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What’s driving UK house prices?



By Simon Nixon

The UK is going through one of its regular bouts of hysteria over house prices. Prices have risen 10% nationally in the last year and 17% in London. As I explain in my Europe File column for Monday’s WSJ, this is now dominating the debate over the direction of UK monetary policy. Bank of England Governor Mark Carney believes he can use the central bank’s new so-called macroprudential powers to address directly any signs of an emerging bubble in house prices, thereby enabling the Monetary Policy Committee to keep interest rates low for longer, in line with the latest version of its forward guidance.

In my column, I given three reasons why I think this is likely to be a bad idea. First, there’s limited evidence that there is in fact a housing price bubble; second, there’s no evidence of a risk to financial stability, which is what macroprudential powers are supposed to address; and third, there’s plenty of evidence to suggest that macroprudential tools are likely to have limited impact. I think a number of BOE policymakers share this analysis, so Mr. Carney may struggle to get his way, although the in-built majority of BOE internals on both relevant committees may guarantee a degree of groupthink.

At the core of this debate is an argument over what is driving the house price rises. At the moment, it doesn’t appear to be driven by excessive credit: there is little evidence of significant loosening in underwriting standards, which are anyway subject to tough new regulatory rules requiring banks to take rigorous affordability checks–including assessing the impact of sharp interest rate rises–before extending new mortgages. Banks will also be subjected later this year to a severe stress test of their mortgage books based on a scenario that includes a 35% fall in house prices and higher interest rates.

House prices in London rose 17% last year.
Another popular explanation for rising house prices is that they are driven by a lack of supply. On the face of it, this looks more plausible. In the year to March 2014, the UK produced only 134,000 new units; an oft-cited 2004 study by former MPC member Kate Barker concluded that to keep up with the rate of household formation and thereby keep house prices stable, the UK would need to build 260,000 units a year; the average since then has been 115,000. Mr. Carney is fond of pointing out that his native Canada last year built twice as many houses, despite having only half the population.

But there’s a problem with this argument: as Fathom Consulting points out, “the evidence for a housing shortage is evident everywhere but the data”. The economics consultancy notes that the number of houses in the UK rose by 0.6% in 2012, which is exactly the same as the rise in the population. Indeed, Fathom reckons that on a per-capita basis the quantity of housing in the UK has been stable for the past 15 years. It also argues that if there was a real shortage of housing in the UK, one would expect to see rents rising rapidly in real terms. But they’re not: in the year to the end of March 2014, rents rose by just 2.2%, according to the Office for National Statistics. In fact, Fathom reckons that rents have fallen over the past decade relative to income per capita, again suggesting no problems with supply.

This suggests that the overwhelming reason for soaring house prices in London–remember that in most of the UK, they’re barely rising at all–is ultra-low interest rates which have cut the cost and increased the availability of mortgage finance. Of course, this means that the overall stock of private sector debt is likely to rise as bigger loans are required to buy the same homes.  But that doesn’t mean lending is certain to get out of control: the UK has roughly £2.7 trillion ($4.5 trillion) of housing equity, much of it concentrated in households where there is either no or very little debt, reckons Alastair Ryan of Bank of America Merrill Lynch. Some of this equity is sure to be recycled to help fund deposits for new entrants–the so-called Bank of Mum and Dad–to keep mortgage debts down. This may raise difficult distributional issues for politicians to address but these don’t fall within the remit of a central bank.

If the BOE is worried that rising house prices pose a risk to monetary or financial stability then the only effective solution is likely to be to raise interest rates. Policymakers acknowledge that even a small rate hike now would be unlikely to disrupt the economy. After all, UK consumers paid £42 billion in interest costs in 2013, equivalent to 2.7% of GDP, down from £69 billion or 4.75% of GDP in 2007 when the economy was booming. The argument against raising rates is simply that with inflation and inflationary pressures apparently low due to slack in the economy, higher rates would lead to slightly lower growth and higher unemployment–or under-employment–than was necessary to hit the MPC’s mandate. But that needs to be set against the risk that by leaving rates too low for too long, larger rate hikes will be needed in the future, causing more violent shocks. That debate is now finely balanced.

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