Can lower interest rates re-inflate the property price bubble?

June 26th, 2008

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Recently, those people at BIS Shrapnel are busy spreading misinformation in the mainstream media again (see this mainstream news article: House prices set to climb despite rates). Their first ‘analysis’ regarding house prices was first released in March this year. This month, their ‘analysis’ was again reported in the mainstream media. We had already criticised their flawed ‘analysis’ earlier in Another faulty analysis: BIS Shrapnel on house prices and would not repeat them again in this article.

But we would like to add one more point with regards to one of their flawed assumptions. When you read the mainstream news media, you will notice that one of their assumptions is that when the RBA eventually cut interest rates (insert: Mr Angie Zigomanis, the report author, said that “As credit conditions recover over the course of 2009…”), it will lead to the further re-inflation of property bubble. Judging from this flawed assumption of theirs, we wondered whether they are really that ignorant about economics.

To understand the flaw in their assumption, we have to first understand the RBA’s latest decision to hold interest rates in June. Currently, the RBA is still keeping an eye on price inflation. As BIS Shrapnel themselves acknowledged, the RBA is likely to raise interest rates again this year to combat price inflation. But the reason why the RBA kept interest rates on hold this month was that they expected the Australian economy to slow down in the coming months. In other words, the RBA is expecting the economy to slow down so that inflation will be kept at bay, which will reduce the necessity to raise interest rates.

When the economy slows down, what happens? You will see rising unemployment, falling profits, declining consumer confidence and so on. Given the astronomical levels of debt Australians owe, en economic slowdown will increase the debt servicing burden, which in turn (1) increases the likelihood of bad debts and thereby, (2) decreases the quality of the loans in the banking system. Effect (1) increases the likelihood of debt deflation (see Aussie household debt not as bad as it seems? for more detailed explanation). Effect (2) will lead to the contraction in the supply of money and credit (or at least a slowdown in its expansion) in the economy (see How money & credit can shrink (i.e. deflation)? for more detailed explanation).

As we said before in Australian property good investment? Part 3?prospects of capital appreciation (written more than a year ago),

Traditionally, it is the rising income levels that drive property prices upwards over the years. Naturally, as people?s general income level increases, the prices paid for property will increase as well. Recently, we have another phenomena that drive property prices upwards?the sudden availability of easy credit and low interest rates, which are manifestations of monetary inflation (?printing? of money). The result is a short-term property price bubble…

So, given that Australian house price inflation are driven mainly by credit (NOT income), shrinking supply of credit will at least put a brake on further price inflation. In fact, we can argue that for every same percentage increase in asset prices, the amount of credit required increases exponentially. Thus, we do not even need a shrinking amount of credit to induce asset price deflation- a slowdown in credit increase is enough to do that job. In Australia’s case, credit is the oxygen for the property market. Without it, no matter how much excess ‘demand’ for housing is out there, there will not be enough people who can afford them.

As we can see from this Bloomberg article, Australian House Prices Fall Most in Five Years on Higher Rates,

Australian house prices fell in the first quarter by the most in five years after the central bank raised interest rates at the fastest pace in more than a decade.

The median price for houses fell to A$458,488 ($439,644) in the March quarter, down 2.7 percent from the previous three months, the Real Estate Institute of Australia and Mortgage Choice Ltd. said. Apartments also fell 2.7 percent to A$355,297.

The statistics at RBA shows that credit growth in Australia is starting to slow due to interest rates rise. And at the same time, we see property price deflation in the first quarter of 2008.

Therefore, a slowing economy is NOT good for house price.

But what if the economy slows down too much for the RBA’s liking? In that case, given the high levels of debt of Australians, if the economy slows down too much, the Australian economy can tip into a dangerous downward deflationary spiral. That was what happened to Japan during the 1990s. Today, the Japanese are still trying to recover from that deflation. When that happens, the RBA will be cutting interest rates just like Ben Bernanke did recently. In short, while the RBA is looking at inflation, it will not cut interest rates unless deflation becomes a serious threat. By the time deflation becomes a serious threat, will cutting interest rates re-ignite the property price bubble?

Again, we doubt so. As we said before in What makes monetary policy ?loose? or ?tight??,

A common misperception is to assume that any rise in interest rates automatically implies a monetary tightening (and conversely for a fall in interest rates).

Underneath BIS Shrapnel’s assumption lies the erroneous misconception that the cutting of interest rates automatically result in a loose monetary policy (i.e. increase in the quantity of money and credit in the economy). If deflation gets serious enough, the cutting of interests will still result in a ‘tight’ monetary policy. Japan was an excellent case in point. Another excellent case in point is the United States today. Despite Ben Bernanke cutting interest rates desperately, did it re-inflate the property bubble over there (see this news magazine article, US Home Prices Tumble in April)?

In short, BIS Shrapnel has no credibility.

P.S. Temjin & David: We will continue to answer your questions (in What is a crack-up boom?) in the coming articles.

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