Weak economy outweighs house price surge for RBA

The economic debate in Australia has changed dramatically in the last few months as house prices have jumped dramatically in Sydney, Melbourne and Perth.  This has raised alarms that overheating property market is posing new financial risks to the Australian economy and this will change the course of RBA policy.

In terms of managing the cycle, the big jump in house prices suggests the RBA has a little time to monitor other variables, but I think they are still likely to have to cut rates given the weakening growth outlook.

From a financial risk perspective it also seems that the RBA has time up its sleeve given the big changes in household borrowing behaviour since the financial crisis.

It remains to be seen whether low interest rates can generate a problematic house price bubble when the rest of the economy is weak.

The high level of household indebtedness means, the RBA will probably be more willing to normalise interest rates when the general economy starts to turn than they were prior to financial crisis.

But that point still seems far away, with the risks to growth still high.

While house prices have jumped sharply in the last couple of months, other key indicators have not been alarmingly strong.  Housing loan approvals have risen steadily over the past few months, but this rise has been much more gradual than previous years.

Overall credit growth is also relatively modest. Gone are the days of 20%+ rates of housing credit growth as those with debts are paying down principal a lot faster than they used too.

Perhaps we are just on the cusp of a rapid acceleration of these variables given the leap in house prices.  But is is also equally plausible at this stage that the recent strength in house prices will run out of steam given risks to the rest of the economy.

Problematically for real activity is that stronger loan growth has not translated in particularly strong housing construction at this stage.  Building approvals remain relatively subdued, with high-density construction so far leading the way against detached housing.

Elsewhere there have also been scarce signs of improvement.  For example, retail sales over the last few months have been bad, not withstanding a rise in August.  At this stage it looks like household consumption won't be adding much to growth in Q3.

The spectre of much weaker business investment is also a huge potential drag on growth.  To be sure, we get much less high frequency data on business than we do on housing and consumer activity, but the recent information has been weak.

The prime example of this is the NAB Business Survey.  Confidence actually jumped quite a bit last month, although that could be just relief that the Federal election was finally over

Business conditions, which actually match activity and investment intentions much better, remains very weak along with capacity utilisation. This bodes poorly for investment, which is so critical to growth in the next 12 months given the slow growth elsewhere.

So overall activity still looks sub-trend, with growth likely to move from the current 2.5% growth rate to below 2% next year.

This should see the unemployment rate rise further and probably a bit more quickly, with jobs growth likely to slow as many of the leading indicators are pointing too

Against that backdrop, I think the RBA will probably be inclined to cut rates a little further, with the weak economy taking precedence over bubble concerns at this point.

There has been some discussion as to whether the RBA, along with bank regulator APRA, should implement other tools to help manage some of the risks from sharply rising house prices and more importantly from loosening of lending standards.

In particular, it could implement limits on LVRs akin to the recent move by the RBNZ.

This is not necessarily a bad idea, although I don't see this as hugely complementary to the setting of policy rates, which remains the key but crude tool in managing the economic cycle.

House prices are likely to rise if interest rates are low even with curbs on some types of very risky lending.  To be sure, what is probably more important is not letting house prices rise in the first place, which is necessary to boost things like home building, but to ensure you can tame frothy activity once the broader economy is in better shape.

Prior to 2008, this proved to be problematic given the global credit boom and policymakers lax attitudes towards the risks.  But the post 2008 experience shows that both policymakers and households are much more cautious, with housing market activity proving to be much more cyclical as policy and market interest rates move.

So macro-prudential tools are useful to help tame some of the bad lending risks in banks, but probably don't help you manage the cycle any better if you don't get the cash rate settings right.