What is the risk of instability from the housing market?
The strong overall performance has been driven by a buoyant services sector and domestic demand, while net exports and the manufacturing sector have been a drag on activity, reflecting both the sharp appreciation of the exchange rate between 1996 and 1998 and the weakening of activity in Continental Europe in recent years. In sharp contrast to the euro area, consumption, which has been boosted by terms of trade gains and more recently by wealth effects associated with sharply rising house prices, remained vigorous throughout. Indeed, private consumption has been the prime driver of growth. Yet, the propensity of house prices to surge in response to lower interest rates, which contributed to the resilience of the UK economy, may also become a source of fragility in the context of an inelastic housing supply and rapid build-up in household debt, increasing the risk of setbacks in the ongoing recovery. The OECD projects growth of 2¾ and 3 per cent in 2004 and 2005, respectively, underpinned by a recovery in foreign trade and the further rapid rise in public spending. Despite the assumption of a gradual decline in house price inflation, private consumption is likely to remain strong. Given the increased importance of mortgage equity withdrawal in driving consumption, a potential risk is that house prices surge ahead again in the short run instead of slowing down, but then fall abruptly which could trigger a sharp reduction in consumption growth. However, the situation is different from the late 1980s because of low household income gearing with high housing wealth in relation to income. In addition, there is now greater scope for monetary policy to react, particularly because inflation currently remains under control.
Correlation between real house price growth and consumption
1970 - 2002
1. Real house prices are measured as the house price series from the Office of the Deputy Prime Minister deflated by the private consumption deflator.
Source: Office of the Deputy Prime Minister and OECD.
Should monetary policy be tightened?
Despite this increasing risk to macroeconomic stability, but in line with the current consensus among central banks, the Monetary Policy Committee of the Bank of England has repeatedly rejected the idea that monetary policy should explicitly respond to changes in asset prices, except insofar as they affect future inflationary pressures. Nevertheless, they raised the repo rate for the first time in nearly four years in November 2003 on the grounds that inflation is likely to pick up in the context of a vigorous recovery. The labour market is already tight with the unemployment rate near its structural rate and the wage share at a high level which in the past has signalled a pick-up in inflation. Gradually raising interest rates further would reduce the risk of a larger and more abrupt tightening later on, and hence reduce the risk of triggering instability in the housing market and the wider economy.
What supply-side measures could be recommended?
Beyond an early tightening of monetary policy, policy measures should focus on the supply side of the housing market. Reforms of the planning system which improve the supply of housing would be welcome, not only because a more elastic supply would tend to moderate swings in house prices, but also because increased housing supply and associated lower prices would be highly desirable from a wider economic and social perspective. The planning issue has implications for the efficiency of the housing and retail sectors and a variety of services sectors as well as capital accumulation, which in international comparison suffers from a low rate of investment in structures. The government is doing more, including through new legislation, to ensure that local authorities meet objectives for house building. However, given the inevitable lags before there is an appreciable effect of such policies on the housing stock, other measures acting on the demand side should also be considered, not least because reducing swings in house prices could itself be an important factor in encouraging housing supply. On the fiscal side the most promising option is to reform the “council tax” to relate it more closely to current valuations of property. The government is due to revalue properties for the purposes of the council tax by 2007, but revaluations should then be updated more regularly. At the same time it should be made less regressive. More regular updating would also imply that rising real house prices would generate higher taxes and so tend to automatically damp the stimulus to consumption and reduce the risk of macroeconomic instability. The advent of statutory regulation of mortgage markets by the Financial Services Authority in 2004 is also to be welcomed. There is a need, in particular, to ensure that prudent lending requirements are not relaxed during a boom in house prices.
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