Inflation spells an end to liquidity driven booms in house prices

House prices could fall by up to 20 per cent.

With another high inflation reading expected at the end of this month, most likely taking the annual CPI increase to close to 7 per cent, the RBA governor’s forecast of further increases in the official interest rates is be taken seriously. Indeed, a third 50 basis point rate rise is highly likely at the August 1 meeting of the board. This would take the cash rate to 1.85 per cent, a rise of 1.75 percentage points in just four months.

At 1.85 per cent, the cash rate is getting closer to more normal levels, which could be in the range of 2-2.5 per cent, but probably is not yet sufficient to achieve the governor’s aim of the RBA charting a credible path back to an inflation rate of 2-3 per cent.

Indeed, the message from policymakers at the annual conference of the European Central Bank was that the persistence of significant supply-side shocks from Russia’s invasion of Ukraine and the pandemic had fundamentally changed the medium-term outlook for inflation.

They could have added that by acting only slowly to respond to this new reality, the continued highly stimulatory stance of monetary policy risked embedding a change in inflation psychology. As a result, they are now playing catch-up.

There are two broad implications of this current situation. First, real interest rates may not return to the unusually low levels of last decade. According to one paper presented at the RBA’s annual research conference, a large inflation shock or a large increase in public debt could trigger a reversal of the past downward trend in the real rate of interest. The paper notes that “Since both these forces are currently at play, it raises the possibility that the future could involve a much higher real rate.”

If this is correct or at least partly the case, then the second implication is that economies and markets will behave very differently to how they did last decade.

Then, low inflation and low and even negative real interest rates during the pandemic encouraged rising levels of debt and asset prices. This in turn produced a significant widening in wealth inequality.

For Australia, a reversal of these trends could be particularly painful. This is because Australia’s household debt is among the highest of its global peers and economic growth has benefited from very large rises in house prices.

There are already some early signs that house prices are cooling, even though interest rates remain relatively low. A wide range of forecasts suggest that if the RBA lifts the cash rate to neutral levels, house prices could fall by up to 20 per cent.

This in turn would weaken growth in consumer spending and housing investment would decline, probably sharply. The result would be at least a moderate rise in the unemployment rate, something the RBA so far thinks can be avoided.

Of course, the future could be more benign. Inflation could fall quickly, causing less pain to the economy and in markets. This would probably require a rapid resolution of supply-side shocks and, to be sure, there are some early signs that pressures in parts of supply chains are easing. But given the current geopolitical backdrop, persistent labour shortages and less efficient supply chains as globalisation is partly reversed, it would be heroic to assume that supply-side issues will just fade away as a source of inflation. Inflation could also fall quickly if the tightening of monetary policy destroys demand abruptly. Again, there are some signs that demand is cooling quickly, particularly in the US, Britain and New Zealand. Markets have jumped onto these signs to price the risk of recession. Bond yields have fallen from their recent highs and markets are pricing less tightening of monetary policy than previously and a moderate easing cycle by central banks later next year, including the RBA.

But of those expecting recession, most are of the view that this would be relatively mild and would not trigger a return to exceptional monetary policy responses. Central banks also appear willing to accept at least some pain in their economies, if that is the cost of reducing inflation. They are continuing to wind back their asset-purchase programs along with the rise in interest rates.

Either way, a shift from a world flush with liquidity, central banks buying assets, and rapidly rising asset prices seems unavoidable.

The silver lining is that this might be the catalyst for a focus back on productivity to put living standards on a surer and a more equal path.

Paul Brennan is chief economist at Suncorp.