continues to turn. Traditionally this has helped eased inflation. But inflation pressures are looking more broad-based and not being helped by splurging government spending.

How much bludgeoning will the Reserve Bank be prepared to dish out in the name of inflation? The answer is of course enough until they are comfortable that their objectives of 2% inflation and maximum sustainable employment (think of an unemployment rate above 4% not below 4%) are within reach.

We could be on a collision course between the current inflation objective and the necessary bitter medicine required to achieve it.

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