They say the trend is your friend until it bends. So it may be with interest rates.
The decades-long decline in Australian interest rates, from 1995 to 2019, has gone hand-in-hand with the rise in house prices, as the next chart shows. Interest rates have risen from 0.1% in 2022 to 4.35% today, with speculation of a cut in February. But if interest rates were to hold steady or even increase further, bucking the long-term trend of declining interest rates, could that change the momentum of house prices too?
A new working paper published by the Reserve Bank of Australia — part of a recent workshop where RBA boffins and academics kicked around ideas in quantitative macroeconomics — spells out the extent to which the run-up in house prices between 1995 and 2019 is due to the fall in interest rates.
“The Australian housing market is particularly interesting both because of its exceptionally high housing costs by international standards and its distinctive institutional settings,” says the paper, written by two central bank insiders and a Sydney University researcher and which is marked “preliminary and incomplete”.
The models the authors use incorporate a range of assumptions — for example, that households do not anticipate interest rate falls. (It is important to bear in mind the saying: “All models are wrong, some models are useful.”)
The authors find that the series of interest rate cuts since 1995 has driven house price-to-income ratios up by 40%, which has reduced home ownership. Bigger deposits required and higher stamp duties account for the fall in first-home buying.
The assumption that households did not see the interest rate cuts coming certainly seems like a fair one. Just look at this chart, showing the forecasts made by the futures markets, and the eventual path of interest rates.
Until 2021, markets never dreamed rates could fall so low. After 2022, markets had no idea rates would rise so fast.
As 2025 starts, markets think rates will fall. The big question is what happens if that assumption is badly wrong.
The implication of the RBA paper is we could have a mirror-image scenario: rates could rise, systemically, unexpectedly and over the medium term, which could cause house prices to stall — or even fall. We have certainly seen house price reversals in Melbourne over the past year as rates held steady, and house price momentum is stalling in other capitals too. Bond yields are suddenly rising in global markets.
Is this something to be feared? The RBA paper implies that lower house prices (in absolute terms or merely relative to incomes) could increase home-ownership rates. Deposits would be easier to gather and stamp duty burdens would be less. That’s a good thing!
But there’s a downside. If rates don’t come back down, it could be because inflation isn’t under control. Would higher home-ownership really transpire under a scenario of runaway inflation? Or would young households be under even more pressure?
And just how likely is runaway inflation? Recent fires in LA guarantee the insurance component of the CPI basket will continue to rise steadily. Further geopolitical uncertainty could also push up prices (do we really think the Middle East will simply settle down after the past year?), as could Donald Trump’s plan for a giant trade war against literally everyone.
The big picture
At a macro level, falling interest rates and low inflation in the past two decades could be explained by China’s entry into the global economy. China brought an unprecedented level of manufacturing capacity into the global economy, adding hundreds of millions of capable workers to global supply chains. China also saved a lot of money, with that abundant saving flowing into global markets, making money cheap.
But China is now running out of rural workers to urbanise, running out of young people, and running low on growth. The period where China’s sudden shocking rise drove macroeconomic variables to extremes could be over. We may look back at the pandemic as a turning point when China’s influence on the global financial system shifted. That’s when rates started going back up and asset prices stopped going crazy.
Financial markets are highly volatile; economies, meanwhile, are strange and dynamic systems. I’m not saying a rise in interest rates and a fall in house prices is certain, but you should have this possibility in the mix. Even if it is a low-probability event, it is one with high-level consequences. The trend is your friend until it bends.
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