Interest rates and population growth lead to extreme property price swings

Falling interest rates, a rising population and demand for better-quality homes are some of the main reasons for the large swings in home prices across New Zealand, according to a new paper.

The discussion paper from the Reserve Bank of New Zealand – Housing Quality Improvement, Property Market Dynamics, and Sustainable House Prices, found the unique nature of housing markets makes them prone to periods of temporarily high price surges followed by price declines.

The research suggests the demand for better quality housing – which cannot be quickly met from new supply – is a major reason for unsustainable house prices and a reason why house price cycles are often so different from price cycles in other industries.

Paper author Andrew Coleman said interest rate movement plays a significant role in property price movements.

“Lower interest rates cause a large number of people to demand better-quality houses, all at once, resulting in a price increase,” Mr Coleman said.

“As the construction industry adjusts by building more high-quality houses, the price surge ends and prices can fall as the supply of housing slowly increases.  

“The slow pace of change in housing supply means that price rises caused by demand for quality are ultimately unsustainable – the supply response, building new and better houses, cause the price increase to come to an end, and then decline.”

The paper also found that the demand for new housing comes from three main areas: an increase in the number of new households, the need to replace old housing and an increase in the desire for higher-quality housing due to income or interest rate changes.

When demand for better quality housing increases rapidly, it exacerbates construction sector capacity constraints and supply restrictions, leading to unsustainably high prices.

Interest rates play a key role in determining property prices and can be temporarily raised to prevent cyclical backwardation.

Mr Coleman said property prices could be said to be “cyclically backward” or cyclically unsustainable when capacity constraints in the property construction and development industry lead to temporarily high house prices and temporarily high construction costs

“These prices eventually fall back to normal levels when the demand for better quality housing is satiated, and at this point of the cycle construction activity subsides to usual levels,” he said. 

“These episodes are to some extent amenable to central bank policy interventions such as higher interest rates, as high interest rates reduce the extent to which high prices are needed to mitigate demand pressures.”

Mr Coleman said that the huge population growth that has occurred in New Zealand over the last few decades has been a key contributor to the ongoing demand and the fact that home prices have risen by more than most other developed countries.

The paper also said that periods of high or low prices can cause welfare losses, destabilise price expectations and increase the risk of financial crises and recessions. 

Mr Coleman said the effect of interest rates on land prices is complex and depends on factors such as land regulations and the ease of developing new land.

While rapid inward migration and inadequate construction sector capacity can exacerbate periods of cyclical backwardation he said.

“The declines in global interest rates over the last two decades are likely to have been a factor in booming housing markets around the world, and in New Zealand,” Mr Coleman said.

“While higher interest rates can slow down housing market activity and reduce the size of house price and building cycles, central banks need to take into account much wider considerations than just the housing market – such as the inflation rate and employment – when setting local interest rates.”

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Rowan Crosby

Rowan Crosby is a freelance journalist specialising in finance and real estate.