Australia’s penchant for property is about to be tested as the Reserve Bank of Australia (RBA) embarks on raising interest for the first time since 2009. In a rare interview with the national broadcaster, Governor Philip Lowe said the RBA would expedite the cash rate back to a normalised level of 2.5% to tame inflation. This came after the RBA shocked the market when it raised the cash rate by 50bps to 0.85% in June.

The notable shift in rhetoric from Lowe and the RBA is in stark contrast to the commentary given in October where it was implied rates wouldn’t rise until 2024. Now it seems the RBA will be unrelenting in its pursuit of demand destruction to bring inflation under control.

​- Philip Lowe, June 22

All else equal, rising rates typically result in lower house prices. The ability of households and businesses to service existing or acquire new debt falls, leading to a reduction in demand for property.

ANZ expects national prices to fall 5% in 2022 and a further 10% in 2023. CBA forecasts prices to fall 18% in both Sydney and Melbourne over the next eighteen months, with a 15% national decline. Given property prices increased 25% since the onset of the pandemic, both estimates leave the vast majority of households better off.
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However, the market believes further rises will be needed given the strength of households. Australians have more than $200bn in extra savings stashed away while the income-to-savings ratio is nearly double pre-pandemic levels. Per the Financial Stability Review, just 5% of loans have a loan-to-value ratio of more than 75%, compared to 25% before the pandemic. Subsequently, the market is expecting a 3.72% cash rate by year-end to bring inflation back.

It’s highly improbable the cash rate reaches that number by year-end. But even if it did, its impact would be diminished. 30% of households don’t have a mortgage at all. Of the 37% with mortgages, around 40% remain on fixed-rate loans. Most of these will roll off in the next eighteen months but that still leaves a sizeable chunk of the population with little incentive to curb spending. In fact, households with strong balance sheets may capitalise on the price dip, entrenching housing inequality.

One offsetting segment is the 31% of households that rent. With supply restricted and borrowing costs on the rise, it’s likely this segment will feel the heat most.

The other big issue is that much of the inflation problem is largely supply, not demand-driven. Sure, the pandemic brought forward some discretionary spending. But rising oil and energy prices, Russia’s invasion of Ukraine, supply chain bottlenecks and a global food shortage are all outside of the RBA’s direct control.
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Lowe is acutely aware of the strong economic backdrop. Part of his recent uptick in public appearances is to paint a dim outlook to the public and discourage excess consumption without needing to actually change rates. If Lowe can shock the market into thinking the RBA will raise rates aggressively, this will curb spending and give the RBA some wiggle room to slow future increases.

The RBA has been somewhat successful so far, with the latest Westpac-MI consumer confidence survey indicating that sentiment had reached its third-lowest point since 1994. The only two times confidence had gone lower were in the Global Financial Crisis and at the start of the pandemic. Meanwhile, construction activity has begun to fall, a lead indicator of economic confidence.

While the majority of households are well-equipped to weather rises, newer buyers could be in for a shock. APRA’s latest data indicated that 24 per cent of new mortgages had a debt-to-income ratio of six times or more, which is considered risky by the banking regulator. Most took out these loans on the basis that interest rates wouldn’t increase until 2024. One mitigating factor may be unemployment, which is at a record low level of 3.9%. As long as borrowers remain employed, defaulting on home loans is usually the option of last resort.
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​Given the resilience of households, Lowe will keep his foot on the pedal for time being. A Goldilocks scenario would entail households getting the hint, demand falling enough to offset the supply-side challenges and inflation returning towards the RBA’s desired upper bound of 3%. In this case, Lowe likely won’t need to raise rates by 2.5% and house prices fall around 10%.

The more likely outcome is that between now and 2.5% Lowe pauses to assess the impact of cash rate rises on the economy. If arrears and unemployment remain low but inflation is still persistent, he likely sends the cash rate to 2.5% and inflicts a ~15% correction in home values in line with ANZ’s forecast.

Should inflation still persist, the risk of a more material housing downturn emerges. Lowe may be forced to increase the cash rate as unemployment rises, thus sending Australia’s economy into a recession. However, by this point, the elevated inflation numbers will be cycled. This means the supply-side challenges like energy and food shortages would need to worsen further for inflation to remain elevated.

Overall, for the overwhelming majority of households, the initial interest rate rises will be manageable. Normalising the cash rate will also be beneficial in the long run, as it will give the RBA ammunition to support the economy in future downturns. The elephant in room is how much demand destruction is required to rein in inflation and if the RBA needs to go beyond its stated neutral rate of 2.5% to achieve this.