Popping a housing bubble fantasy

As an alternative, let’s examine inflation. Today the RBA believes that the acceptable rate of consumer price inflation is around 2.5 per cent per annum. Yet the 30-year average rate is 4.2 per cent per annum. Does this mean that the RBA should substantially revise up its inflation target? Of course not.

These variables were not selected by chance. The truth is that the crux of this debate hinges on how inflation, interest rates, household debt, and house prices have varied over the last three decades.

In its survey, The Economist takes median house prices and median rents over the last circa 30 years – which is the longest horizon over which these data are publicly available – and calculates a long-term ‘average’ ratio, which it assumes to be the ‘correct’ benchmark. It then compares current house prices and rents to this 30-year benchmark. If current ratios are above (below) this 30-year average, The Economist claims they are over- (under-) valued.

The Economist does not question whether the old housing ratios might be nonsensical to today’s home owners as a result of: (a) fundamental changes in the structure of the economy wrought by the fact that interest rates over the past 15 years have, on average, been 43 per cent lower than interest rates in the 15 years that preceded that period (see first chart below); (b) the fact that average inflation since the middle of the 1990s has been 55 per cent lower than inflation in the 15 years prior (see second chart); or (c) the fact that the rise of two-income households and the female participation rate in concert with a near halving in the nominal cost of debt might have triggered a once-off upward increase in household purchasing power, and hence housing valuations.

Now we have tried to replicate The Economist’s analysis using the longest publicly available time-series of median houses prices and median rents in Australia, which one can purchase from the Real Estate Institute of Australia. This covers the period June 1982 through to December 2010.

If we adopt The Economist’s method, we conclude that the current ratio of median Australian house prices to median rents is about 38.7 per cent above its 28-year average. We do not know how The Economist gets its 56 per cent estimate, but ours is in the same general ballpark.
Interestingly, we can get a 56 per cent number if we look at inflation over this exact same period. Australia’s current inflation rate of 2.7 per cent would have to rise by 56 per cent to agree with its long-term average of 4.2 per cent since June 1982. But, of course, nobody in their right mind would claim that this makes any sense. It is just that The Economist uses this logic when it analyses housing.

One can undertake a similar exercise with interest rates. The headline mortgage rate today is 7.8 per cent. The average headline rate since June 1982 is 9.9 per cent. Does this then mean that Australian mortgage rates are currently way too low? Applying The Economist’s method, Aussie home loan rates should rise by 27 per cent in order to correspond with this historical benchmark.