How the housing market and changes in house prices affects the rest of the economy, including how the housing market affects economic growth, inflation, interest rates and the banking sector.
Wealth Effect.
A rise in house prices creates an increase in wealth for householders. As a consequence of this increase in house prices, householders will generally:
- Be more confident about spending and borrowing on credit cards.
- Equity Withdrawal. A rise in house prices enables homeowners to take out a bigger mortgage. Banks can lend more on the basis of increased wealth. Households could use this bigger loan to spend on other items. This can create a significant increase in consumer spending. For example, in 2006, with rising house prices, equity withdrawal added an extra £14bn to consumer spending. In 2008, with falling house prices, equity withdrawal was -£7bn
Importance of Housing
- Housing is the biggest component of most household’s wealth. Therefore it has a big impact on the economy. The UK has one of the highest rates of property ownership in the UK. in 2006, it was roughly 77% compared to 50% in France. However, in recent years, the % of first time buyers owning a house has declined because it has been more difficult to get a mortgage. Home-ownership rates have declined to 72%, meaning the importance of the house prices is slightly reduced.
Effect on Economic Growth (Real GDP)
- If house prices rise, then the wealth effect is likely to cause an increase in consumer spending. This will cause higher Aggregate Demand (AD) and is likely to cause an increase in Real GDP, and a higher rate of economic growth.
Multiplier Effect
If there is an increase in Aggregate Demand from rising house prices, there may also be a multiplier effect which causes the increase in Aggregate Demand to be bigger than the initial effect.
How A House Price Crash Affects the Economy
When there is a fall in house prices, there tends to be a negative wealth effect, and a negative impact on economic growth.
- Because households see a fall in house prices, their main form of wealth declines, this reduces their confidence to spend. They are more likely to devote a higher % of their income to trying to pay off their mortgage early.
- Falling house prices causes more to be trapped in negative equity (when house is worth less than outstanding mortgage). This causes a fall in spending, and precludes opportunity for equity withdrawal.
Examples of Falling House Prices
In the 1990 house prices crash, there was a sharp fall in consumer spending and this caused the recession of 1991-92. Falling house prices wasn’t the only factor (high interest rates and high value of Sterling) was also important. But, falling house prices was definitely a factor.
In 2008, falling house prices also occurred at same time as deepest recession since 1930s. Again, there were many other reasons for the recession, but falling house prices was bad news for both consumers and banks.
Inflation
- If the economy is close to full capacity and already growing strongly, then a rise in consumer spending due to rising house prices could contribute to inflationary pressures. For example, in the late 1980s, the rise in UK house prices and consequent boom in spending was a key factor in causing inflation of 10% by 1989.
- However, in the house price boom of 2000-2007, inflation remained relatively muted, and close to the government’s inflation target.
Impact on Interest Rates
- An increase in house prices will cause an increase in the cost of mortgages and therefore will lead to an increase in the RPI. Also the increase in AD could cause demand pull inflation, However again it does depend upon the slope of the AS curve and other factors in the economy.
- The Monetary Policy Committee of the Bank of England is responsible for setting interest rates. The MPC are committed to keeping inflation within the government’s target of CPI 2% +/-1.
- If they felt, rising house prices was causing inflation to go above the target, then as a result they may decide to increase interest rates. Higher interest rates will reduce the rate of economic growth and moderate inflationary pressure.
- However, note, the MPC are very unlikely to increase interest rates just because house prices are rising at a rapid rate. The MPC primarily consider headline inflation and economic growth. They can’t use interest rates just to target moderate house price growth. For example, in 2000-2007, there was a housing boom, but the MPC didn’t change interest rates because they were focused on inflation and economic growth.
- House prices are only one factor affecting monetary policy
Housing Prices and Banking Sector
House prices have a habit of changing the lending practises of banks. When house prices are rising rapidly, banks see an improvement in the value of their assets. They feel more confident in increasing bank lending and reducing their reserve ratio. The long housing boom of 1995-2007, was one factor that encouraged bank lending to increase. Some former building societies like Northern Rock and Bradford & Bingley were so keen to lend, they were borrowing money on money markets to lend more mortgages. This bank lending proved unsustainable when the credit crunch hit.
- It should how a boom in house prices (asset) can distort economic behaviour especially in the financial markets.
Geographical Inequality
- High House prices could cause some workers to be unable to afford to but houses. High property values has caused a shortage of workers in London and the South East.
- Increased Supply of Houses: With High house prices there is a greater incentive to build new houses. Therefore house-building firms will do well.
Related
Useful article on how the housing market affects the UK economy.