How much do house prices matter? Many claim there is only a modest link with the rest of the economy. Earlier this decade, when house prices were rising rapidly, there was also a surge in remortgaging. But the Bank of England used to say that most of the money taken out from mortgage top-ups was spent on the home – extensions, for example, or on buying other assets, and did not create higher consumer spending, and was, therefore, sustainable,
It was all rather convenient, because it gave the Bank an excuse not to take into account house price inflation when setting the rate of interest.
Earlier this week, we received a comment on our blog making a similar observation.
If this view is right, then falls in house prices would not necessarily lead to a recession.
This has become a key issue. Others argue that the single biggest factor that created the credit crunch was the refusal by central banks to do anything to check rising house prices. As a result, they say, asset prices spiralled and an unsustainable bubble was created. They conclude: the unwinding of this bubble in the US is the true cause of all the woe doing the rounds at the moment.
Alan Greenspan, on the other hand, decided against taking into account asset prices because, he argued, it was not possible to tell whether the price changes were based on solid foundations or were unsustainable.
So who is right? Do rising house prices lead to higher consumer spending, and then higher long-term inflation? Should central banks set interest rates accordingly? Or were they right in the first place, and should they carry on ignoring house prices?
It does seem a little unlikely that there is only a modest link between house prices and consumer expenditure. Sure, many homeowners might be paragons of responsibility, and ensure sure they never spend the extra wealth they accumulate via their homes on holidays, eating out, or LCD TVs. But, economic growth is often determined by the actions of individuals on the margin.
If some individuals have funded their spending by releasing equity in their home, then these individuals will now be suffering – and their fall from fortune alone could have a disastrous knock-on effect.
In recent years property possession levels have remained quite modest – some suggest this illustrates the strength of the economy, but equally, these low possession levels may have simply been down to the ability of individuals struggling to make ends meet to top-up mortgages. In short, people struggling to make payments could just borrow more. And when house prices went up again, borrow yet again.
What is clear is that savings in the UK have been low for some time, while consumption has been high. Money saved for the future – pension payments in particular, has been modest.
But, as the Halifax constantly reminds us, our net wealth, thanks to rising house prices, has been increasing. Therefore, concludes the Halifax, the low savings rate has been sustainable.
But you can’t have it both ways. You can’t on one hand say there is no correlation between consumer spending and high prices, and then say, in any case it doesn’t matter that consumer spending is high, because house prices have been going up.
It also seems likely that many homeowners, and buy-to-let investors in particular, see their property, or properties, as their pension.
In the UK in particular, property investment is seen by many as the safest form of investment, so who needs money stashed away in a pension policy, invested in high risk equities, when instead you can invest in bricks and mortar, and get leverage on your investment to boot?
But this is a dangerous mindset. When the baby boomers retire and try to release the equity tied up in their properties, the result could be a surge in demand which can not be met by supply. Inflation could be the result.
Spending is only sustainable if it can be met by output, and for this to occur we need to invest our money into sectors that create wealth.
Now the IMF has taken a look at this controversial area in its latest World Economic Outlook report.
“We find that the effects of monetary policy changes on output are larger in those economies where housing finance markets are relatively more developed and competitive,” said the IMF.
As for its recommendation: “We conclude that economies with more developed mortgage markets could become more economically stable by pursuing a monetary policy approach that responds to house price movements.”
The IMF report added, “Paying attention to house price developments does not require changing the existing monetary policy approaches. Rather, these approaches should be interpreted in a more flexible manner, for example, by extending the time horizon over which inflation and output are returned to target.”
In other words, rising house prices lead to higher consumer inflation in the longer-term, so if central banks are told to target inflation over an extended time frame, they will automatically take into account house prices.
The IMF also found the highest correlation between house price growth and consumer spending was in countries where access to mortgage credit is easiest. Interestingly, in seventh place, the UK sits quite a long way down the list of countries which enjoy the easiest access to mortgage credit. The US tops the list, followed by Denmark, Netherlands, Australia, Sweden, Norway and then the UK.
This would suggest then that the UK is less reliant on house prices than other economies. But, then again, house prices have risen faster in the UK. So while it might be marginally harder to raise mortgage debt in the UK, house prices are so much higher that, in absolute terms, mortgage debt in the UK is relatively high. In fact, mortgage debt as a percentage of GDP is only higher in the Netherlands and Denmark.
