It's well-established that when house prices rise, homeowners spend more because they feel wealthier.
What is less clear is how changes in house prices affect the consumption of different groups of homeowners according to their particular circumstances.
It's this analysis that UNSW Business School researchers Konark Saxena and Peng Wang reveal in
How do house prices affect consumption? The role of income volatility, housing wealth share, and age.
"House prices have grown strongly in the past few years," notes Saxena, a senior lecturer in the school of banking and finance at UNSW Business School.
"Now they're stable and there's a potential for them to decline. We know this will affect the economy as a whole: it affects expenditure, employment, it affects GDP. We know less about how a decline will differentially affect groups of Australian households."
The study comes after a period of unprecedented house price growth in Australia's capital cities, with the median house price in Sydney now topping $1 million by some measures.
The researchers drew on the federal government's Household, Income and Labour Dynamics in Australia (HILDA) survey dataset, which follows individuals over a period of years and contains detailed spending records and other household characteristics, such as income, homeownership, tenure and mortgage.
While they found that, on average across the economy, each $100 increase in house prices would lead to an extra spending on non-durable goods of 40c per household, there were stark variances in how different groups reacted.
'In other words, their precautionary savings motivation goes down a bit because now they have a more valuable house to borrow against'
– KONARK SAXENA
To look at young homeowners (aged 20 to 40), the researchers divided them into two groups – those with high income volatility and those with low income volatility.
Those with high income volatility, such as the self-employed or people with less stable jobs, were much more price sensitive. For each $100 rise in the price of their house, they would spend an extra $5.10 on non-durable goods.
By contrast, young homeowners with low income volatility would change their spending by just 45c for each $100 change in house prices.
The researchers suggest that those with high income volatility use their equity in their house as a hedge against the possibility of lower income. When house prices rise, they are more confident about increasing their spending.
"In other words, their precautionary savings motivation goes down a bit because now they have a more valuable house to borrow against," Saxena explains.
But if house prices fall, their capacity to draw on extra credit is diminished, so they rein in their spending.
Older homeowners (aged 60 and over) also increase their spending when house prices rise, but for different reasons.
"Older people have enough housing. If anything, they're going to downsize their house – unless they plan to give it as inheritance. They typically don't plan to buy a house in the future or they're less likely to buy a house in the future compared with the young and middle-aged," Saxena says, explaining that the main consideration for them is their overall wealth.
"When their wealth increases because house prices increase, then they consume more."
The wealth effect
Older people generally don't have mortgages or variable incomes, so changes in house prices mostly contribute to changes in their overall wealth, not their capacity to borrow or repay.
This is known as the wealth effect when it leads to a change in consumption.
If an older person plans to sell their home and downsize to a cheaper one, they would realise some of the gains in the price of their present house. However, this only partially explains why the wealth effect works.
Saxena and his colleagues discovered that the wealth effect also applied to those older homeowners who were not planning to downsize and tap into their home equity.
Another important consideration for how older people (and in fact younger people, too) increase their spending in response to rising house prices is how much extra income or cash they actually have to spend.
Put simply, if they don't have the spare money, they can't increase their spending, regardless of how much house prices go up.
'Will a substantial drop in house prices hit economic activity directly in the housing sector?'
– RIC SIMES
While both the young and old increase their spending as house prices rise, they spend on slightly different things.
According to the research, the young with high income volatility spend most of their increased housing wealth on meals eaten out, groceries, clothing and alcohol. The unconstrained older homeowners with high housing wealth share tend to spend on groceries, phones, internet, petrol and diesel, and repairs.
Middle-aged homeowners (aged 40 to 60) appear the least sensitive to house price changes. They enjoy less of the wealth effect than older homeowners because any increase in value of their present house value is offset by the increase in value of the larger house they are more likely to purchase during their relatively longer lives ahead.
They are also less motivated by a change in collateral value than younger homeowners, because most by this stage in life have accumulated enough wealth to overcome borrowing constraints.
The consumption of some middle-aged homeowners is negatively correlated with house prices – so when house prices rise, their spending falls.
This is the group with low liquid assets, and the researchers suggest that these homeowners might want to buy larger, more expensive houses, perhaps to accommodate growing families. When house prices rise, upsizing becomes more expensive, so they save more and spend less.
A rational link?
Ric Simes, a senior advisor to Deloitte Access Economics, agrees that changes in house prices can have some effect on spending, but he says this will depend on the extent to which changes are perceived to be permanent rather than short-term fluctuations.
He also notes there isn't necessarily a purely rational link between house prices and spending, with psychological effects also proving important.
Simes says there are two channels by which house prices can affect the economy. The first is via the wealth effect, which the researchers focused on, and the second is directly via the housing market.
The second is more the reduction in housing activity that would result from a fall in prices.
"That's the biggest concern here. Will a substantial drop in house prices hit economic activity directly in the housing sector? And, at the same time, if you start to see that happening with the risk of unemployment going up and all the rest of the consumption is going to fall, you have a bit of a cycle," Simes says.
The Reserve Bank of Australia is concerned about the high level of house prices, because householders have taken on an increasing amount of debt to buy expensive homes.
Even if house prices fell sharply, the effect would not be uniform across the economy. The researchers point out that even in such a scenario, various groups of households would respond differently.
While older homeowners with high housing wealth shares may be adversely affected by falling house prices, it may be an opportunity for young renters to buy their first homes.
In addition to understanding the consequences on the 'average household', it is prudent to discuss and quantify the redistribution consequences of any policy aimed at influencing house prices, they add.
"Our paper takes a step in this direction by identifying relevant groupings of households and quantifying differences in house price sensitivity across these groups" says Saxena.