House prices are not only a key indicator of what is happening in an economy but they can also be a trigger for a change in economic conditions. Hence the state of the housing market comes under close scrutiny by the Reserve Bank and other Government officials. There is a very close link between house prices and inflation.
This is understandable when you consider that the cost of a mortgage or rent is often the single biggest expense in a household budget.
The Consumer Price Index (CPI) measures the changing price of a fixed ‘basket’ of goods and services purchased by households of which a weighting of around 13% is given to rent and house purchase costs. Any change in these costs therefore has a significant effect on inflation, which is measured by the CPI.
As house prices go up, there can be other impacts. For existing home owners, there is what is referred to as a ‘wealth effect’. The increase in house values makes people feel wealthier which can cause them to borrow and spend more, thus adding to inflationary pressures.
For first home owners, house price increases mean larger mortgages, with the risk that mortgage repayments may become unaffordable, especially as interest rates often rise along with house prices.
If home buyers struggling with mortgages quit their homes in sufficient numbers, this can trigger a sudden drop in house prices and a downward spiral in which homes are sold at a loss. Such an event in the USA was a key trigger for the Global Financial Crisis.
As the Reserve Bank of New Zealand continues to increase interest rates while maintaining its restrictions on low-deposit loans, it will be interesting to see what impact this has on the housing market. First home buyers should proceed with caution.