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Inflation and the Housing Cycle

Strong conditions in the housing market over the past year or so have exerted upward pressure on inflation. This is in contrast to a general easing in domestic inflationary pressures, associated with spare capacity in product and labour markets. Stronger demand for new and established housing affects inflation directly and indirectly:

Direct effects: housing components represent about one-fifth of the total CPI basket, and around one-third of non-tradable items. Housing components include the cost of owner-occupied housing and rents, as well as other housing-related costs. Importantly, the cost of owner-occupied housing is measured as the price of a newly built dwelling, excluding the value of the land, so it is related to price pressures in the new housing market. That is, the price of established dwellings has no direct influence on CPI inflation.1

Indirect effects: demand for a wide range of goods and services included in the CPI might be affected indirectly by conditions in both the new and established housing markets. In terms of the direct effects, housing inflation has picked up over the past two years, to be around its average over the inflation-targeting period. In contrast, the other components of non-tradable inflation have generally slowed over the past two years. Non-tradable inflation overall is below its inflation-targeting average. RBA Bulletin

Strong growth in dwelling investment is likely to continue, as evidenced by the high level of building approvals and strength in other forward-looking indicators. Conditions in the established housing market also remain strong. Housing price growth has slowed from the rapid pace of late last year, but is still quite high in Sydney and Melbourne. While growth of housing credit for owner-occupiers is only a little above that of income, investor credit continues to grow at a noticeably faster rate.

Household consumption appears to be growing moderately, reflecting the opposing forces of slow growth in incomes on the one hand and very low interest rates and strong increases in wealth on the other. Consumption is expected to continue growing a little faster than income, which implies a further gradual decline in the saving ratio.

Conditions in the labour market remain subdued. On revised estimates, the unemployment rate has risen a little over the past six months. Employment has grown by about 1 per cent over the year which is somewhat slower than population growth. The cash rate has been unchanged at its current low level for over a year and interest rates paid by borrowers have declined slightly over this period. The very low levels of interest rates are having the sorts of effects normally expected on the economy, contributing to a pick-up in the growth of non-mining activity via strong growth in dwelling investment and providing support to growth in household expenditure more generally. Also, the conditions are in place for stronger growth in non-mining business investment. Despite the recent depreciation of the exchange rate, the Australian dollar remains above most estimates of its fundamental value, particularly given the further declines in key commodity prices over the course of this year. As a result, the exchange rate is offering less assistance than would normally be expected in achieving balanced growth in the economy.

The very accommodative monetary policy settings will continue to provide support to demand and help growth to strengthen, in time. Meanwhile, inflation is expected to be consistent with the 2–3 per cent target over the next two years. Given that assessment, the Board’s judgement at its recent meetings has been that monetary policy is appropriately configured to foster sustainable growth in demand and inflation outcomes consistent with the target. On present indications, the most prudent course is likely to be a period of stability in interest rates.RBA Statement on Monetary Policy-November 2014

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