Executive Summary
The housing market in the UK is very volatile and has been found to have strong relations with macroeconomic indicators and monetary policy. The housing market has gone through cycles of boom and bust, which coincided with the business cycles of the economy (Ewinga & Wangb, 2005). Two such busts in the economy have been observed in 1990 housing market crash and the recent bust in 2007. In this paper, it is argued that the housing price boosts or slumps are not a source of fundamental shock to the economy; rather they are a prediction of the changes in the interest rates in short term. The two hypotheses taken in the paper are (1) a tightening of monetary policy will increase mortgage interest both in 1990 and in 2007 and will therefore reduce the number of loans given to purchase houses, and (2) tightening of the monetary policy affects the house prices, due to a fall in the household disposable income and savings. The study conducted in the paper suggests that there is a strong relationship and covariance of the housing prices with that of the consumer disposable income. Arguably, housing price boosts or slumps are not a source of fundamental shock to the economy; rather they are a prediction of the changes in the interest rates in short term, which affects consumption, creating output gap, and therefore inflation. The time period, which is compared, are 1990-1995 and 2007-2009. Time series data is collected from Office of National Statistics and Bank of England Database. The data that are studied are house price in nominal terms, base rates, mortgage rates; gross loan amount given for houses, etc. affordability index is also studied as it provides the percentage of mortgage given vis-a-vis income of the individual. The analysis was done using correlation analysis, regression analysis, and F-test.
Introduction
UK housing market has gone through two vital booms in the last 4 decades. One was in the 1980s, which led to the eventual bust in the early 1990s, and then in early 2000 until 2007 when again there was a housing market bust. The bust of 1990 was of unprecedented scale in the UK and so is that of 2007. This asks for significant attention by policymakers and academicians alike to find a relationship between business cycle and housing demand, which is reflected through the housing prices. The question that arises is that if housing prices fluctuations are caused due to macroeconomic conditions or is vice versa. The study conducted in the paper suggests that there is a strong relationship and covariance of the housing prices with that of the consumer disposable income. Arguably, housing price boosts or slumps are not a source of fundamental shock to the economy; rather they are a prediction of the changes in the interest rates in short term, which affects consumption, creating output gap, and therefore inflation. Thus, it is important to understand the transmission mechanism through which these changes occur.
Background
A great amount of changes has occurred in the monetary policy in the UK’s financial retail sector since early 1980s. The new structure of monetary market has accepted credit cards and unsecured loans in the market. Increased competition due to opening of the monetary market has increased competition, thus, making credit more available and cheaper. Thus, it is important to understand, if these monetary variables have any effect on the housing market. In the 1980s, financial deregulation led to a large availability of mortgage finance that increased the demand for housing. An increased demand evidently pushed up the real house prices, which then rose by 4.5 percent annually during the decade. In 1988, the nominal housing price increased by 28 percent. Subsequently there was a tightening of the monetary policy in late 1980, as a boom in the housing prices, pushed up inflation, and mortgage interest rates increased over 15 percent in 1990. The effect of this situation was a recession, and a bust in the housing market. There was a growth of dwelling from around 10 percent in 1914 to 66 percent in 1991 has changed the housing market dramatically in the UK (Forrest & Murie, 1994). Deregulation in the financial sector and building societies led to a change in the lending practices led to an increase in the housing prices. This resulted in the slump in the UK economy in 1990s. There was a drastic rise in the mortgage rates from 9.5 percent in 1988 to 15.4 percent in 1990.
Similarly, in 2007, due to financial crises around the world, the UK economy again has entered a recessionary phase. There has been a downfall in the housing prices after tightening of the monetary policy. This paper will compare the busts in the UK housing sector of the 1990s and 2007, compare, and contrast the same with monetary policy, household savings, and mortgage rate.
Aim and Objective
The aim of the paper is to understand the comparable and contrasting features of the busts in housing market in the UK in 1990 and 2007. For this, the period of 1990 to 1995 and 2007 to 2009 is studied. The questions that are answered through the paper are:
- Is there any link between the monetary policies of the government with the mortgage lending practices or interest rates?
- How does a change in the monetary policy affect housing prices and therefore housing demand?
- How do changes in the mortgage lending change mortgage demand and subsequently housing demand?
- Are there any comparable features in the bust of 1990 and 2007 evident from the analysis? If yes, then what are the features?
Chapter Structure
Given these questions, the paper will try to ascertain how the UK housing market behaves, due to changes in the monetary policy of the Bank of England. The paper is divided into two sections. In section 1, a brief literature review is done which shows the changes in the UK financial lending market, especially with changes in mortgage lending in 1980 and 2006, the housing market price movements, and previous research on the same. Then hypothesis is generated from the literature review. This section will also present the methodology that will be used to analyze the hypothesis. In section 2, the analysis of the data is done, in order to test the hypothesis. In this section, a general model for the housing bust of 1990 is done, which is then applied to the bust of 2007. This will help in comparing the busts in both the periods. This section will also provide the discussion and limitations of the study. The chapters’ structure for the research paper will be in the order of introduction, literature review, hypothesis, methodology, analysis, discussion, and conclusion with limitations and scope for further research.
Literature Review
The literature review discusses the co-movement of the housing market with the business cycles and the macro-movement in the economy. In the first part, previous research in the UK housing sector and the effect of macro-movements in creating a cyclical movement in the UK housing market are discussed. Then the effect of the monetary policy on the housing market is discussed. This discussion is extended into the discussion of the mortgage market, its economic effect on the housing market and how it has affected the market in the UK.
Business cycles and Housing
Business cycles comprising of booms and busts in housing market have been described in two ways by Muellbauer and Murphy (1997). They state the ways is to determine the affordability ratio by calculating the ratio of house prices and income and the other is to measure the investment return from housing. (1997, p.1704). Muellbauer and Murphy (1997) studied the prices of the second-hand houses to income ratio from 1953 to 1995. They demonstrated that housing demand in UK then was subject to transaction costs. Further, in the 1980s due to major regime change in the credit market led by the financial deregulates in 1980s made mortgage availability easier in 1980s than in the 1960s and 1970s. However, when there is credit constraint, expected future income or present income can readily determine the housing demand (Muellbauer & Murphy, 1997). Thus, Muellbauer & Murphy (1997, p.1721) found out an equation for the real house prices as an inverted housing demand function. They suggest that after the liberalization of the financial market in the 1980s, there have been shifts in several parameters like consumer spending at national and regional levels. Further the study also predicts an increase in the effect of “income growth expectations and real interest rates” in the 1980s (Muellbauer & Murphy, 1997, p.1721). Their study ultimately reveals that the main source of volatility in house prices in the UK in the 1990s was due to low house prices and income ratios. Further, they also predicted that the next upturn would dampen due to adverse factors like “unfavorable demographic trends, high levels of debt and high real after-tax interest rates” (Muellbauer & Murphy, 1997, p.1723).
Aoki, Proudman and Vlieghe (2002, p.164) state similar view has been presented by:
“Because house prices affect households’ borrowing decisions, structural changes in the market for retail financial services—such as those that have occurred in the United Kingdom over recent years—are likely to have affected this element of the transmission mechanism.”
They also have shown that the strongest relation has been found between housing prices and consumption of consumer durables. However, this change is consistent when credit channels, as consumer durable goods purchase are usually believed to be done by financial borrowing (Aoki et al., 2002). Therefore, the demand for consumer durable goods is found to be interest-sensitive. Thus, if interest rate changes are correlated with housing prices then a strong co-movement between the two can be established (Aoki et al., 2002). Therefore, business cycle and housing prices suggest a strong relationship between monetary policy, interest rates, and housing prices, in the UK.
Monetary Policy and Housing
Changes in monetary policy will have a strong effect on the housing prices and demand (Ewinga & Wangb, 2005). Research has shown that “unanticipated money supply changes as generate movements in single-family housing starts” (Ewinga & Wangb, 2005, p.188). Thus, research has suggested that unexpected tightening of the monetary policy will affect the real cost of borrowing and therefore increase housing prices. However, theory suggests that the effect of anticipated monetary policy is neutral on the housing prices. Ewinga & Wangb studied the effect of the monetary policy in housing starts from 1981 to 2001, and they concluded that housing prices fall and remain at a lower equilibrium level due to the shock from the bank rate (2005, p.189). Their study supports the theory that state that unexpected monetary policy change will affect housing prices and further added, “If there is a higher than expected fed funds rate, then fewer new houses will be started as real financing costs will have risen.” (2005, p.189)
Research has also suggested that nominal and not real interest rates affect household borrowing decisions more (Cooper & Britton, 2003). It is suggested that at 1 percent fall in interest rate of mortgage, there will be an increase of 0.6 percent consumption in the long run. This is due to the decline in return to saving and the cost of borrowing. Further, it has also been suggested that UK is more sensitive to interest rate change, which is reflected through changes in its housing prices (Cooper & Britton, 2003). In addition, the study suggests that interest sensitivity of GDP is also found higher in the UK than that in Eurozone (Cooper & Britton, 2003). Therefore, housing prices in the UK are found to be highly sensitive to changes in monetary policy, especially changes in bank rates.
Mortgage Market Effect
The relation between mortgage market and the housing prices became important in the 1970s in the UK, when there was a housing price boom (Meen, 2002). Various lines of arguments have been stated by Meen to show the effect of mortgage rates on housing prices. One such argument states that mortgage market becomes important during the time of credit rationing, as has been observed in the 1960s and 70s UK. The argument suggests that under regulatory conditions, the amount of loan available to the consumers was limited, and therefore, restricted the demand for houses. In a deregulated condition, however, the balance of power shifts towards the buyers as funds could be attainable as and when required. Therefore, interest rates were more demand-driven than supply-driven. Through this argument, it is stated that as demand for houses was low, in the 1990s, the house prices, as well as the interests, remained low. Another argument that tries to establish the linkage between house prices and mortgage rates is through negative equity effect. This, however, is rejected by Meen as an adequate explanation (2002).
Adrian Cooper (2004 ) studied the effect of change in the mortgage interest rates in the UK on housing prices. His study showed that an increase in interest rate will reduce GDP. Bringing in the effect of the housing sector, mortgage rates increase will reduce demand for houses, which will again offset GDP. Thus, Cooper showed that a decline in GDP due to increase in interest rates occurs through a direct effect of the increase in mortgage rates on housing prices.
In the UK, there has been a severe recession in the UK housing market between 1988 and 1993. The present mortgage contract in the UK is the endowment mortgage, which is a “package of a floating rate non-amortizing bullet loan, a companion endowment insurance contract and mortgage indemnity insurance” (Chinloy, 1995, p.403). This insurance makes the borrower pay fixed rate. This endowment policy is sold as a “tied sale”. The variable rate loan is payable monthly, and term is usually set for 25 years. Another component of the UK mortgage is the insurance policy, which ensures sharing the loss of the lender when default occurs. The study conducted by Chinloy shows that “Borrowers generally continue to make their mortgage payments even if they have negative equity. Both income and wealth appear to enter the household’s decision-making.” (1995, p.419) Therefore, the study reveals that the mortgage market and housing market are interlinked and the linkage is through the income, saving, and wealth effect of households and their consumption of consumer durable goods.
Methodology
Data
The required data for the study are housing prices (not seasonally adjusted) from the times series data from Office of National Statistics UK website (2010). Data related to mortgage lending are collected from Bank of England statistical dataset (2010) and Office of National Statistics (2010). The period for which the data is collected is from 1990 to 2009. The time period, which is compared, are 1990-1995 and 2007-2009. Time series data is collected from Office of National Statistics and Bank of England Database. The data that are studied are house price in nominal terms, base rates, mortgage rates; gross loan amount given for houses, etc. affordability index is also studied as it provides the percentage of mortgage given vis-a-vis income of the individual. Transaction data is not used as measure for housing demand due to the problem posed by that transactions are discounted at list value thereby creating problem of capturing the popularity of the product (Ward, 2008). However, the demand function intends to understand how much a consumer is willing to pay for a property rather than estimating the popularity.
Method
The data is analyzed using correlation analysis and regression analysis in order to understand the degree of variance in the housing prices and mortgages is determined using correlation analysis to check the variances in the two periods in the reaction of house prices to changes in mortgage rates. Further, a regression analysis is done on the house prices of the two periods in order to estimate the effect of income, mortgage rate, and bank rate on housing prices, which will in turn give the demand equation for housing. Thus, these statistical tools are used to analyze the data. The methodology that has been adopted is to correlate the data in order to understand the directional relation between house prices and the monetary policy instruments and mortgage interest rates. Further, a regression analysis is done in order to ascertain the difference in the degree of the effect of the mortgage lending rates on housing prices. The methodology has been used in previous studies conducted by many researchers (Iacoviello, 2005). Further, a linear correlation model is developed by using regression analysis on the data derived from the two periods. This will provide the degree of correlation between the two variables in the early 1990s and 2007.
Housing demand is dependent on the mortgage availability and disposable income of the household (Chinloy, 1995). Therefore, these values can mostly determine the effect of change in the housing prices. Further, to compare the effect of mortgage rate on housing prices in two periods the best method is to use correlation analysis (Iacoviello, 2005).
Muellbauer & Murphy (1997) studied booms and busts in the UK housing market. The method that was used by them will be used to a certain extent in the proposed paper. Clearly from the period of 1990 to 2009, the UK housing market has undergone a bust, then a boom, and then again a bust (figure 1). Further the methodology will be used to understand the change in mortgage rate and the change in housing affordability. The paper will ascertain if there was any change in the affordability ratio in the 1990s and that in 2007. Thus, the affordability ratio i.e. housing price to income ratio will be correlated with the mortgage to income ratio. A linear regression done on these ratios will provide a relationship between housing prices, mortgage rate, and income of the UK economy and how it differed in the two periods under study. A regression analysis is done for housing prices and all the others as variables. This analysis is done to find out the effect of mortgage rate, bank rate, base rate, disposable income, household savings ratio, consumer expenditure, and number of loans available on the house prices for the two periods. The regression will be done on these variables for the period 1990-95 shows that the housing prices will be positively affected by bank rate, and mortgage rate. Further, F-test is done on house prices and mortgage rates for both the periods. This test is useful when there is small number of observations, and the variability of two series is to be judged. This will provide the proof for the hypothesis testing.
Hypothesis
The proposed study will have a hypothesis. The hypothesis is derived from studying the general movement of the house prices along with changes in base rate and mortgage rate. Further, studying the literature review has also helped in deriving the hypothesis.
The annual data from 1990 to 2009 on mortgage rate, base rate, and housing prices are shown in the figure. The house prices are observed to be declining from 1990 through 1995. The base rate and the mortgage rate are shown to be declining too during the period. Therefore, there was a decline in the bank rate and mortgage rate from almost 15 percent to 6 percent in 1993. Similarly, the housing prices fell too.
In the period from 1995 to 2006, there was an increase in the house prices. During this period, there was a decline in the base rate and bank rate with minor increases in 1998 and 2000. Again, the base rate and mortgage rate increased from 2003 through 2007, after which they started declining. A similar trend has been observed in case of housing prices, which started to increase and reached their peak in 2007 after which they began to fall. Thus, 1990s and 2007 are the period when the housing market in the UK entered a period of slump.
The graphic correlation of house prices, base rate, and mortgage rate show that housing prices are negatively correlated to Bank of England interest rate. This implies when there is an increase in the bank rate; the credit situation in the country tightens. This makes loans dearer. As houses are usually bought by taking finances, there is a reduction in the demand for loans due to higher bank rates and mortgage rates; there is a reduced demand for houses, which pushes down prices. Thus, lending interest rates have a negative relation with house prices.
From the literature review, it is clear that a tightening of the monetary policy i.e. an increase in the interest rates will increase the mortgage rates. Monetary policy was tightened both in the 1990 recession and in 2007. In early 1980s, due to deregulation, there was excess availability of credit, which led to inflation, increased consumer spending, and demand for houses. This pushed up the prices of houses. Increases in prices of houses in turn resulted in higher inflation. In 1990, the mortgage rate reached 15 percent. In order to control inflation, bank rate was reduced, thus resulting in a tighter monetary policy. The first hypothesis is that a tightening of monetary policy will increase mortgage interest both in 1990 and in 2007 and will therefore reduce the number of loans given to purchase houses.
As monetary policy is tightened, the income of the individuals will reduce, thus affecting the disposable income and savings of the households. Thus, there will a decline in the household savings ratio. This will have an adverse effect on the demand for houses, as credit crunch in the monetary market, higher rates of interest, and lower-income will reduce demand for houses, and thus, reduce their prices. As both in 1990 and in 2007, Bank of England followed the policy of monetary tightening, it can be intuitively concluded that through this mechanism, in both the periods there is a fall in the prices of the houses. Thus, the second hypothesis is that the tightening of the monetary policy affects the house prices, due to a fall in the household disposable income and savings. Therefore, it is expected that the hypothesis will hold true in both the times periods under study.
Timeline
The research study is expected to be completed in 1 month. The brief of the timeline is provided in the following table. The table indicates the timeline required for the completion of the paper. The first three weeks will be dedicated to the study of literature. The fourth week will be used for collecting data and fourth and fifth weeks for data analysis. The sixth and seventh weeks will be used to write the report and the last week will be kept for proofreading and editing.
Reference
Anon., 2010. Bank of England. Web.
Anon., 2010. Office of National Statistics. Web.
Aoki, K., Proudman, J. & Vlieghe, G., 2002. Houses as Collateral: Has the Link between House Prices and Consumption in the U.K. Changed? In Economic Policy Review. New York, 2002. Federal Reserve Bank of New York.
Chinloy, P., 1995. Privatized Default Risk and Real Estate Recessions: The U.K. Mortgage Market. Real Estate Economics, 23(4), pp.401-20.
Cooper, A., 2004. The impact of the Interest Rates and the Housing Market on the UK economy. Economic Outlook, 28, pp.10-18.
Cooper, A. & Britton, E., 2003. The Housing Market and the monetary transmission mechanism in the UK, in and out of EMU. Economic Outlook , 23(3), pp.10-22.
Ewinga, B.T. & Wangb, Y., 2005. Single housing starts and macroeconomic activity: an application of generalized impulse response analysis. Applied Economics Letters, 12, p.187–190.
Forrest, R. & Murie, A., 1994. Home ownership in recession. Housing Studies, 9(1), pp.55-74.
Iacoviello, M., 2005. House Prices, Borrowing Constraints, and Monetary Policy in the Business Cycle. The American Economic Review, 95(3), pp.739-64.
Meen, G., 2002. Why do Mortgage Market Matter? Economic Outlook, 24(4), pp.12 – 17.
Muellbauer, J. & Murphy, A., 1997. Booms and Busts in the UK Housing Market. The Economic Journal, 107, pp.1701-27.
Ward, D., 2008. An assessment of mortgage interest inflation measurement bias in the UK. International Review of Applied Economics, 22(3), p.373–386.
Appendix
Table 4: source: bank of England, Office of National statistics