Title: UK House Prices, Consumption and GDP in a Global Context
1UK House Prices, Consumption and GDP in a Global
Context
- Andrew Farlow
- University of Oxford
- Department of Economics, and Oriel College
- John D Wood Co.,
- The Cavalry and Guards Club, Piccadilly,
- London, 20 January 2005
- This is based on a paper to be found at
- http//www.economics.ox.ac.uk/members/andrew.farlo
w - (Syntax slightly improved post-presentation to
make the slides more easily readable given the
lack of a presenter)
2Todays Presentation Part Three of Five Parts
- Part One UK House Prices A Critical
Assessment - Part Two Bubbles and Buyers
- Part Three UK House Prices, Consumption and GDP
in a Global Context - Part Four Risk Premia and House Prices
- Part Five Mortgage Banks and House Prices
- Book February/March 2006, Publisher Constable
Robinson
3UK historically strong housing cycles
- Strong housing market cycles, linked to volatile
consumption, have been an overriding feature of
the UK economy for over three decades. - OECD (2004) 1971-2002, UK the strongest
correlation of housing wealth and GDP of any
country surveyed. - IMF(2004) The UK (along with Finland, Ireland,
and Switzerland) has had one of the most
procyclical housing markets in the world.
4Something more global this time?
- Something extra this time The first global
house price bubble (The Economist)? - Small probability large loss events matter.
- Even if only a small chance, we should analyze
the possibility. - IMF, 2003 World Economic Outlook, 40 of booms
followed by busts, and 8 cumulative GDP loss. - State of housing markets, part of a bigger
picture of global imbalances?
5UK House price falls and GDP falls
- No fall in real house prices (blue line) not
followed by major fall in UK GDP (gray bands) - Will the pattern repeat?
Source Bank of England Inflation Report,
May 2004, p7, Chart 1.10.
6Consumption and House Prices
- 1970-mid 1990s, rapid increase in house prices
(green line) accompanied by rapid growth of
consumption (red line) - Recently, house price inflation has accelerated
but the rate of growth of consumption has
steadied.
Source Bank of England Inflation Report May
2004, p12, Chart 2.1.
7A breakdown?
- Misleading causation.
- Both driven by income expectations? Not directly
observable. - Credit constraints?
- A very different central bank response next time?
8More evidence durables and non-durables
- Real durable and semi-durables consumption is
highly pro-cyclical. - But need to adjust for rapid price falls
Source Bank of England Quarterly Bulletin,
Spring 2004, J Power, Chart 1.
9Nominal ratio of durable to non-durable
consumption
Source Bank of England Quarterly Bulletin
Spring 2004, J Power, Chart 11.
10Real house prices and share of durable spending
in consumption
- Durables more likely purchased on credit.
- Share previously very correlated with house
prices. - Correlation has broken down since the late 1990s.
Source Bank of England Inflation Report November
2004
11More Evidence
- Swings in spending relative to income in all
periods - of homeowners is nearly as great as
renters. - But risk premia and options thinking of owners,
etc.
Source BOE Inflation Report May 2004, p12, Chart
2.3, based on the Family Expenditure Survey.
12Possibilities
- Credit constraints less important?
- No upwards revision in expected future earnings
and wealth? - This would have driven higher housing demand (and
house prices) and higher desired stock of
durables. - Flow increase in durables expenditure on the path
to new desired stock level.
13Awkward Conclusions
- If real income expectations are pretty stable,
how could these have driven house prices so much
higher? - Not enough ability of demographic factors and the
slow rate of house build to explain house price
rises. - Great deal of weight placed on a credit
constraint story for house price rises. - But difficult to create a consistent story if
credit constraints are highly important for
housing consumption but not for non-housing
consumption, especially durables.
14Or
- Very high real house prices (and/or low interest
rates) are not regarded as long-term sustainable
by the general public? - Also some distributional issues since rapidly
rising house prices (relatively) redistribute
wealth from asset-poor to already asset-rich,
from young to old. And this feeds subtle
differences in aggregate consumption behaviour.
15Mortgage Equity Withdrawal
- 0 of household income in the late 1990s
- Now over 8 today
- Yet, consumption as a percent of household
disposable income has hardly changed (1997-today) - What if MEW were to collapse this time?
Source Bank of England Inflation Report May
2004, p 13, Chart 2.4.
16Correlation between annual house price inflation
and annual consumption growth
Source Bank of England Inflation Report
November 2004, p12 Chart B.
- 10 year rolling correlation coefficient has
collapsed
17Need to correct for
- Demutualisation of building societies. Windfall
payments (fungible with MEW) of 35 billion, or
7 of annual consumption, helped the jump from
90 to 96 in two years with hardly any change in
MEW. - Introduction of self-assessment.
- The relationship is still weaker than in the past
but nevertheless is more positive than it first
appears.
18The big consumption story?
- Levels v. stocks The surge in the level of
consumption from 86 to 96 of household
disposable income created high rates of growth of
consumption in the 1980s. - Recent consumption has run consistently at a much
higher level for much of the last 7-8 years (with
3-5 consumption growth per year). - The big consumption story of the late 1990s and
early 2000s is the historically high level of
consumption from disposable income, low levels of
savings, and deteriorating pension provision.
19More on MEW
- Insignificant in the UK up to 1980.
- 1980s liberalization.
- No other country in the EU ever managed anywhere
near to 8. - 1979-1999 Germany, France, and Italy net
injection of 6 of household income into housing.
Source Bank of England, Office for National
Statistics and HM Treasury calculations. Chart
5.5, HMT 2004 p52, not updated.
20Key MEW findings
- 50-60 is last-time sellers and those trading
down, i.e. those most likely to pay off debt and
save. - A large proportion that is spent goes on home
improvement and new goods for the home. - But, house prices and MEW are partly endogenous
to any price bubble (family transfers, home
improvement). - Borrowers who withdraw to spend are concentrated
at higher incomes, but a sizeable proportion are
on low incomes, and their borrowings are
relatively high-level. - Low levels of serial remortgaging.
21MEW and housing market Transactions
- UK has one of the highest rates of housing market
transaction in the EU. - Transactions volumes matter if most current MEW
is released through last-time sales and trading
down.
Source HMT Table 5.4, p51. Source Bank of
England and Office for National Statistics.
22MEW cont.
- MEW is more lumpy than many credit constraint
stories suggest, which is why so much MEW is
immediately saved and then generates a later
flow. - Much of the consumption flow from recent MEW is
still to come. More stabilizing? - If MEW plummets, there is no new flow into the
stock of assets to generate new consumption flow.
Less stabilizing? - In turning, or stagnant, housing markets price
does not fall heavily at first transactions do.
The liquidity of the market and ability to
release equity falls.Those wanting to
trade-down are heavily dependent on chains of
buyers. Their ability to release MEW falls.
23But
- Only element of MEW that seems not cyclical is
remortgaging (but evidence is hard to interpret). - For those forms of MEW that involve
borrowingdebt bites much more in a low inflation
environment. - What if those borrowing on MEW are excessively
buying into the house price rise? - If MEW replaces more expensive forms of
debtthis dries up if house prices fall. - A small consumption response can still be
magnified by a big collapse in MEW. - If prices fall, there will be a collapse in MEW.
24Demographics of MEW
- Withdrawal of equity by last-time sellers is much
greater than injection by first-time sellers.
Stock of debt naturally rises over time. - If house prices are overvalued, those at the top
have been removing more equity than they would
have done in a less overvalued market, leaving
behind on average more indebted households. - Price bubbles are highly redistributive.
- Price bubbles are popular with voters, and
politicians. - Element of being a Ponzi game.
25MEW is not the main storySavings and pensions
are!
- State of the housing market, level of savings,
and pensions crisis are linked. - Global liquidity story too.
- If consumers believe that rapidly rising prices
are sustainablethen they may believe that
current consumption can be run at very much
higher levels than in the past. - Shocking evidence of unrealistic price
expectations. - (Case, K.E., Quigley, M., and Shiller, R.J. 2004)
- Slack taken from other parts of the household
balance sheet, and over-reliance on housing to
generate future pensions provision.
26What about non-MEW
- If many of those withdrawing housing equity are
not immediately spending, what are non-MEW
consumers doing to maintain consumption
consistently at 96 or more of income? - Low savings
- Eating into pensions contributions they should
be making - Non-MEW forms of debt
- Relying on house prices? Some notion of asset
value allusion. Housing wealth fungible with
other forms of savings? The cheapest form of
credit?
27Saving ratio
- Shows UK households saving ratio and house
prices (plotted with negative of saving ratio) - Paradox of thrift too in a major correction.
Source HMT 2004, Chart 6.3. p. 60. Source
Office for National Statistics and Office of the
Deputy Prime Minister.
28Saving ratio cont.
- Correlation between saving ratio and house price
inflation one period earlier
Source HM Treasury, 2004, p64.
29Impact of interest rates on house prices and
consumption
- EITHER house prices are less volatile than in the
past - OR, if they are still just as volatile, the links
to consumption are weaker - OR, interest rates can cope with any problems
(ease cash-flow problems, cushion/slow house
price falls, etc.) - Direct and Indirect effects of interest rate
changes via housing market - both have forces working for and against
- Both are difficult to be precise.
30Conclusions on direct and indirect effect
- The direct effect of reducing interest rates
after the last house price crash was large.
Likely more modest today. - The Bank of England should worry less this time
when raising (or holding high) interest rates,
but also feel less confident of the power of rate
cuts to make a big impact on aggregate cash-flow. - Indirect effect stronger, but not much interest
rates can do if large speculative aspect to house
prices. - But many caveats, including
- Distribution and fragility of debt is not fully
clear. Caution - Credit conditions generally
- Dangers of moral hazard if perceived to be
bailing out.
31Redistribution effects of falling/rising house
prices
- Rapid house price rises have similar consequences
to sustained budget deficits, depressing the
current real productive capital stock in exchange
for current consumption by the gainers. - House price booms, just like government budget
deficits, are popular with older consumers (and
younger bubble-motivated consumer who know no
better, or suffer asset price allusion). - Like deficits, older consumers benefit from the
borrowing from future generations, even as
long-term income levels are reduced due to the
crowding out of real productive capital stock.
32Distributional issues suppressing long-run values
- Depressing influences on the investment potential
of housing of the current generation (since the
market for the value of their homes is the next,
smaller, more burdened generation) include - demographically aging population
- falling cohorts in younger generations
- record low savings
- deteriorating provision for retirement
- the burden of social security and health
increasing over time.
33Still overvalued
- This and other analysis (risk premia, etc.)
suggests the market is still overvalued. - Given current overvaluation, the real rate of
return on housing for, say, the next 20 years is
much lower than the historical average of about
2.5 (indeed, zero is within the 95 confidence
interval for the 20 year real rate of return). - It also suggests that if correction is
inevitable, it is not obvious that correction
should be resisted.
34Global House price correlations and global
liquidity
- Highly synchronized positive movements in house
prices, and global build up in mortgage debt. - An extremely recent phenomenon that does not
affect all countries equally - US, Australia, UK, China, France, Ireland, New
Zealand, South Africa - Relatively few EU countries.
- The correlation between real house prices and
output (and consumption) has declined since the
mid-1990s, reaching unprecedented low levels by
2003. - Potential for instability from outside UK
- Hence issues of timing, interest rate decisions,
etc.
35Variance decomposition of house prices
Source IMF 2004, data
from Haver Analytics IMF, International
Financial Statistics national sources
OECD and IMF staff calculations.
36UK case
- House Factor and Global Factor over time, per
cent change, constant prices, demeaned
Source IMF 2004, data from Haver
Analytics IMF, International Financial
Statistics national sources OECD
and IMF staff calculations.
37UK decomposition of house price change over time
- Orange Actual
- Blue Global Housing Factor
- Red Global Factor
- Black Country Factor
Source Extracted from IMF 2004
38Global Liquidity
- Global driving forces especially US house
prices, US interest rates, and global liquidity. - 25 per year growth in the sum of Americas cash
and banks reserves held at the Fed, and in the
foreign reserve holdings of central banks around
the world. - Excess liquidity in the past flowed into
traditional measures of inflation (goods and
service prices). - Does extreme liquidity show up in asset price
inflation house prices and record high global
levels of debt, especially mortgage debt?
Overreaction after stock market crash? - US housing stock has risen in paper value by 5
trillion, almost precisely matching the
5trillion of lost stock market wealth of the
early 2000s.
39Did Global interest rates go too low?
- Natural rate of interest the rate at which the
supply of savings of households exactly balances
the demand for funds by firms for investment
purposes. - Natural rate is roughly equal to the rate of
inflation plus the real trend rate of growth. - Natural rate moves about according to
- technological improvement
- changes in preferences
- the impact of demographics on the need for
savings, etc. - If cost of capital set below this, get
overcapitalization, the level of borrowing and
investment will be excessive, saving too low, and
the chances of bubbles greater.
40Natural rate too low, continued
- For UK about 5 (2 inflation plus 2 to 3).
- Global natural rate (difficult to work out
precisely) may even have risen (China, IT, global
integration, inflation success, etc.). - Yet, some of these forces have also lowered
inflation and even encouraged lower interest
rates. - And bubbles encourage households not to save,
making things worse. - Low rates followed collapse of late 1990s and
various other crises/collapsing bubbles.
41The US
- US (especially) interest rate kept below natural
rate for too long? 3 to 5 too low? Maybe after
previous bubbles? Went from 6.5 in 2001 to 1 in
2003. - Past five years Americas national spending has
exceeded its income by about a fifth. - Private debt has boomed (nearly 10trillion).
- Savings have hit 0.5 (compared to historical
average of 8). Sometime, a reversion back to 8? - Private debt service is historically high even
before interest rates rise.
42US cont.
- US government has joined US citizens. Approx
450bn budget deficit per year. - Externally held portion of debt risen from 20 to
45. - Problems with depth of US mortgage markets.
- Problems with US lender of last resort.
43US cont.
- If a country has strongly favourable investment
opportunities that will ultimately make its
inhabitants much better off it is economically
rational to consume some of the fruits now,
borrow from the rest of the world, and repay from
higher output later. - Meanwhile, run a strong currency and high trade
and current account deficits that generate a net
capital flow equal to the current account
deficit. - However, decomposition of US data shows that debt
is currently largely being used to finance public
and private consumption, rather than investment.
44Asia and US mutually reinforce
- Global foreign exchange reserves have doubled
since the Asian crisis of 1998, to 3,800bn, with
two-thirds of this in dollars. Asia accounts for
80 of this growth and now has 70 of global
reserves. - Reserves account for 9 of global gross domestic
product, compared to less than 2 during the
pre-1971 Bretton Woods era. - High demand for US debt may be a response to
previous crises. It has chipped 0.5 to 1 off US
yields. It has helped the US to run large
government and trade deficits. - China has chipped 0.1 to 0.3 of US inflation
(maybe as much as 1). - In turn, Chinas boom has been helped by low US
rates.
45House price contagion?
- If sufficiently strong house price falls in one
country (for example, rebalancing in the US will
require lower spending on housing consumption) or
several countries generate a decline in
consumption for them, then it is more likely that
consumption will fall in other countries too - Real contagion (via consumption).
- Financial contagion (via, in particular, mortgage
bank and government balance sheets). - Equity-based bubbles less damaging than
debt-based bubbles. Has mitigating the first, led
to the latter? - See Farlow, UK House Prices, Consumption, and
GDP in a Global Context, Section 6, for
scenarios for correction.
46Impact on UK policy
- How do these possibilities affect our attitude to
falling house prices in the UK and central bank
policy on interest rates? - If rebalancing of the UK housing market is
inevitable, this suggests allowing rebalancing to
proceed sooner rather than later leaving the
housing market in a better position to withstand
global disturbances consequent on rebalancing
elsewhere. - Reversion to fundamentals, while it harms
consumption, at least conceivably puts the
economy back on a footing that emphasizes real
economic activity over speculative housing
activity and ends the distortions that lead to
long-term pension and saving misallocation.
47Lessons for the UK
- Global instability might matter more for UK house
prices than is perhaps currently accepted. The
fate of the UK housing market may currently be
one of the less domestically controllable aspects
of UK macroeconomics. - The Bank of England has faced an unenviable
choice between trying to turn the tide of house
prices and not sacrificing growth and risking
under-hitting its inflation target. - Emphasis on controlling the housing market has to
include reforms and not just rely on interest
rates.
48Lessons for UK cont.
- Interest rates may have little power to influence
house prices in a price collapse anyway. Trying
to generate a cash-flow affect to offset a
wealth effect caused by an unwinding bubble may
simply not work very well. - Handling global surges in house prices might need
more of a coordinated response than it probably
gets, or is ever likely to get. - Stop-go cycle via house prices in place of
stop-go cycle via goods and services prices?
49Bubbles confuse inflation signals
- Recent asset price bubbles might have helped to
dampen up-front inflationary pressures. In case
of equity market bubbles - Artificially boost profits as measured in
standard accountancy measures firms adopt more
aggressive pricing strategies - Positive feedback via capital accumulation and
favourable supply-side developments, especially
productivity gains, the spreading of technology,
and catch up in emerging economies (c.f.
China), with consequent lower inflationary
pressure - Firms able to make much lower contributions to
pension schemes (and employees willingly accept,
c.f. US 1990s) - Employees tolerate less inflationary wage claims
given perceived gains on stock market investments
(especially evident in the US in the late 1990s)
50Bubbles confuse signals, cont.
- Governments benefit from bubble-inflated asset
prices that inflate the tax yield (stock market
taxes at the end of the 1990s, housing
transactions taxes, consumption taxes, low use of
pension tax allowances, etc. in current housing
bubble) and allow them to run lower tax rates
than otherwise would be the case, even as their
fiscal positions are strengthened - When the bubbles unwind, all these things go into
reverse just at the wrong time.
51A public sector generated cash-flow shock?
- There are dangers in running a fiscal policy that
risks a sudden tax increase in the face of a
declining housing market (maybe at the same time
as a swing in global credit conditions). - This time, the impact may show up more than
usually as a public sector cash-flow problem. - But burdens for the public sector are ultimately
private sector burdens. It is simply an issue of
timing. - If house price falls are slow enough, this
cash-flow problem can be offloaded to the private
sector at a more timely pace.
52Public sector cash-flow, cont.
- If price falls are more rapid (and confidence
takes a greater hit) then the cash-flow
difficulty (or even just expectations of it) may
be fed much more quickly to the private sector
especially in the form of higher taxes
reinforcing the private sectors cash-flow problem
and putting downward pressure on house prices.
The economy finds itself on an even higher tax
trajectory at quite the least opportune time for
it. - And tax rises are hard to target on the
relatively less indebted (unlike interest rate
falls). - Growing tension between Bank of England and
Treasury.
53Precarious balancing act for central banks
- If rates are raised too slowly, any
momentum-driven bubbles will expand even further,
financial imbalances intensify, with inflationary
pressures built up for the longer term.
Adjustment is simply delayed till a point when
the fragility is even greater and when the
dangers of triggering a switch to deflation are
higher. - If rates raised too quickly, fragilities may
unwind too fast. - Balancing act for debt holders too.
- This time real price falls will need nominal
price falls. - This time the Bank of England would not allow the
run-away inflation needed to create the negative
real interest rates that would generate a similar
situation today to that easing previous price
collapses.
54Central bank difficulties, cont.
- Interest rates may have too much to do and be
unable to fall as far as the housing market might
require - If the pound were to weaken too quickly
- OR oil or commodities prices rise too strongly,
feeding UK inflationary pressures - OR the US were to suffer a fiscal crisis and
sudden swing in sentiment forcing it to raise
real interest rates much higher in defense - OR UK government finances were to deteriorate
quickly as lower confidence and economic activity
reduced the tax yield. - Rising spreads may keep interest rates off the
floor. - System has not been stress-tested yet. Best to
set so as to minimize the fall-out from mistakes.
55Central banks cont.
- Policy in the late 1990s settled on price
stability via interest rate adjustments and not
tax adjustment, since easier to set up an
institution independent of elected government. - Danger that governments rely on even
over-exploit the policy credibility created by
central banks. - A slow revision upwards of interest rate
expectations is better than a sudden unexpected
tax rise. Gradual reversions without surprises
are best. - Openness about interest rates and at least the
chance for households to think the scenarios
through and factor higher interest rates in
contrasts sharply with the complete lack of
openness about (and the political nature of) the
timing and level of future tax rises.
56A Few Summary Thoughts
- Global rebalancing at some point.
- Expected consumption and GDP response will
matter. - Much of the analysis of the consumption response
is based on efficiently operating bubble-free
markets. - Once we allow bubble mispricing, consumption
responses are generally not well captured. - Soft landing is not fully convincing when a broad
picture of consumption is considered, including
pension and savings, and when levels as well as
changes in levels are reviewed.
Continued on next slide
57A few summary thoughts cont.
- Debt-backed housing bubbles probably more
damaging than stock market bubbles. - The new stop-go cycle?
- Politicians love to exploit bubbles.
- Aftermath of current period likely to focus
attention on a wide range of issues. Many of
these require coordination across diverse
economies, something usually achieved more easily
in stable times. In less stable times, something
much easier to handle if some thought has gone in
ahead of time. - Being better educated helps. Caricature of
optimists or doomsters, experts or
pundits does not help.
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