The housing market has to manage its own
inflation rates just like the RBA does with the broader economy, especially
because the housing market has less tools at its disposal on the downside.
There’s a
reason the RBA is so committed to avoiding general deflation where prices are
falling across the economy – deflation can be self-fulfilling.
If everyone
sees prices falling, and expects them to keep falling, they are more likely to
put off their big expenditures. Why buy now when it will probably be cheaper in
the future? Households put off buying that new TV, fridge, couch or car.
Businesses put off investing in that new warehouse, office, production
equipment or staff. Even governments may delay major infrastructure works –
which are often subject to cost-benefit analyses – if parts and labour are
expected to be cheaper in the future.
The very
act of all these parties putting off major expenditure is precisely what causes
a self-fulfilling deflationary spiral. In the 1930s, it was called the Great
Depression.
Ironically,
it can start by actually allowing inflation to creep too high. If the price of
everything accelerates too fast, households and businesses can reach a tipping
point where things become (or are suddenly perceived to be) too expensive to
afford or more expensive than they are worth (in the latter case, financial
stocks, for example). This sudden withdrawal of demand can then cause prices
not just to slow, but reverse to offset some of the preceding ‘unjustified’ price
gains.
When the
RBA sees inflationary pressures rising then, what do they do? They increase the
supply of assets in the financial market, causing the price of these assets to
decline and their interest rates to rise, thereby increasing the cost of
borrowing throughout the economy, reducing the desire to borrow, slowing the
economy and slowing down inflation. This avoids the sudden stop and risk of
deflation that can come from inflation accelerating too fast.
If
inflationary pressures are conversely too weak, the RBA withdraws the supply of
assets from the financial market, increasing their price and decreasing
interest rates, thereby stimulating the economy again and avoiding deflation.
This
importance of avoiding deflation (and also excessive inflation) doesn’t just
apply to the macro level though. It also applies to individual sectors,
especially ones as significant as the housing industry where many people invest
and perceive most of their wealth.
When house
prices start accelerating rapidly, new land supply needs to be made available
quickly, whether this is through swifter and simpler approvals processes,
zoning and planning rules that allow increased infill and density in
established suburbs, or investment in transport infrastructure to open up new
well-located land for development. This would allow new houses to be brought to
market faster, softening the pressures on house prices.
Right now
we are witnessing the impacts of a failure to do this.
For most of
the 21st century, rapid overseas migration drove demand for housing
through the roof, but new housing supply wasn’t readily available. We now know
what happened next – house prices accelerated rapidly to the point where – in
addition to forcing regulatory changes that deterred investors – many
owner-occupiers suddenly decided they couldn’t afford to enter the housing
market. This reversal of demand then caused house prices not just to slow, but
decline. At the same time that this demand went into reverse, a sudden
(delayed) influx of new housing supply finally came onto the market too,
forcing house prices down even further.
Now we are
in a deflationary phase in the housing market where many people are
deliberately holding back, not necessarily because they still can’t afford to
enter the market, but because they now expect prices to continue
downwards.
Unlike the
RBA though, the housing market doesn’t really possess a mechanism whereby it
can withdraw supply of land from the market in order to support prices. We just
have to wait until prices find their floor and recover. Unfortunately, by the
time this happens, the housing downturn could have spread to the rest of the
economy, making the job of the RBA and the government in supporting a recovery
much harder.
This is why
it is so important to ensure a supply of residential land that is flexible to
increases in demand. Excessive price inflation can result is a sudden stop and
big downturn, and there aren’t as many tools to turn this around once it has
begun.
