Is price inflation good for real estate in Australia?

July 24th, 2011

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One of the assumptions made by many people is that rising price inflation is good for property prices in nominal terms. In other words, many people see property as a hedge against price inflation. The experience of the past (especially 1970s) has a strong influence on this belief.

But today, in Australia, from our observations, we believe that the relationship between price inflation and property prices is breaking down. In fact, we would argue that price inflation probably has a negative effect on property prices.

To understand why, recall that we wrote in Does inflation (deflation) benefits the borrower (lender)?,

Debt servicing burden = (Debt payment rate ? Growth in wage) + Price inflation rate

Today, the problem is that in Australia, with the two-speed economy, wages are rising in one section of the economy but is relatively stagnant on the other. In relative terms, mining wages in Western Australia are sprinting ahead of wages at say, office workers in Sydney.

But unfortunately, since the GFC, cost of living has been rising faster than general rise in wages. For example, as Retail therapy impossible in this housing market reported,

Now look at your pay packet, take away the things you can’t avoid spending money on, remove what you’re paying in rent or paying off a loan, and look at what is left. You may find that’s smaller than ever, despite the fact we’re in a mining boom. But the trickle-down effect of that boom seems a long way away from Sydney. We’re part of the second tier of the economy here, the one that isn’t doing so well. Still, rent and housing prices continue to go up. And the bills come first before that new coat, that new stereo . . . even repairing those cracks on the walls or the dents on your car.

As you can see from our simple equation, with the cost of living rising faster than increase in wages, debt servicing burden will increase. Furthermore, the Reserve Bank did not help by raising interest rates. The increase in debt servicing burden puts a squeeze in discretionary spending- that explains why shoppers seems to be going on strike, putting the retail sector under pressure.

This increase in debt servicing burden is putting on the dampener on house prices. It dampens people’s appetite for borrowing more money and increases their propensity to save. Less borrowing means less capacity to bid up house prices. It also pushes more mortgage holders to be delinquent with their home loans, which increases the likelihood of forced sales. This is the first round of effect on house prices.

Rising cost of living pushes the retail sector deeper into trouble as shoppers shut up their wallets. Since consumer spending account for 60% of the Australian economy, a weak retail sector is hardly good news for employment in the country. As we wrote in RBA committing logical errors regarding Australian household finance,

Given Australia?s high household debt (see Aussie household debt not as bad as it seems?), prime debt can easily turn sub-prime when unemployment rises.

Rising unemployment will put further pressure on house prices. As we wrote in Does house price crash follow unemployment or is it the other way?,

[Rising unemployment] will feed into the second round of impact of lower house prices, which in turn lead to further rising unemployment. This will feed into the? third round of impact.

Now, cost of living is rising despite a rising Australian dollar. What if the dollar falls substantially? What will happen to the cost of living?

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  • Pete

    Good article, I agree completely.

    This is yet another one of those ‘unforeseen consequences’ of Govt meddling with the economy. By boosting house prices with the First Home Owners Grant, continuing to subsidise property through taxation, and supporting banks with guarantees,?the Govt succeeded in avoiding a collapse in the property market.
    However, the result means that we not only have a systemic housing market and banking problem, we also have severe economic balance issues as highlighted in this article.

    Less employment will mean less tax receipts. Where will the Govt make up the shortfall? By taxing our productive industries (mining) even more? That will discourage capital investment.

    Not to mention that another unforeseen consequence is retirees using their Superannuation to pay off their oversized mortgages – thus reducing the amount of Super they have to pay for their retirement and adding extra burden to our other systemic issue – funding retirement pensions of the large wave of baby boomers.

    I’m sure it is not easy to manage the budget of an entire country. But recent political/economic decisions by our ‘leaders’ have proven to be far from insightful.

  • Pete

    Incidentally, this report:

    about Stagflation in Australia had an interesting point:

    “Remember the phrase: Inflation in everything you need, deflation in everything you own.”

    That would mean, deflation in house prices, inflation in consumer items (eg CPI).

  • We doubt the budget can ever go back to surplus anytime soon. The handout genie is already out of the bottle.

  • Pete

    This is what I think the real purpose of the Carbon Tax is – to ‘return to surplus’ (RTS).

    The Labor Govt has become?fixated on a RTS because (IMO) it had so much trouble with it’s economic credentials in previous election campaigns against Howard, and it desperately wants to prove that a Labor Govt is not synonymous with massive govt debt.

    In which case, they shouldn’t have?wasted so much money on stimulus then, huh!

    I see the mining tax and the carbon tax (and the flood levy) as sneaky ways to RTS. However I think they will still fall short, particularly if China cools.