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The relationship between interest rates and housing pricesIntroductionAt times of economic uncertainty or prosperity the prices of houses will always be discussed. It is an aspect to which we draw comparisons and are inherently fascinated with looking at house prices with interest and curiosity. Many experts theorise as to why prices of houses fluctuate and this paper attempts to explore some of those theories and whether interest rates have any bearing on the price of houses and if so, to what extent.
This is an appropriate moment to conduct this study amid experiencing the first increase of interest rates for more than 10 years by the Bank of England. As such, it is a valid time to review the effects interest rates have on house pricing and the implications of such findings. This study will ask if we can utilise this information to predict the changes in house prices or use this in our own investment strategies. Furthermore, demonstrating the underlying economic theories of how interest rate changes impact the demand for housing and the consequent changes in house pricings and considers the wider macroeconomic implications this may have.The purchase of houses and subsequent mortgages constitute the bulk of bank transactions, these are necessary for these banks to function and thrive.
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Banks that are actively loaning and encouraging consumer spending is positive for the economy, thus a decrease in house prices may be explained by a reduction in demand and hence a smaller number of mortgage loans being processed. This may potentially have negative implications on the economy and GDP.
This study will compare the changes in house prices with changes in interest rate in the UK from 1975. The findings will explore whether there is any impact on house prices with regards to the interest rate changes, considering the potential reasoning and its implications. This study conducts a literature review critically reviewing the relevant research, leading to the specific research question. Followed by the data and methodology section, setting out the logic behind the data used, describing the trends and characteristics. A critical analysis section of results follows, and a completion of an empirical analysis on the data using OLS regressions ran in EViews. Finally considering the overall significance of the findings and the central issues, alongside the corresponding implications. Literature ReviewA wealth of studies exists conducting similar investigations comparing house prices variations with interest rates. Shi, Jou and Tripe (2014), state real interest rates are significantly and positively related to real housing prices. This raises important questions around the effectiveness of interest rates as a means of restraining sharply rising house prices, or more generally, how strong the impact of interest rates is on house prices. For example, Taylor (2007,2009) similarly argued low interest rates contributed to boom and bust cycles in the USA, explaining how house price increases fluctuate as rates change. However, others like Glaeser et al (2010) remain sceptical and argue about the extent of this correlation, finding decreases in interest rates only explained a mere 20% of the increase in real house prices. Additionally, research found a semi-elasticity of housing prices with respect to real rates (Himmelberg, Mayer, Sinai 2005), suggesting a 100-basis point change in real rates should be associated with roughly a 20 percent increase in price, which relates to the views of Glaeser et al. This study will investigate this correlation and look to determine whether this figure is correct and if it can be deemed significant. An expansion of those findings is shown by research from Campbell and Shiller (1988) who suggest the relationship is further complicated by mortgage borrowers' hedging activities in choosing between fixed and floating rate loans, in anticipation of rate changes movements. Changes in the relationship might be expected in response to extreme shocks as found by Bjornland and Jacobsen (2010). They claim Norwegian, Swedish and British house prices reacted immediately and strongly to monetary policy shock. Whilst this demonstrates a clear relationship between the variables, in contrast this paper will look at changes over a wider period of time as opposed to restricted event study windows. Considerable academic and policy work has focused on the role of interest rates and other credit market conditions in the boom-bust cycle. One common explanation for the boom is easily available credit, perhaps caused by a global savings glut. This leads to low real interest rates that substantially boosted housing demand and prices (e.g. Himmelberg, Mayer and Sinai 2005). Others suggests that easy credit market terms, including low down payments and high mortgage approval rates, allow people to act at once and helped generate large, coordinated swings in housing markets, (Khandani, Lo, and Merton 2009). The underlying macro-economic theory of this study has been supported by numerous studies assessing the wider impact of house prices on the economy. Muellbauer (2018), for instance states falling house prices increase bad loans and lower financial firm's capital, raising risk spreads in credit markets and impairs the banks ability to extend credit. This relays further on residential investment and household spending, increasing unemployment and reducing GDP, and further reducing demand for housing and the capital of financial firms, (Muellbauer 2018).Wider economic implications of this study suggest monetary policy changes have side effects on financial stability and believes historical evidence supports this. A study by Jordia et al. (2015b) show that expansionary monetary policy has historically coincided with substantial increases in mortgage lending and house prices. Using simulation of the U.S. housing market, Khandani et al (2013), found the declining interest rates and growth of refinancing business contributed significantly to the recent housing boom and the massive defaults during the bust. Furthermore, Favilukis et al (2017) argues most housing price appreciation can be explained by relaxation of credit constraints. Yet in contrast, Glaeser et al (2010) present evidence supporting the view that easy credit in the form of low real interest rates and permissive mortgage approval standards is not a strong contributor to the rising house prices. It is worth investigating the significance of this impact which is what this study will attempt to discover. Some argue that the correlation runs in the opposite direction. Goodhart (1995) found that property prices significantly affect credit growth in the UK and Hofmann (2004) also argued that property prices are important in determining long-run borrowing capacity in the private sector. Goodhart and Hoffman (2008) followed up by finding evidence of a Pan-European multidirectional link between house prices and monetary variables, with the correlations being stronger in recent years (1985-2006). Findings such as these appear to imply that in examining the relationship between interest rates and house prices in this paper require consideration of alternative monetary related variables (All Tse, Rodgers, Niklewski 2013).The research suggests changes in house prices have wide spread implications. In this study we will clearly look to see whether changes in interest rate affect house prices, and what wider implications this may have.Data and methodologyThis study will focus on monetary policy, thus, base interest rates in the UK were used as a point of comparison for the changes in house prices. These rates are the fundamental determinant of loans and mortgages, changes of these tend to have consequent impacts on all other loan rates, including mortgages. Data was collected from the Bank of England website using a sample consisting of 44 observations of interest rates from 1975 to 2018. The same number of observations and time frame is used for the independent variable; the average annual house prices in the UK. This study uses the real house prices, i.e. figures that are adjusted for inflation, allowing more appropriate conclusions to be drawn from the data. The real house prices were obtained from the HM Land Registry. The strength of this data is that they are from reliable, trusted sources therefore should be accurate and free of bias. Also, the house prices are adjusted for inflation which allows an appropriate insight into the changes and correlations. Base interest rates allow for one point of comparison which affect the lending rates. A weakness of the data source however is that the variables can change throughout the year, for consistency annual averages were taken. This data will be used to determine whether there is a statistically significant relationship between house prices and interest rates by conducting a regression analysis. The dependent variable would be house prices and the independent variable being interest rates. A limitation of this method is the lack of other variables and reducing the effect of house prices to just one factor. As a result, there stands a possibility of having a large error term in the regression. This may suggest that a large amount of the change in the dependent variable will be unexplained by the regression itself, unless the correlation is significant.
Interest Rates & Housing Prices in Economic Uncertainty. (2019, Aug 20). Retrieved from https://studymoose.com/the-relationship-between-interest-rates-and-housing-pricesintroductionat-times-of-economic-uncertainty-essay
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