Monday February 27, 2006 - 11:41:35 GMT
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Economics Weekly: UK house prices could boom, leading to higher interest ratesEconomics Weekly: UK house prices could boom, leading to higher interest rates
The MPC is worried that housing market strength increases the threat of inflation
In the minutes of the February meeting of the UK Monetary Policy Committee (MPC) one of the most significant sentences was, â€˜â€¦concern that a reduction in interest rates at this stage would provide further support to the housing market and consumption at a time when gdp growth was already strengthening â€¦.â€™ This effectively put an end to any chance of a cut in interest rates in the next few months and possibly throughout 2006. This is not to say that a fall in house prices or a sharp slowdown in economic growth would not lead to lower interest rates but this is not what the data are currently suggesting is the most likely outcome. In fact, our analysis of the link between housing approvals and house price inflation suggests that interest rates may rise later in the year. We explore some of the issues in this weekâ€™s briefing.
Housing market is recovering strongly
The UK housing market has made a perhaps startling recovery to some in the past year. Worries that after rising strongly for a number of yearâ€™s house prices would collapse and plunge the economy into recession through negative effects on consumer spending proved to be unfounded. There was a slowdown in consumer spending in 2005, but only enough to slow economic growth to a little under its 40-year annual average rate of 2.25%. (UK economic growth in 2005 was 1.8%, down from 3.2% in 2004.)
Chart a shows that the UK housing market is showing signs of a strong recovery. By this we do not just mean house prices, but the value of mortgage lending and transactions - the number of houses changing hands â€“ as well. The value of mortgage approvals is up by 60% from its low point a year ago. The same is true of mortgage approvals, which leads the value of mortgages by about three months.
What does this mean for monetary policy?
Since this would depend on what these increases mean for house prices, we need to see if there is a link between house price inflation and mortgage approvals. Chart b suggests that there is indeed a powerful connection between these variables, with mortgage approvals leading the change in annual house price inflation by seven months. The correlation between the two variables is, at 0.9, nearly one for one. A test of the extent to which house price inflation is impacted by changes in mortgage approvals suggests that a 1% sustained rise in the number of mortgage approvals raises annual house price inflation by 1.6% above where it otherwise would have been in seven monthsâ€™ time, see chart c.
Sustained increases in mortgage approvals have a powerful effect on house prices
This is a very powerful effect but one that is vindicated by the long history of the relationship between the two series, see chart b. But in our opinion it is not so much that mortgage approvals are driving house prices but rather that they are both being driven by other factors. Chart d shows that one of these other factors is interest rates. Interest rates are clearly reflecting the cost of funding a mortgage. And mortgage interest rates track base rates, with a premium to reflect demand and carry costs. Chart d shows that both interest rates have fallen dramatically in the period since the 1980s.
But there have been two episodes of a sharp decline in interest rates during the last 25 years: in the early 1990s and in early 2000. Both of these cut the cost of mortgage borrowing dramatically, increasing demand for housing and so house prices. Of course, there are other factors that have to be taken into account as well, such as employment, unemployment, real increases in personal disposable incomes and price inflation. However, all of these factors have been favourable in the last decade and are captured to some extent by interest rates. The fall in interest rates, which is a sign of low sustained price inflation, has allowed stable, steady economic growth. The latter has in turn led to low unemployment and high employment and solid real household income gains.
A strong housing market could mean higher interest rates
Chart c shows that interest rates lead house price inflation and suggests that a rise or fall in the former can have a big effect on the latter, which may be even more the case when price inflation is as low as it is at the moment. This may be why the majority on the MPC feared that a small fall in interest rates could boost house prices. In fact, as the economy is already recovering with interest rates at 4.5%, the risk is that house prices could accelerate further as the economy continues to recover if interest rates are not raised. This is what our estimates of the link between mortgage approvals and house prices suggest (see chart c); that annual house price inflation will accelerate into the 8 to 9% range in the spring, if the usual relationship with mortgage approvals holds. Hence, our view is that interest rates are unlikely to be cut and may have to be raised later in 2006, if housing market activity continues to strengthen. The MPC worry that this firmness could feed into faster consumer spending, which in turn could generate quicker economic growth (rapidly eroding the limited spare capacity that is currently available in the MPC's view) and greater inflation pressure.
Trevor Williams, Chief Economist
Lloyds TSB Bank,
London EC3R 8BQ
0207 283 - 1000
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