Forecasting the housing boom using a key RBA model
In a new research paper (download here), Coolabah’s Chief Macro Strategist, Kieran Davies replicates one of the RBA’s internal models on the Australian housing market and finds that house prices are expected to appreciate by about 25% over the next few years. Read the overview enclosed below.
Like nearly every other advanced economy, Australian house prices increased during the pandemic, which was a marked break from the large declines seen in past recessions. Admittedly the pandemic was different in that interest rates were relatively low leading into the outbreak, but the striking resilience of prices stands as testament to the unprecedented and immediate easing of fiscal and monetary policy, particularly the success of the JobKeeper wage subsidy in limiting the rise in unemployment and banks deferring mortgage repayments for stressed home-owners.
With house prices picking up after languishing over recent years, Coolabah Capital Investments (CCI) has applied the Reserve Bank of Australia’s (RBA) ground-breaking model of the housing market developed by Peter Tulip and Trent Saunders to produce internally-consistent forecasts for the next few years. The model, which allows for feedback between housing construction, rents, vacancies and prices, points to a large gain in prices of around 25% through to the end of 2023, driven by low interest rates. (This is consistent with the forecasts previously released by CCI’s chief investment officer, Christopher Joye.) Rising house prices and low rates should underpin a similar gain in real residential investment, although rents are expected to be weak given a relatively high vacancy rate.
The model estimates how the housing market will behave on the basis of past relationships, where CCI has calculated margins of error around the model’s predictions based on past forecast errors. The estimated margins of error are wide, which is not surprising given the volatility of house prices and rents. Clearly, though, the pandemic has created significant additional uncertainty around the outlook given entirely new developments such as the closure of Australia’s border and the move to working from home. That said, we believe that past behaviour provides a very useful starting point for considering the impact of any lasting changes from the outbreak.
The RBA should take comfort from rising house prices because higher asset prices are a key part of the transmission mechanism of both conventional and unconventional monetary policy (QE in its current form being an exception given banks do not offer long-term fixed-rate mortgages). While we expect the RBA will keep policy loose until it achieves its economic objectives, there is always the risk that banks lower lending standards as house prices strengthen, which would trigger a regulatory response that would challenge the model’s forecasts. To date, though, regulators are only monitoring the situation given credit spreads for riskier mortgages remain unchanged with the RBA reporting that lending standards remain conservative.
A large rise in house prices would intensify concerns over affordability and inequality. Homes are very affordable insofar as debt-servicing costs are very low thanks to ultra-cheap mortgage rates, but raising a deposit remains a barrier to entering the market and home ownership has trended lower for the first home-buyer age group. Easy monetary policy reduces income inequality by lowering unemployment, but can add to wealth inequality, which reflects very low home ownership among low-income/resource households. CCI’s view is that concerns over affordability and inequality are better addressed by government via the tax/transfer system. The other step that government can take is to address the longstanding inflexibility of the supply side of the housing market, which has seen lower interest rates manifested in higher house prices more than the construction of new homes.
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Based in Sydney, Kieran Davies joined Coolabah Capital in 2020, an asset manager than runs over $7 billion in fixed-income strategies, and is responsible for macroeconomic research and investment strategy, contributing to the investment decisions...