As UK house prices continue to head sharply higher, Bank of England governor Mark Carney thinks they represent the biggest danger to the economic recovery in Britain. They certainly pose a stern test for a new set of measures designed to help the financial sector absorb the ensuing risks.
These so-called macro-prudential instruments announced last month by the UK’s central bank seek to limit the quantity of risk in bank portfolios and put the brakes on lending to riskier households. This regime does not seem unduly restrictive at a time of extraordinarily loose monetary policy, and Carney’s hope will be that it can gently deflate the bubble before it bursts.
The enduring topic of house prices dominates discussion about the UK business cycle. Indeed, one of the most important policy debates during the long economic expansion from 1992 to 2008 was about the importance of house prices. How did they affect economic activity, and should house price movements directly influence interest rates?
One influential idea was that rising house prices did not impact on the overall level of household net wealth at all. Any increase in the net wealth positions of those who owned housing was balanced by those who did not. If this proposition was right, then we need not worry about house prices, per se, when deciding monetary policy.
That was the theory anyway. In practice, house price inflation continued to have a significant role in explaining future household consumption growth which was something of a puzzle to many economists. To some extent the puzzle could be resolved if we consider that house prices might simply, as with all asset prices, be forward-looking. That would mean they contain useful information about the present assessment of future household income; an important variable to follow in order to forecast demand.
So providing the evolution of aggregate demand was being correctly thought about, we could safely put house prices in the box titled: “not for monetary policy purposes”.
The sudden stop in economic and financial activity in the aftermath of the collapse of Lehman Brothers in September 2008 provided further evidence that house prices and economic activity seem to move in lock step. It did indeed seem that house prices told us something important about households’ income expectations, their confidence and about the availability of lending within the banking system.
In fact, the escalation in house prices during the long expansion was also telling us about important structural changes in the economy. First, single earner households became twin incomes in the main and this would tend to raise house prices for a given stock of housing. Second, low and stable inflation significantly reduced the costs of repayments in the early years of a mortgage when typically household income is more stretched. And third, seemingly ever-lower global interest rates could significantly push up the prices of safe assets, such as housing, that were in short supply.
Even if the escalation in house prices did not matter for overall demand, the sheer scale of lending relative to income put the economy at risk. Households discovered that interest rates paid on borrowing would be much lower if they could offer housing equity as collateral. So it became easier to smooth household consumption in the face of income shocks if that household was a homeowner. A heightened tendency towards home ownership was then coupled with the rise of a new buy-to-let class of landlord and skewed bank lending towards the property sector. This made both the banking sector and household balance sheets vulnerable to any shocks that might cause house prices to fall rapidly.
The resulting problem for policy makers was not so much how to control aggregate demand in the face of escalating house prices, but how to manage the risks in the tail should there be large-scale defaults. They also needed to protect against the development of negative equity and perhaps an unacceptable level of risk held by an overcapitalised and illiquid banking system.
The answer was to try to develop these macro-prudential instruments, which would be designed to constrain financing by the banks and limit the tail risks faced by the UK economy. New global banking rules – which essentially increased the requirements for capital, leverage and liquidity – can be viewed as minimum requirements that must be observed all the time. The macro-prudential instruments, by contrast, can be altered by The Bank of England’s Financial Policy Committee (FPC) over the business cycle to cope with issues as they emerge.
And so, against a backdrop of increasing signs of a robust recovery and extraordinary accommodative monetary policy, we have started to observe large increases in house prices. The Office for National Statistics estimates that UK house prices have increased by 9.9% in the year to April 2014, as compared with a CPI (consumer price index) inflation rate of 1.5%. Many observers have identified these large increases as posing an emergent threat to the sustainability of the current UK recovery. The International Monetary Fund stated:
A steady increase in the size of new mortgages compared with borrower incomes suggests that households are gradually becoming more vulnerable to income and interest rate shocks … more policy action is warranted.
And so, just in time perhaps, the Bank of England announced those first interventions to prevent the build-up of housing related imbalances. The committee recommended that no more than 15% of a lender’s total number of new mortgages should be at or greater than four and a half times borrowers’ income and that an affordability test should assess whether borrowers could afford their mortgages if interest rates were three percentage points higher. These constraints do not bite particularly at present but probably do much to change the post-crisis perception that banks cannot be relied upon to judge accurately the risks that may arise to society from the their lending policies.
The first noises from the experts seem to be positive. The Centre for Macroeconomics’ July survey of leading UK economists focused on UK housing market dynamics and on the appropriate policy response to changes in house prices deemed to pose a threat to financial stability. The responses suggest economists are broadly supportive of the use of macroprudential policies to counter this threat. Carney and the FPC will be hoping they are at least an important move in the right direction just as the risks start to loom large.