Interest rates will rise, but so will rents and incomes

Mortgage rates will rise over the next couple of years, but the impact on the housing market won’t be too dramatic.

Rates to rise…also incomes and rents

This week’s inflation figures confirmed that core inflation finally got well and truly back into the target band in 2021, after half a decade of undershooting.

Figure 1 – Underlying inflation
Figure 1 – Underlying inflation

Australia’s inflation profile is somewhat different from overseas, with a trimmed mean inflation reading of only 2.6 per cent. In fact, for much of the past half-decade commentators have been calling for a lower inflation target, after so many years of undershooting!

Compared to some of the readings coming out of Europe or the U.S. – and even New Zealand – inflation is not exactly running out of control in Australia. In fact, inflation has largely been driven by food and new dwelling costs, where pressure will likely ease in 2022, and fuel costs, which are admittedly somewhat less predictable.

Rents are rising at the fastest pace since 2007, which will keep property investors interested in the housing market, while household incomes will also increase materially as we approach full employment.

Steady increase

Financial markets are pricing interest rate hikes fairly aggressively, but we believe it’s unlikely we’ll see a significant move in the cash rate any time soon. Even if the cash rate does increase in time, we think that any such increases will be delivered gradually, and in a controlled manner.

Figure 2 – Cash rate futures / Source: Australian Securities Exchange
Figure 2 – Cash rate futures / Source: Australian Securities Exchange

The Reserve Bank of Australia may not be in too much a rush to hike, though, given that annual wages growth is only 2.2 per cent, and expectations for pay rises are still anchored at low levels.

Fiscal support will also be wound back over the next year or two, and it’s not yet clear how the economy will track when this very large fiscal support is withdrawn. 

In any case, much of the inflation relates to supply chain issues in 2021, which will be mostly resolved later in 2022, particularly for food and new dwelling costs, so hiking interest rates significantly while real wages are negative might not be desirable.

Rents are rising at the fastest pace since 2007, which will keep property investors interested in the housing market.

Market modelling

Commentators have sometimes overstated the impact of rising mortgage rates on the housing market for four main reasons.

Firstly, because inflation is exogenous to housing market modelling, estimated impacts on housing prices should be based upon changes in real mortgage rates. If inflation expectations are to move materially higher, then any related impact on housing prices would correspondingly be lessened. Given Reserve Bank modelling was referenced in 2019 to isolate the impact of lower real rates, it doesn’t make sense to translate estimates across to forecasts today, given that the context is not the same.

Secondly, the response of prices in the housing market model is non-linear, so logically interest rate cuts should’ve had a greater positive impact on sentiment as interest rates approached zero.

Thirdly, any impact on housing prices should be relative to your baseline forecasts. Thus, if forecasts were for housing prices to increase by, say, a few per cent per annum, then only relative to these forecasts would the impact on prices be seen as a result of rising mortgage rates.

Fourthly, any dramatic predictions of a crunch would need to assume no other change in macro variables, which is clearly unrealistic.

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The wrap

We should be expecting employment growth and population growth to come roaring back over the next couple of years, comfortably offsetting even a potential 1 per cent increase in interest rates. We also expect hikes to the cash rate to be delivered in a considered and gradual manner, even if funding costs are rising.

We have consistently discussed many of these variables with our clients such as employment growth, the immigration reboot, fierce competition between lenders, low out-of-pocket expenses, and the ability of households to absorb higher repayments comfortably.

Overall, mortgage rates will rise in 2022, but the impact of this on the housing market has often been overstated.

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