Sign house prices could plunge 30 per cent

As the Reserve Bank lifts interest rates, house prices will fall – but by how much? A proven model suggests the change could be drastic.


The Australian property market is worth $10 trillion so any significant correction in its value will have a large wealth impact on Australians.

There is debate about how far house prices will fall as the Reserve Bank lifts interest rates. Its own models used to suggest any 100 basis points (bps) change would result in a corresponding 20 per cent shift up or down in house prices. This model had a good track record. More recent modelling has shown a smaller impact.

If we use the proven, older model with some discount for risk, the first four hikes (100bps) will be enough to deliver a 15 per cent fall in house prices. This appears plausible today given house prices were already falling before the RBA hiked, and we have the $500 billion fixed mortgage rate reset looming as well.

That is minus $1.5 trillion in wealth and would, in any normal cycle, weigh on household consumption enough to slow the economy to stall speed somewhere around 1 per cent growth.

However, Australia faces a very unusual and potentially more destructive cycle this time around.

Inflation is stronger than it has been for many years. So the RBA is raising rates more sharply with a higher target in mind.

Moreover, this has been made considerably worse by the east coast energy crisis. Although wage growth is still quite weak, its role in boosting late-cycle inflation has been occupied by energy prices instead.

Owing to the war-profiteering of Australian gas and coal firms, which are imposing runaway international prices upon Australia despite digging up the materials for next-to-free down the road, we are going to see a much stickier CPI than in previous monetary tightening cycles.

At current prices for coal and gas, energy bills will roughly double over the next year or so. That will add 3 per cent to CPI plus whatever businesses try to pass on.

This raises the distinct possibility that critical components of Core Inflation do not fall at the pace the RBA is used to during cyclical downturns and it keeps lifting interest rates past levels that the structure of the politico-housing economic model can take. This loomed large after the RBA recent meeting.

Inflation is expected to increase further, but then decline back towards the 2-3 per cent range next year. Higher prices for electricity and gas and recent increases in petrol prices mean that, in the near term, inflation is likely to be higher than was expected a month ago.

As the global supply-side problems are resolved and commodity prices stabilise, even if at a high level, inflation is expected to moderate. Today’s increase in interest rates will assist with the return of inflation to target over time.

In short, if we see a 2 per cent cash rate, with the second 100bps the direct consequence of energy prices, then the house price correction is going to double in scale to 30 per cent. The wealth hit to households will be $3 trillion, half of it attributable to the energy shock.

The scale of such losses is beyond contemporary Australian experience and may, therefore, represent a structural adjustment to the economic model itself.

For more than two decades, Australia has operated a “houses and holes” economy that earns income by selling dirt to the world. Our banks then leverage that income in global markets and dump the debt into mortgages to inflate house prices that drive demand for services.

This will be replaced by the “holes and hollow” economy that pays the world to take our dirt, while it charges us ever more to borrow, dropping house prices and deflating demand for services permanently.

David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geopolitics and economics portal. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.

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