The Reserve Bank is walking a precarious tight-rope with interest rates. The economy is weak and cutting interest rates would seem to be a good way to boost economic activity. But with interest rates already at record lows and housing prices and housing debt already at record highs, further cuts may only serve to create a housing bubble that is in danger of bursting and destroying our economy with it.



All suggestions are that the Reserve Bank will cut rates again. The market is so sure that rates will be cut that it is actually pricing in 2 cuts – all the way down to 1.75% by October. This belief has actually become stronger since the Reserve Bank left rates on hold on 3 March:



There’s always a bit of warning though when looking at market predictions. One of my favourite graphs compares the market’s expectation of interest rates last year with this year. 12 months ago, the market was anticipating that by August 2015 interest rates would be at 3%, now they think they’ll be half that:

So the market can get it wrong, but whereas last year the mistake was to assume the economy would improve, this time the economy would have to improve for it to be wrong – and the signs don’t suggest that is going to happen.

In March, the department of employment’s leading indicator of employment (which takes into account job advertisements, consumer sentiment, and industry outlook such as the purchasing managers’ index for manufacturing output in China) fell for the 6th month in row:

So the economy is not exactly going gangbusters and yet the dilemma for the RBA is the worry that the housing market is already too hot. Thus the problem is that while a further cut (or two) of interest rates might help the economy, it will also further blow up a housing bubble.

The RBA has indicated it is also worried about this. In its latest Financial Stability Review released a couple of weeks ago, it devoted a separate section to “Responses to risks in the housing and mortgage markets.”

The section noted that last December the Australian Prudential and Regulation Authority (APRA) informed banks and authorised lending institutions that assessments of prospective loans “should include an interest rate buffer of at least two percentage points above the standard variable rate... with a floor assessment rate of at least 7%”.

This is to ensure that people who take out a loan at the current rate of around 5.6% could still afford it if rates rose 2 percentage points. Give it was only three years ago that mortgage rates were that high, it’s not an unreasonable assumption.

The APRA also suggested that banks be mindful of “strong growth in lending to property investors”. It suggested that investor credit growth “materially above a threshold of 10% will be an important risk indicator” that could lead to THE APRA considering “further action”.

In the latest RBA data, the investor credit growth in the past 12 months hit 10.1%:

That growth, while well below the 25% plus growth that occurred during the 1990s and early 2000s, is still sizeable enough within an otherwise weak economy to suggest that property values are growing at a bubble rate – faster than the underlying economic conditions would suggest they should be.

Such has been the growth in investor activity in the housing market that now, for the first time ever, the value of investor housing loans is greater than that of new loans for owner-occupiers:

And the surge in such loans since November 2011 – when the RBA began cutting interest rates – looks unlikely to be able to be sustained.

There are signs that the ever-growing rise in house prices may be about to come to an end when you look at the growth in the number and value of owner-occupier home loans since November 2011:

For around 18 months, the number and value of the loans grew at around the same rate. But from July 2013 onwards, the value began to outstrip the actual growth of number of loans. And since February last year, the number of mortgages has been decreasing.

There were 5% fewer owner-occupier mortgages taken out in January 2015 than there were 12 months earlier. Given the growth in number of mortgages and their value is generally in sync, it’s not surprising that in the past 12 months the value of owner-occupier mortgages grew by just 0.3% – the lowest since May 2012.

So it would appear owner-occupiers are already struggling to keep up with the growth in investor housing driven market.

The RBA noted that strong investor demand can “amplify the housing price cycle” and cause prices to rise faster than they would otherwise, and that this “increases the risk that prices later fall significantly.”

One concern the RBA has is that the low interest rates and fast rising housing prices will lead to an over-supply in certain areas, and this will inevitably lead to a (perhaps dramatic) fall in prices.

It noted this risk was greatest in “inner-city Melbourne, where the level of high-rise apartment construction has been elevated for a number of years”.

But even if housing price rises in the past year appear to have come off the boil slightly, there are worries about the record level of housing debt:

Total housing debt in 2014 reached a record high 140.3% of disposable income, and owner-occupier housing debt hit 92.2% – also a record.

And while the growth of housing debt is nowhere near the absurd levels of the early 2000s, in the past two years the ratio of debt has risen on average by 4.2 percentage points – well above the average annual rise of 2.2 percentage points observed over the near quarter of a century from 1977 to 2000.

And whereas the growth in the ratio of total housing debt rose last year, for owner-occupiers it slowed.

It’s tough to believe house prices can keep going up while the rest of the economy stays weak. And owner-occupiers already seem to be easing back on their home buying.

But further cuts to rates in an effort to boost the economy will keep investors buying and keep prices going up. Unless there is also economic growth, the conditions for a property price bubble will become even stronger.