What Does a High Surge in Inflation Mean for the Australian Housing Market?

The demand for housing is impacted by inflation, but so is the housing market. Understanding the relationship between housing and inflation helps to clarify the market picture for the coming year.

In June 2022, ABS data revealed the greatest annual inflation rate in almost 32 years. The Treasury and the RBA predict that annual inflation will peak at above 7% as we approach the start of the new fiscal year. As a result, household budgets will be more restrained, savings will be lessened, and there will probably be less demand for property.

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The demand for housing is impacted by inflation, but so is the housing market. Understanding the relationship between housing and inflation helps to clarify the market picture for the coming year.

How does the housing market impact inflation?

The Consumer Price Index (CPI) tracks the price of a variety of goods and services that households specifically purchased from other industries, governments, and corporations. CPI is used to measure inflation.

The fluctuation in established housing values over time is not taken into account when calculating inflation because established residences are traded inside the household sector. Additionally, purchases of land are excluded because it is seen as an asset rather than an item for consumption.

Due in large part to the RBA's early 1990s decision to target inflation when setting interest rates, mortgage interest payments were removed from inflation beginning in 1998. Constantly measuring the interest costs made it difficult to understand the impact of the monetary policy on genuine cost pressures of the economy.

Inflation calculations take new housing costs for owner-occupied households (less land value) into account, as well as changes in rent prices. Rates and fees, property repairs, upkeep, and renovations are just a few other costs associated with real estate that is taken into account.

How is the housing market factored into inflation?

Items not factored in inflation 

Items factored in inflation

  • Cost of purchasing land

  • Cost of purchasing an established dwelling 

  • Cost of servicing a mortgage

  • Change in rent 

  • Cost to build a new building minus the land value

  • Cost of renovations, repairs, and maintenance 

  • Rates and charges

  • Utility costs

The CPI’s housing component has the highest weight of all the commodities and services (around 23 per cent, 8.7 per cent for new homes, and 6.2 per cent for rents). This is a reflection of how much money households spend on housing. As a result, changes in rents, the cost of new homes, and utility rates all have a significant impact on inflation. In June 2022, the yearly change in the CPI's overall housing component was 9.0%. After a 13% increase in transportation costs, this CPI component saw the second-largest increase.

The cost of a new home for households increased by 20.3% annually in the June 2022 quarter (a series high). This is significantly higher than the series average of 3.9%, illuminating the dire circumstances facing the housing building industry.

Supply chain issues have limited the availability of building materials. The construction incentives implemented as a result of the pandemic (such as HomeBuilder and the "new homes" version of the first home loan deposit program) have unexpectedly increased demand. Even while building expenses and pipelines are still overvalued, the expiration of these government funds has increased inflation in this category even more since grants and subsidies are taken into account when calculating CPI.

The price of rent also increased 1.6% yearly in June. According to CoreLogic's hedonic regression model understanding changes in rental valuations suggests that the rent component in inflation could also see further upward pressure in the coming quarters.

It might take longer for rent growth in capital cities to slow as international migration increases and travel restrictions in Australia relaxes. This is due to the demand for housing being skewed toward renting in the major cities by a large number of foreign visitors and migrants.

These changes in new construction and rent over the previous two years have raised inflation. But in turn, the high inflationary environment can have a variety of effects on the housing market.

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How does inflation impact the housing market?

Inflation affects the housing market both directly and indirectly. However, whether these effects are "good" or "bad" depends on what is causing inflation as well as other current economic conditions.

For instance, a direct impact of inflation is that it can erode the value of debt, which can be advantageous to mortgage holders. As the economy grows, the wages may increase but as the mortgage principals are fixed, mortgage payments may drop significantly. This is also one major characteristic of the 1980s' high inflationary period — while interest rates rocketed, so did inflation and wage growth.

Income growth has proven to be harder to come by for 2022 mortgage holders. The ABS stated the pay price index increased 2.4 per cent in the year to March, which was less than the series average growth of 3.1 per cent, but it is still rising. Furthermore, the ABS's national accounts statistics revealed a pick-up in household income growth starting in 2021, and the RBA's monetary policy pronouncements suggested wages growth was on the rise. However, until wage growth accelerates significantly, consumers will continue to struggle with high debt levels and growing living expenses.

The fact that price increases have been sharper in areas where it is difficult to reduce spending is another important aspect of inflation in 2022. The goods in this spending category referred to as "non-discretionary," include basics like food, housing, and fuel. In June 2022, the ABS reported that annual inflation in non-discretionary spending was almost twice as high as annual inflation in discretionary spending.

The implication is that homeowners with mortgages will likely experience a greater squeeze on their household budgets as a result of growing mortgage expenses at high debt levels and the difficulty for households to cover these costs by reducing spending on essentials like food and fuel. Instead, during the next few months, discretionary spending is more likely to decrease quickly.

Another direct impact of inflation is that it diminishes the real value of housing. According to CoreLogic’s Home Value Index, which is used to calculate the real growth in housing values, for the June quarter of 2022, the real change in Australian home values was -1.9 per cent, against a nominal decline of -0.2 per cent.

The subsequent rises in the cash rate are the most significant indirect impact of growing inflation on the housing market in the current environment. This is because RBA plans to influence inflation by utilizing the cash rate. The RBA sets core inflation targets to remove volatile, short-term influences on the CPI. Currently, the annual core inflation is at 4.5 per cent which is above the RBA target range of 2-3 per cent. The RBA is currently raising the cash rate at its fastest rate since the 1990s in light of the exceptionally high core inflation rate and the unusually low "emergency low" cash rate settings during the pandemic.

Inflation may decline as interest rates rise and economic activity slows. As a result, it becomes less appealing to borrow money to acquire a home, which slows the pace of sales and price increases in the housing market. This indicates that there is an inverse relationship between changes in property values and the cash rate.

Additionally, there is some evidence to support the idea that as home prices decline, household spending may also decrease. This is another indirect way that higher interest rates serve to keep inflation in check. In 2015, the RBA conducted research on the correlation between rising property values and a rise in new vehicle registrations. According to the study's findings, there may be a less significant correlation between total household consumption and home values. Australian consumption is anticipated to be more sensitive to changes in the cash rate as mortgage costs rise due to the country's unusually high levels of household debt, the majority of which is housing debt.

The significant correlation between interest rates and property values makes inflation a crucial indicator to keep an eye on when assessing the housing market's prognosis. The RBA will change the cash rate settings when it appears that inflation will remain between 2 and 3 percent.

How long will it take to curb inflation?

Due to a combination of domestic and international factors pushing up the prices, inflation is expected to remain high in 2022. These include the Russian invasion of Ukraine, the return of COVID and COVID lockdowns in China, and capacity limitations in several economic sectors on a global scale. Extreme weather events have influenced price rises for various food commodities domestically, and the resilience of consumer expenditure is still questionable.

The economic pressures caused by supply and demand are beginning to ease, though. Retailers are discounting various products in the US due to an increase in inventories, and input and commodity prices have also started to ease internationally. The cash rate is expected to peak at a lower level than was initially predicted a few months ago, and the CBA has suggested that the RBA may slash cash rates as early as next year. 

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