Why house prices are continuing to fall as inflation rises in Australia

House prices are going one way just as every other price in the economy is going the other. This means that if you inflation-adjust house prices, they look even cheaper. House prices are down only about 5-10% in cash terms, but when inflation-adjusted, they are down far more — back to 2017 levels.

The next graph shows what I’m talking about. Inflation-adjusted house prices rose extremely sharply during the pandemic, pulling them out of the lull they fell into during the 2017-18 price correction. That sharp rise is being reversed again now, and if the forecasts of high inflation and falling high prices are correct, it has a way to go.

Does it make sense to inflation-adjust house prices? We often talk about inflation-adjusting wages. That makes sense because it allows us to find the buying power of wages too. We also inflation-adjust GDP, to see if it’s gone up in real (i.e. inflation-adjusted) terms or just nominal terms.

When we inflation-adjust house prices, what we’re really finding is the ratio of the price of housing to everything else in the economy. In recent years, housing has been getting more expensive than everything else.

These kinds of “exchange rates” can tell us a lot about our society. A famous example is the number of TVs we can buy with each boatload of iron ore we export, which helps explain how Australia has such a high standard of living despite not doing any real value-added manufacturing.

As RBA governor Glenn Stevens said in 2010: “Five years ago, a shipload of iron ore was worth about the same as about 2200 flat-screen television sets. Today it is worth about 22,000 flat-screen TV sets.”

Incidentally, iron ore costs less now than it did then. But so do TVs — we haven’t lost much buying power.

Relative prices are always changing. Chicken, clothing and TVs were once expensive. The number of chickens you had to forgo to get a house was once ludicrously low. You could buy a house for the price of 8000 chickens. Now it’s more than 60,000, as the next chart shows.

Same with shoes. A median house in a capital city once cost 900 pairs of women’s shoes. Now it’s 8000.

A house once cost as much as four cars, whereas now it’s 20 cars, etc, etc.

In all these cases, the cost of the consumer item has been suppressed by ever more efficient ways of manufacturing — mass production, automation, importing from places with low labour costs — while the price of land is being bid up and the price of the building on it is has a lot to do with local wages, which are rising.

In this sense, house prices are very high.

But the number of steaks you forgo when you buy a house hasn’t risen nearly so much, because beef has, like property, been soaring in price. In steak terms, housing is cheaper than it was in 2010 and has merely doubled since the 1970s.

I’d hypothesise that mortgage holders are roasting a lot more chicken than beef these days, compared with the 1970s.

Where are house prices heading?

House prices and inflation: do they usually go in opposite directions?

There’s two reasons to think they would:

1. People devote as much as they can to their house purchase. But they do need to eat. If prices of food and petrol go up, people have less left over to spend on their house. In this story, it’s the relentlessly low inflation on food, clothing, etc, that has helped drive up house prices over the past couple of decades. We can meet our basic needs with less and less of our pay, meaning there’s more to put towards the house.
2. When inflation is low, interest rates are low, and when interest rates are low, people can borrow more to buy a house.

The data tells us the opposite. As the next chart shows, historically we see that when inflation is high, house prices are rising fast too.

What’s going on here? Could the effect be delayed? If we timeshift things and see how house prices react nine months after a period of high inflation, we start to see a negative reaction.

The data shows only 3% of the variation in the change of house prices is explained by inflation nine months earlier, so it’s not a tight correlation, but there’s some effect.

The big reason inflation causes house prices to fall is that the central bank reacts. First inflation rises, then the bank hikes interest rates, then house prices fall. It’s notable that if you timeshift the correlation even further, it disappears — beyond a year after a quarter of high inflation, there’s no correlation with falling house prices. This could suggest that Australian house prices will stop falling once inflation is back under control, stabilising and then growing again.

After all, while chickens grow in battery cages and land is in fixed supply, the number of chickens you have to forgo to buy a house is unlikely to keep plummeting forever!

This article was first published by Crikey.