Rising UK house prices

The impact of three decades of decline in the risk free real interest rate

The big rise in UK house prices relative to incomes between 1985 and 2018 can be more than accounted for by the substantial decline in real risk-free interest rates over the period. This is slightly offset by net increases in home ownership costs from higher rates of tax.

These are the findings of a new research report by David Miles of Imperial College London and Victoria Monro of the Bank of England. Their analysis predicts that a 1% sustained increase in index-linked gilt yields from current rates could ultimately result in a fall in real house prices of around 20%.

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This study presents evidence connecting the decline in the real yield on index-linked gilts, as a proxy for the risk-free rate, to rising UK house prices and falling rental yields over the long term.

The conclusions are stark – since 1985, the observed decline in index-linked gilt yields and other changes in the cost of home ownership are associated with an increase in house prices of around 90%; income rises account for about a further rise of 80% – between them these factors account for all of the observed rise in UK house prices.

This does not mean that other factors are unimportant for short-run fluctuations in prices; the equilibrium conditions explored here provide an explanation for the long-run trajectory in house prices. Over shorter horizons house prices will be driven by other factors – such as movements in mortgage availability, shifts in uncertainty and the ups and down of the business cycle. But over the longer term, one can account for all of the rise in house prices relative to incomes as being due to persistent declines in real interest rates.

Today, global yields on inflation-proof government bonds are at a historical low. In the UK, the 10 year index-linked gilt yield at the end of 2019 was -2.4%. Were the 35-year trend to reverse, and gilt yields to rise rather than fall, this research indicates that there would be a very substantial long-term consequence for real house prices. The results suggest that a 1% change in real interest rates that was persistent could move real house prices by around 20% across many years.

This calculation illustrates the sensitivity of house prices to changes in interest rates. But it does not suggest that house prices are likely to move lower. That would only be reasonable if a reversal of the 35-year downwards trend in safe real interest rates seemed likely. But measures of real interest rates in the UK and other developed countries show little sign of mean revision.

The authors also note that forward rates consistently move in line with spot rates implying that the bond markets’ best estimate of yields in the future has generally been the current rate. That is consistent with a random walk model of real yields and not with mean reversion. Nor do explanations of the current low level of real interest rates – be they based on the secular stagnation hypothesis or a savings glut story – give much reason to anticipate a reversion to higher real rates.

There are factors beyond rising real interest rates that could bring house prices in the UK down. But the calculations described here – which show the overwhelming importance of falling interest rates in driving up house values – suggest that the effects might be relatively small. Even a doubling in the supply elasticity in the UK would have had a relatively small impact on house price rises over the past 35 years. Only an implausibly large rise in house building could change the stock of housing enough to unwind more than a small part of the rise in values over the past few decades.

What has happened in the UK – and to a lesser extent in other countries – is ultimately not such a mystery. The value of a long lived real asset that generates a flow of services over many decades and whose aggregate supply is slow moving is likely to be driven up dramatically if the real discount rate used to value those future benefits declines dramatically. The bad news is that this rise in price does not reflect a rise in the intrinsic benefits generated by the housing stock.

It has significant consequences for policy-makers: for those concerned with financial stability, it may be reassuring that this evidence does not point to a bubble, but it does indicate that high levels of mortgage debt to incomes may be here to stay (at least in the medium term).

House price rises also create large intergenerational shifts in wealth. Ultimately most of the rise in value will flow down to future generations in the form of inheritances. But it will do so unevenly – so while the intergenerational redistribution will (to a significant extent) ultimately be self-correcting, the intra-generational shift in the distribution of wealth may not be.

‘UK house prices and three decades of decline in the risk‑free real interest rate’

Authors:

David Miles (Imperial College London)

Victoria Monro (Bank of England)