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5 Jul 2022 4:17
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  •   Home > News > Business > Features

    Are House Prices Setting a Trap?

    History indicates that you cannot have a steep increase in the price of oil without slowing the economy. So far, however, there has been no sign that high prices are constraining spending in other areas.

    Investment Research Group
    Investment Research Group
    US economist John Makin in a recent report has explained the reason for this. He says oil prices are being offset by the wealth effect of a robust real estate sector. "House price increases have accelerated in 2005, enabling homeowners to continue to draw equity out of real estate and therefore to boost discretionary spending despite more costly energy."

    "The two opposing forces operating on US growth have enabled gains in gross domestic product to be sustained even as energy prices rise further, thereby fostering the notion that US growth is impervious to higher energy prices. Yet, that notion is tenuously based on a US housing bubble."

    He also casts his eyes to the UK housing sector and we should assume that what has happened there in the past 18 months is likely to be repeated everywhere else, including New Zealand, one day. House prices have been booming for years and between November 2003 and August 2004 the Bank of England boosted interest rates several times. At first, there was no response from the housing sector. Housing prices continued to rise and observers suggested that a mere 125-basis-point increase was not sufficient to slow the housing boom.

    After about a year, however, when short-term fixed rate mortgages were renewed, the market for rental properties, particularly apartments, weakened. The increase in UK. home prices cooled from the 25% annual rate in 2004 to nearly a zero increase so far in 2005. Almost immediately, retail sales fell sharply so that, by the first quarter of 2005, household spending was also growing at a rate close to zero.

    Consequently, economic growth dropped sharply and sterling began to weaken. Meanwhile, the Reserve Bank in this country and the Federal Reserve in the US have been aggressive about pushing up rates. "The ability of rate increases of that magnitude to slow the rate of increase of housing prices is not in question," Makin believes.

    Scarily, he concludes that housing can become a drag on growth even if house prices are not falling. When rental yields are low, people do not hold investment properties if they cannot get capital gains. Therefore, the market quickly turns from a housing shortage to a glut.

    "Once the desired stock of housing falls below the existing stock, construction activity ceases and the rush of speculators to purchase more real estate switches to a desire to sell. If the process is orderly, housing price inflation just falls toward zero. If it is disorderly, house prices collapse as panicky speculators, unable to service their mortgages because of falling rents and less ability to obtain loans, start dumping properties."

    Reserve banks tend to signal rate increases until they observe a marked slowdown in housing. "The chance that the Fed will overtighten and induce an actual drop in housing prices is present, although it is not as likely as an outcome whereby housing prices simply level off. Were housing prices to fall sharply, it would be very likely that a US recession would follow," he points out.”

    What happens in major economies overseas inevitably will echo in New Zealand. This suggests it may be prudent to consider a more defensive personal response that includes reducing debt and planning for all scenarios before investing in property.

    © 2022 David McEwen, NZCity

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