Why rising rates will hurt property buyers more than the ’90s
CBA head of Australian economics Gareth Aird – the first economist to pick an interest rate rise in 2022 – says a rate of close to 4 per cent would imply that previous rate increases had caused no slowdown in economic growth or inflation.
Aird says a rate of about 2.5 per cent would still slow the economy and inflation markedly over the next year, and in his view prompt the RBA to lower interest rates by the end of 2023 because of the handbrake on growth.
Rate rises to ‘hurt more than ever’
The idea that an increase in the cash rate to 2.5 per cent would be a significant drag on the economy is supported by an analysis done by the Grattan Institute. It found that rate increases would “hurt more than ever before” – including in the 1980s and 1990s when interest rates hit 17 per cent.
“High house prices have changed the game, making it much harder for today’s borrowers,” Grattan senior associate Joey Moloney and program director Brendan Coates wrote in The Conversation this week.
“It is true even a mortgage rate of 5 per cent is well below the peak of about 17 per cent earlier generations paid at the start of the 1990s,” they said. But 30 years ago, the increase in mortgage interest payments as a share of income was modest as house prices and mortgages were much smaller.
Today, higher house prices and much larger mortgages – sometimes six times more than household income – mean that “for any given mortgage rate, the share of income taken up by mortgage payments is much, much higher”.
“The extraordinary increase in house prices and debt means mortgage rates of 7 per cent would be as painful to borrowers today as rates of 17 per cent were decades ago. Skyrocketing house prices have changed the game. For millennials, even historically small increases in interest rates will hurt.”
Aird says recent borrowers have a legitimate reason to be miffed.
“Lots of households transacted in the property market through 2021 under the assumption interest rates weren’t going up until 2024 at the earliest because that’s the message the central bank was giving,” he says.
Many also did so on the assumption that low rates would continue to put upward pressure on house prices, creating a sense of urgency to take the plunge into the housing market.
Aird says a common refrain was: “If rates aren’t going to go up, prices aren’t going to go down, and we should just get in now”. This was reflected in the massive rise in the number of first homebuyers getting into the property market.
Sydney, Melbourne prices to fall 18pc by 2023
That’s history now. This week, CBA downgraded its forecasts to an 11 per cent decline for Sydney house prices this year, a 10 per cent fall for Melbourne, and an 18 per cent slump in both cities by the end of 2023.
In March, by contrast, the bank had predicted a modest 3 per cent decline in the two cities this year.
Such a fall, if it bears out, would top the 10.2 per cent slump in capital city dwelling values over the 21 months to June 2019.
That drop in value was a consequence of higher mortgage serviceability requirements imposed – particularly on property investors – by the Australian Prudential Regulation Authority as well as concerns about the loss of negative gearing and capital gains tax discounts promised by the Labor opposition before the May 2019 election.
The next sustained decline came as the pandemic hit in 2020, with a 2.8 per cent fall in capital city housing values between April and September.
An analysis done by Melbourne Institute Associate Professor Sam Tsiaplias, which was presented to the Melbourne Economic Forum this week, showed that low interest rates, rather than government policy, were the main factor driving about 300,000 first homebuyers into the market recently.
According to Tsiaplias, it’s when interest rates fall during economic downturns that first homebuyers are most active. This is because investors exit the market, interest rates drop and their borrowing capacity increases. This was also evident in 2009 following the global financial crisis.
In explaining the RBA’s decision to abandon yield-curve control – the policy of targeting a 0.1 per cent yield on the 3-year government bond – after financial markets forced its hand in November last year, governor Dr Philip Lowe was clear in his language about the outlook for interest rates.
“I want to make it clear this decision does not reflect a view that the cash rate will be increased before 2024,” he said. Yes, there was “genuine uncertainty” about the timing of future rate rises, but “it is still entirely possible that the cash rate will remain at its current level until 2024”.
Yet, at its board meeting in May, almost 20 months after past guidance, the RBA decided to increase the record low 0.1 per cent cash rate to 0.35 per cent in what Lowe described as a “business as usual” rate rise.
The RBA then increased the cash rate in June, this time by a double “business as usual” 0.5 percentage points without much explanation, taking the cash rate from 0.1 per cent to 0.85 per cent in just two months, with another 0.5 percentage point rise now tipped for July as well.
‘An extra $500,000 a year in interest’
Reflecting the experiences of the late-1980s and early-1990s, Rich Lister Max Beck, a developer, says he expects the current period of rising rates to last for two years, pointing to the experience of the short-lived spike in borrowing costs when the Reserve Bank raised the benchmark cash rate to 17 per cent in 1989.
“There was a real squeeze on households at that point as well. But it didn’t last as long as we thought it would,” says Beck, who turned 80 this year.
Beck, who was developing the A-grade Gateway office building on the southern edge of the Melbourne CBD in the mid-80s, got caught out by the rate moves after he fixed the rate on debt taken out for the 312 St Kilda Road project.
“I locked in an interest rate at 14 per cent,” he recalls. “The bloody thing came back to about 8 per cent within 12 months. It was costing me an extra $500,000 a year in interest,” which he had to wear for two to three years.
Beck, who says he will never lock his commercial borrowing costs again, expects the current rise “to start to settle back” by the end of 2023.
Although the RBA’s decision to begin normalising interest rates this year was a natural and correct response to inflation leaping to 5.1 per cent in the March quarter and forecast to head north of 6 per cent in the coming months, many economists believe the central bank erred in effectively signalling to homebuyers that rates would remain low for many years.
Indeed, the RBA’s communication is a key part of why many economists have called for, and the Albanese government has agreed to, a review of the central bank, which is expected to report back to the Treasurer next year.
But as economist Steven Hamilton says: “That’s going to be little comfort for all the homebuyers now facing a large hit to their household budgets.
“There’s a big difference in interest payments between what the RBA is now signalling over the next two years and what would have happened if they had kept rates at zero for the next two years. That’s a very significant amount of money that they had reason to expect would not be taken from them.
“This highlights the Reserve Bank’s basic error, which was to pin their guidance so tightly to the calendar rather than to the fundamental economic conditions. And that’s the point.”