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High house prices - dwellings as assets and the effect of low interest rates!

The dominant discourse on housing is that the various facets of the housing crisis – high prices, lower home ownership etc is due to a lack of supply. But there is an alternative view about why house prices are high, promoted by Ian Mulheirn amongst others but also Simon Wren-Lewis on Mainly macro and a report in Bank Underground which examines the interaction between interest rates and asset values.

[NB. Readers using smart phones may find that font sizes are distorted. This is a feature of the phones not the text here].
 



Summary
Unlike many goods houses are also assets. This is an important factor to consider when looking at house prices and values. Asset values often increase when interest rates are low as people look for gains elsewhere. Periods of low interest rates by reducing the gains from holding money in banks results in people looking from returns from housing, pushing up prices. This is exacerbated by the lower interest rates making it easier to borrow more funds for house purchases. The impact of low interest rates on house prices has been noted in countries other than the UK.
 
Quantitative easing introduced to enable businesses to invest and households to increase spending, by reducing interest rates again makes borrowing to buy property easier hence pushing up values. When interest rates do go up as they have done over the last year borrows find they are paying significant amounts on their borrowings. More affluent households tend to gain from increases in asset values as they purchase extra property often for renting out or for leisure purposes.  For most home owners increasing values give the illusion of being better off, although in reality gains from selling are offset by the cost of buying an equivalent property.
 
Background
Commentators and politicians when discussing the housing crisis, work on the premise that high prices, the lack of affordability and the reason fewer young people can buy or rent, can be attributed to one factor – a lack of supply.  This view is held by those of differing political persuasions and by think tanks with a range of perspectives. 
 
Yet, it is a fallacy which the heading ‘Evidence and the persistence of mistaken ideas: the case of house prices’ used by Simon Wren-Lewis in his Mainly Macro blog neatly sums up.  To cite Paul Krugman’s concept of zombie theories, arguing against the lack of supply assertion, is like  “arguing with zombies” those “ideas that should have been killed by contrary evidence, but instead keep shambling along, eating people’s brains.
 
A good explanation of why house prices are so high is from Paul Claireaux on Twitter. In essence if central banks keep interest rates close to zero, which is what has happened, then people look for gains elsewhere. With very low interest rates, borrowing to buy property goes up and pushes up house prices.
When interest rates go up then the cost to borrowers is far higher as the amounts borrowed have increased substantially. Obviously this is a problem!
Look at the link below for the full details.
 
In 2019, Lewis and Cummings in related reports looked at the interplay between interest rates and asset prices. Using tulip bulbs as an example they state - “Economic theory says asset prices should be determined by the value of future income flows. So how much is a bulb that produces £100 of tulips annually worth? If real interest rates on other assets are say 10%, then people would be willing to pay £1,000 for the bulb to get the same return. If they fall to 5%, the value of that same stream of flowers doubles to £2,000. Supply hasn’t changed, the price of tulips hasn’t changed either, but bulb prices have doubled.”  They say “that same logic should apply to house prices. In the face of falling global real interest rates, this means rising property prices. ….But the direction is consistent with the rise in house prices seen in many countries over the past two decades.” They conclude that “The model says that relative scarcity of housing has played almost no role at the national level since 2000, though it has pushed in opposite directions in different regions.”
 [Lewis, J., and Cumming, F., 05 September 2019, Houses are assets not goods: What the difference between bulbs and flowers tells us about the housing market, Bank Underground, Bank of England].  
 
In a later report under the Bank Underground auspices, Miles and Munro estimate the factors underlying changes in house prices, suggesting that low interest rates and rising incomes where the major ones. . “…Between 1985 and 2018… we estimate that the long-run effect of the decline in the risk-free rate increased real house prices by about 108%; the increase in household income increased house prices by around 80%; whilst the increased net tax obligations pushed house prices down by around 15%..
 [Miles, D., and Monro, V., 13 January 2020, ‘ What’s been driving long-run house price growth in the UK?’, Bank Underground.
 
More recently the Bank of England has stated “Regardless of the permanence or otherwise of the shift in preferences induced by the pandemic, housing prices will continue to be influenced by macro-economic fundamentals like long-term interest rates and wage growth.” [BoE, 2022]
 
Research from other countries
Research from other countries has also revealed links between cheap credit and house prices. “As a follow up study on the Australian housing market drivers and consistent with the findings in (Wong et al., 2020), the housing market performance was unfazed by the traditional drivers such as the nation’s unemployment rate whilst the emerging determinants such as capital liquidity continue to uplift the Australian housing market since 2020.”  [Wong et al], 2022]. 
 
An IMF report in 2016 highlighted the role of low interest with low mortgage rates in pushing up house prices in Canada. “Low mortgage rates are an important factor feeding the housing market boom. This has helped keep interest payments low even as the size of the average mortgage has risen. As the figure shows, the share of interest payments in households’ disposable income has declined from 9 percent in 2008 to 6 percent in 2015, while the average size of mortgages has increased by some 40 percent over the same period. This means more households are able to afford more expensive homes, which, in turn, prompts households to borrow more money and get further into debt, while house prices continue to be pushed upward.”
 [Cheng Hoon Lim, March 21, 2016, Monetary Policy and Financial Stability: Canada's House-Price Dilemma, International Monetary Fund].
 
Quantitative easing (QE) and interest rates
Richard Werner an economist is credited with the defining and developing QE. “In 1995, he advanced the concept of ‘quantitative easing’ in Japan (defined as an expansion in credit creation, published in the leading daily newspaper, the Nikkei, on 2 September 1995).” https://professorwerner.org/
 
One response of the Bank of England to the Great Financial Crisis (GFC), was to use to make use of QE.  Designed to boost spending and investment by lowering interest rates, the policy was intended to maintain and boost economic activity.  Research carried out since then has looked at the effects of QE, in particular its role in boosting asset prices – including houses.
 
One of the main channels through which ultra-loose monetary policies affect income and wealth distribution is changes in asset prices. First, lower central bank interest rates reduce the interest rates on other securities (such as government and corporate bonds) and increase their prices. Second, asset purchases result in a further fall in yields and an increase in their prices.
 
Furthermore, the policy has also had the effect of inflating asset prices artificially, and this has benefited those who own them disproportionately, exacerbating wealth inequalities.”  [European Parliament, 15 June 2015, ECB Quantitative Easing (QE): What are the side effects? Monetary Dialogue, Compilation of notes, Directorate General for Internal Policies, Policy Department a: Economic and Scientific Policy.]
 

Others have highlighted the part played by the purchase of second homes arising from cheaper money. “Empirically, we also provide direct evidence at the household level that, following QE, wealthier households rebalance their portfolios toward housing and raise consumption more.  The household portfolio rebalancing that we document is stronger when we focus on purchases of second homes, consistent with a buy-to-let motive.” [Boddin., D., te Kaat, M.D., Chang Ma, Rebucci, A., 10 March 2022, A Household Housing Portfolio Channel of QE Transmission, European Central Bank.]

 
Does the asset and interest rate hypothesis answer all the questions?
No, although it does appear to account for much of the increase in house value and as the Miles and Munro paper indicates, increases in earnings are also a factor. 
 
Walker in 2023 noted that “… house price changes have varied substantially across the UK, even though interest rates do not. There has been a quintupling in prices since 2000 in parts of London, and less than half that in parts of Northern England and Scotland.” He stated that “For other policymakers, this evidence points to the importance of housing supply in influencing the level and volatility of house prices.”
 [Walker, D., 27 June 2023, How house prices respond to interest rates depends on where they are in the country, Bank Underground].
 
It should be noted that the areas with the highest increases in prices are also those where earnings are higher which is probably a factor.
 
Conclusion
The asset value theory adds an additional and interesting dimension to the housing debate and it would suggest that it is a major contributor to changes in house values and prices. Other factors will influence price changes particularly at the local level.

Background information
The reasoning behind the theory is incredibly simple. Houses are an asset. Like any asset, its price depends on the return from holding them (in the case of housing rents) and the rate of interest. The demand and supply for housing services (i.e. a roof over your head) determines rents rather than house prices. Imagine choosing between investing in housing or in government debt (more specifically a perpetuity, so you never get the money back but the interest pays forever), Interest rates on government debt are 2%, so on every £100 K you invest in government debt, you get 2K a year in interest. Suppose the (net of costs) rent on every £100K of house was 2K a year. Then you are indifferent to whether you own either asset.
 
Now suppose interest rates fall to 1%, but rents stay the same. Everyone wants to become a landlord, and people with money to invest buy houses to rent, because before interest rates rose you are getting double the return you were getting on debt. With perfect arbitrage this will carry on happening until houses that used to be worth 100K are now worth 200K, so that the return to housing again equals the return to holding debt = 1%. House prices have doubled, but the demand and supply of housing services has remained unchanged. The suggestion is that this is the process behind rising house prices in the UK
[Wren-Lewis, S., 21 January 2020, Evidence and the persistence of mistaken ideas: the case of house prices. Mainly Macro].
 
Similarly, (in the market sector) people can obtain housing services in one of two ways: purchase the asset and consume the services yourself (be an owner occupier) or just buy the housing services in the spot market (be a renter) from someone who owns the asset (a landlord).
 
Economic theory says asset prices should be determined by the value of future income flows. So how much is a bulb that produces £100 of tulips annually worth? If real interest rates on other assets are say 10%, then people would be willing to pay £1,000 for the bulb to get the same return. If they fall to 5%, the value of that same stream of flowers doubles to £2,000. Supply hasn’t changed, the price of tulips hasn’t changed either, but bulb prices have doubled.
 
As Simon Wren-LewisThe Economistand others have noted, that same logic should apply to house prices. In the face of falling global real interest rates, this means rising property prices. That doesn’t tell us whether prices are over or undervalued in any specific place because there are many other factors to be analysed. But the direction is consistent with the rise in house prices seen in many countries over the past two decades.”
 [Lewis, J., and Cumming, F., 05 September 2019, Houses are assets not goods: What the difference between bulbs and flowers tells us about the housing market, Bank Underground, Bank of England.]  
 
QE is one of two tools we can use to change interest rates. The other is Bank Rate, which historically has been our most important tool. We first began using QE in March 2009 in response to the Global Financial Crisis. At that time Bank Rate was already very low. In fact, it couldn’t be lowered any further at that point. So we needed another way to lower interest rates, encourage spending in the economy, and meet our inflation target. QE involves us buying bonds to push up their prices and bring down long-term interest rates. In turn, that increases how much people spend overall which puts upward pressure on the prices of goods and services.”
 
 
“Second, the value of an asset is influenced by the net present value of the stream of income from this asset. In the case of housing, this income can either be rental income or the implicit income from using the house (in the case of owner-occupied housing). If the discount rate falls (as implied by lower official interest rates), then the net present value of a home rises. Looser monetary policy thus, ceteris paribus, raises real estate prices. This rise in housing prices can affect household consumption in various ways. First, it can entail that households feel richer and can take out an additional mortgage on their house, to finance other expenditures. In this case, we observe a positive wealth effect. Conversely, rising house prices can also imply that for instance young households need to spend a higher fraction of the disposable income on housing, leaving less for other consumption (see e.g. OECD, 2021). In this case, there would be a negative income effect from rising house prices. Whether the positive or negative wealth and income effects prevail, depends on the fraction of homeowners versus tenants and demographic factors. If, for instance homeowners benefiting from wealth increases have a lower propensity to consume than those just buying a home, the net effect on aggregate consumption will likely be negative.
 
Similarly, rising rents (which are the likely consequence, with some lag and to a certain extent, depending on countries’ institutional and legal frameworks, of higher house prices) will benefit landlords, while tenants will have less of their income left for other consumption. Assuming that renters are wealthier and have a lower propensity to consume than tenants, then a rise in house prices and rents will on aggregate dampen consumption for non-housing goods. A very similar argument applies to households which take out a loan to finance their homes: higher house prices imply the need for a bigger loan, implying lower disposable household income after loan servicing. Thus, the wealth and income effects from residential price swings also imply substantial redistributive effects across individuals and demographic groups.”(see e.g. OECD, 2021).
[Organisation for Economic Co-operation and Development, June 25, 2021 Monetary policy and housing markets: interactions and side effects.]
  
One of the main channels through which ultra-loose monetary policies affect income and wealth distribution is changes in asset prices. First, lower central bank interest rates reduce the interest rates on other securities (such as government and corporate bonds) and increase their prices. Second, asset purchases result in a further fall in yields and an increase in their prices.”
 [European Parliament, 15 June 2015, ECB Quantitative Easing (QE): What are the side effects? Monetary Dialogue, Compilation of notes, Directorate General for Internal Policies, Policy Department a: Economic and Scientific Policy.]
 
Furthermore, the policy has also had the effect of inflating asset prices artificially, and this has benefited those who own them disproportionately, exacerbating wealth inequalities.”
 [House of Lords, Economic Affairs Committee, 1st Report of Session 2021–22, 16 July 2021, HL Paper 42, Quantitative easing: a dangerous addiction?]
 
 “With the absence of foreign investors due to the border closures since the beginning of the pandemic, this study uncovered that the population growth has exerted its positive influence on the housing market whilst the increase in housing supply did not result in the expected reduction in price indicating that the housing demand far exceeded housing supply in Australia. Among the expansionary measures, RBA undertook the historical first QE measure in Australia to probe up the much-needed market financing liquidity. As a follow up study on the Australian housing market drivers and consistent with the findings in (Wong et al., 2020), the housing market performance was unfazed by the traditional drivers such as the nation’s unemployment rate whilst the emerging determinants such as capital liquidity continue to uplift the Australian housing market since 2020."
 [Peng Yew Wong, Woon-Weng Wong, Kingsley Tetteh Baako and Kwabena Mintah, 2020, Quantitative easing and the Australian housing market RMIT University.]
  
References
 
Boddin., D.,Marcel te Kaat, D., Chang Ma, Rebucci, A., 10 March 2022, A Household Housing Portfolio Channel of QE Transmission, European Central Bank.
 
 
Dieckelmann, D., Hempell, H.S., Jarmulska, B., Lang, JH., Rusnák., M.,No 2789,  February 2023. Working Paper Series, House prices and ultra-low interest rates: exploring the non-linear nexus.  European Central Bank.
 
European Parliament, 15 June 2015, ECB Quantitative Easing (QE): What are the side effects? Monetary Dialogue, Compilation of notes, Directorate General for Internal Policies, Policy Department a: Economic and Scientific Policy.
 
House of Lords, Economic Affairs Committee, 1st Report of Session 2021–22, 16 July 2021, HL Paper 42, Quantitative easing: a dangerous addiction?
 
International Monetary Fund, Cheng Hoon Lim, March 21, 2016, Monetary Policy and Financial Stability: Canada's House-Price Dilemma.
 
Lewis, J.,and Cumming, F., 06 September 2019, Houses are assets not goods: taking the theory to the UK data, Bank Underground , Bank of England.
 
Miles, D., and Monro, V., 13 January 2020, ‘ What’s been driving long-run house price growth in the UK?’ Bank Underground Financial Stability.
 
Mulheirn, I., 9 Jan 2020, ‘On The Bank of England’s shifting stance on house prices has big implications, What happens if the music stops?’
 
Organisation for Economic Co-operation and Development, June 25, 2021 Monetary policy and housing markets: interactions and side effects.
 
Peng Yew Wong, Woon-Weng Wong, Kingsley Tetteh Baako and Kwabena Mintah, 2022, Quantitative easing and the Australian housing market RMIT University.
 
te Kaat.,DM, Chang Ma, Rebucci,., February 9, 2021, Real Effects of the ECB’s Quantitative Easing: A Housing Portfolio Channel, European Central Bank.
Walker, D., 27 June 2023, How house prices respond to interest rates depends on where they are in the country, Bank Underground.
 
 
Wren-Lewis, S., 21 January 2020, Mainly Macro, ‘Evidence and the persistence of mistaken ideas: the case of house prices'. https://mainlymacro.blogspot.com/2020/01/evidence-and-persistence-of-mistaken.html
 
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