Things seem to be ticking along OK for the property market – but could it be the calm before the storm.

Now before you throw your arms up thinking that this article is cashing in on gratuitous doom and gloom let me say au contraire.

I don’t want to talk the market down anymore than the next bloke especially given that there have been some positive signs of late, but it is becoming very hard to ignore what might be a gathering storm, in the form of accelerating inflation and rising interest rates.

A high inflation, high interest rate environment, it goes without saying, spells no good for borrowers in the short term. What are the risks?

Come, whilst we take a walk down Economics Lane, and you will see that lurking behind every corner are undesirables.

Full employment and accelerating wages growth

Australia’s jobless rate was 5% in February which, some speculate, is about as low as the unemployment rate can get without causing serious side affects.

You see, a jobless rate of less than 5% is regarded by many as full employment or in other words – an employees market. To get technical – this triggers the Non-Accelerating Inflation rate of Unemployment (NAIRU) .

Given that employees have a strong bargaining platform at 5 per cent UE or lower it puts pressure on wages, which then feeds back into the economy in the form of price inflation. We can see the impacts already with annualised wages growth getting close to 4 per cent.

Rigid labour market with falling productivity

It is good for the economy to create extra capacity by becoming more efficient. That is we should strive to be able to create more goods and services over time whilst using the same amount of effort.

Ross Gittins (who writes for this publisher) reminds us – ‘Australia’s productivity performance has deteriorated dramatically, with the broadest measure of productivity getting worse over the past five years.’

This all means two things in the main. Firstly, that the falling productivity of the nation will contribute to already restrictive capacity constraints and secondly that rising input costs by producers will flow through into costs of goods and services.

Reduced immigration and skills shortages

One last thing on labour markets, this is a property blog after all. Australia’s population growth has slowed to a growth rate of just 1.57 per cent. This is the slowest growth rate in 4 years which is a shame because we need more workers.

Heather Ridout, CEO of Australian Investment Group says that the lack of skilled employees would be ‘the number one danger to Australia’s economic growth.’

This means that the competition for scarce skilled workers such as IT, mining and health professionals will begin to hurt reliant industries and will create undesirable second order effects.

Petrol pain

Guess how much petrol prices were at the start of the decade. $1.20? $1.10? try 70 cents. Today petrol prices are double that, at or around $1.50.

With trouble in the middle-east building there seems little relief in sight. Unfortunate, because increased fuel prices flow through to just about the base cost of all goods and services.

If you don’t think that soaring petrol prices make a difference think again. In 2007 and through to early 2008 (the last time petrol prices hit $1.50) property sections were full of articles about repossessions.

The property markets of Western Sydney at this time were a blood-bath. Soaring petrol prices do practically the same job as soaring interest rates.

The rising Aussie Dollar

There are other factors which I don’t have space to go into fully – like a commodity price boom which has been inflationary in the past and the inflation of our main trading partners.

So let’s take a moment to give thanks to the Aussie dollar which has, up until this point, kept our inflation pressures in check. Buying over $1.04 US cents, at the time of writing this, you would have to think that the little Aussie dollar is close to becoming capped out against the green-back even though some say it has a few more cents to go.

The only way is down for the Aussie against the green-back in the medium term. The natural conclusion must be that this will put pressure on the prices of imported goods sooner or later.

Floods and Carbon Tax

Natural disasters like the Queensland floods need a re-building effort. This clean-up and re-build will create a short term stimulus and lift consumption and therefore, the competition for resources. Take also into account the loss of stock and crops leading to supply shortages in the agricultural sector.

Throw into all of this a carbon tax which will only increase the value of goods and services as it rolls out. Its really difficult to see how inflation can do anything else except raise its ugly head.

Good News

On the bright side for borrowers, inflation also deflates away the real value of your debt. This means that your mortgage feels lighter after a period of high inflation providing that your income keeps up.

It also means that rents increase and eventually, as the dust settles on mortgage rates, the value of property gets back to relativity. Maybe it’s a case of no pain no gain.

Inflation will almost certainly translate to interest rates increases and dampen demand in the property industry but by how much and how quickly?

Don’t you think fixing interest rates is the smart choice for borrowers these days?

Should buyers be cautious about spending well within their limits to buffer against the spectre of higher rates?

Posted by The Age on 5th April, 2011