Low Interest Rates Don't Justify High House Prices

[BandWagon]

This is from a speech made by Mervyn King at the LSE in 2002, while he was still deputy governor.

It debunks the myth that so many people have used to justify the bubble.

The move from a regime of high inflation to one of price stability can have

consequences which again are best illustrated by the housing market. A credible

move to inflation targeting can bring down inflation expectations relatively quickly,

even if with a lag. Chart 7 shows that inflation expectations, as measured by surveys,

fell steadily following the introduction of inflation targeting, and are now anchored on

the 2.5% target. But a move to low inflation has other consequences that may be less

easily understood. Price stability means lower nominal interest rates, and lower

mortgage interest payments. It may also mean lower real interest rates if the inflation

risk premium falls. But the fall in nominal rates is likely to be much larger than the

fall in real rates. The lower mortgage payment largely reflects a rise in the effective

duration of the loan because inflation no longer erodes the real value of the debt as

quickly as before. In a low inflation world, nominal incomes rise more slowly than

before and the real burden of servicing the debt persists. It may take longer for

households to work out the impact of low inflation on real interest rates than to realise

that the rate of increase of prices of everyday purchases has fallen. Learning takes

time.

One possible consequence of a slow adjustment to low inflation is that households

may mistake too much of the reduction in nominal interest rates for a permanent fall

in the real rate. As a result, asset prices are bid up to levels that prove unsustainable

when learning finally occurs – and at the LSE you know that in time we do learn.

How far this theoretical argument applies to the British housing market at present is

difficult to say, but it demonstrates the risks from current house price to earnings

ratios that are close to the peaks reached in the late 1980s.

Page 10, if you don't feel like reading the whole thing.

http://www.bankofengland.co.uk/publication...2/speech181.pdf

Nice to hear someone speak with such clarity and good sense.

Bear in mind that this was in 2002, and the house price to earnings ratio is now significantly higher than the 80's boom.

So homeowners still haven't taken the time to "learn".

Essentially people are confusing nominal interest rates with real interest rates, and not appreciating that the debt burden isn't going to erode as they expect.

This same point was made by "The Economist" in their "In Come the Waves" article.

http://www.economist.com/finance/displaySt...tory_id=4079027

It would be interesting to do some calcs on this, where's spline when you need him?

Edited April 17, 2006 by BandWagon

[Time to raise the rents.]

IMO the real realisation is with the BOE, when they come to the conclusion that once the public pause for thought & consolidation, lower rates are required again to sustain growth & inflation.

IMO this situation creates a position where the authorities will be forced to allow the debts to be inflated away by actions in their policiy decisions rather than people actually paying down the debt at a higher rate than previous generations.

It's only a matter of time & I think the Guardian article posted this morning on another thread is quite relevant to this thread.

http://politics.guardian.co.uk/economics/c...1755334,00.html

It is, indeed, quite difficult to see why this recovery in consumer spending should take place. For a start, real disposable incomes are being squeezed both by low wage increases and by higher taxes. So whereas real personal disposable incomes grew by more than 3% a year between 2000 and 2004, they may grow at only half that rate this year.

This is a pretty downbeat view of the prospects, both for growth and jobs in 2006, but if the worst happens, the Bank could respond by easing monetary policy. With interest rates at 4.5%, it has plenty of scope to cut the cost of borrowing should the need arise.

[Warwickshire Lad]

Essentially people are confusing nominal interest rates with real interest rates, and not appreciating that the debt burden isn't going to erode as they expect.

I keep saying this to people all the time, but I don't think it really sinks in. The British public are morons and basically don't get it.

I think it would be well demonstrated by a couple of repayment schedules.

For example, here is approximately what my parents bought and when, starting from their £900 house and then borrowing further/moving "up the ladder" as wage inflation ate away their debt through the 70s/80s.

1968 - £900 - 2 bed Terrace

1973 - £4000 - 2 bed Bungalow semi

1981 - £17000 - 3 bed Terrace

1982 - £40000 - 3 bed new-build semi

1990 - £68000 - Detached bungalow

Now, I know that today's value of that first house they paid £900 for in 1968 is around £115,000. That's an increase of 127 times in 38 years.

If I started today and bought their house at £115,000 and inflation increased its value by the same amount over the next 38 years, you're looking at a rubbish 2-bed terrace being worth £14,605,000.

It's laughable. More publicity/education is needed on this point.

It needs to be demonstrated that, quite simply, THE LADDER DOESN'T EXIST ANYMORE.

Edited April 17, 2006 by Warwickshire Lad

[Realistbear]

HPI is illusional. As Merv also said, house prices are just a matter of opinion whereas debt is real. Looks like the FT has caught on:

https://registration.ft.com/registration/ba...20abe49a01.html

Dangers of the housing market delusion

By Martin Wolf

Published: April 17 2006 03:00 | Last updated: April 17 2006 03:00

Do higher house prices make a country richer? The answer is simply "no".

Miracle Economy and the great British delusion of wealth?

[The Undertaker]

I keep saying this to people all the time, but I don't think it really sinks in. The British public are morons and basically don't get it.

I think it would be well demonstrated by a couple of repayment schedules.

For example, here is approximately what my parents bought and when, starting from their £900 house and then borrowing further/moving "up the ladder" as wage inflation ate away their debt through the 70s/80s.

1968 - £900 - 2 bed Terrace

1973 - £4000 - 2 bed Bungalow semi

1981 - £17000 - 3 bed Terrace

1982 - £40000 - 3 bed new-build semi

1990 - £68000 - Detached bungalow

Now, I know that today's value of that first house they paid £900 for in 1968 is around £115,000. That's an increase of 127 times in 38 years.

If I started today and bought their house at £115,000 and inflation increased its value by the same amount over the next 38 years, you're looking at a rubbish 2-bed terrace being worth £14,605,000.

It's laughable. More publicity/education is needed on this point.

It needs to be demonstrated that, quite simply, THE LADDER DOESN'T EXIST ANYMORE.

Unless house prices crash back down to £900 for a 2 bed Terrace!!

[DoubleBubbleTrouble]

IMO the real realisation is with the BOE, when they come to the conclusion that once the public pause for thought & consolidation, lower rates are required again to sustain growth & inflation.

Oh come on, that isn't sustainable. What do they do, keep lowering and lowering rate everytime the economy gets into trouble!

[BillyShears]

I keep saying this to people all the time, but I don't think it really sinks in. The British public are morons and basically don't get it.

I think it would be well demonstrated by a couple of repayment schedules.

For example, here is approximately what my parents bought and when, starting from their £900 house and then borrowing further/moving "up the ladder" as wage inflation ate away their debt through the 70s/80s.

1968 - £900 - 2 bed Terrace

1973 - £4000 - 2 bed Bungalow semi

1981 - £17000 - 3 bed Terrace

1982 - £40000 - 3 bed new-build semi

1990 - £68000 - Detached bungalow

Now, I know that today's value of that first house they paid £900 for in 1968 is around £115,000. That's an increase of 127 times in 38 years.

If I started today and bought their house at £115,000 and inflation increased its value by the same amount over the next 38 years, you're looking at a rubbish 2-bed terrace being worth £14,605,000.

It's laughable. More publicity/education is needed on this point.

It needs to be demonstrated that, quite simply, THE LADDER DOESN'T EXIST ANYMORE.

It would be nice to start running some figures. Assuming that someone on an average salary buys an average property, and "reasonable" wage inflation, how will they afford the next rung on the ladder? An actual simulation will show to what degree any "ladder" still exists.

Billy Shears

[Time to raise the rents.]

Oh come on, that isn't sustainable. What do they do, keep lowering and lowering rate everytime the economy gets into trouble!

It's the real interest rate that is important in hyperinflation, not the nominal interest rate. At the moment the real rate is too high & preventing debt from being inflated away. If it's lowered, the debt will be inflated away. It's only a matter of time before this becomes necessary.

[padders]

It's the real interest rate that is important in hyperinflation, not the nominal interest rate. At the moment the real rate is too high & preventing debt from being inflated away. If it's lowered, the debt will be inflated away. It's only a matter of time before this becomes necessary.

The real rate of interest right now is around 1%, if that. And this is too high?

I used to think the government would just try and inflate the debt away, the problem is this will only work for UK held debt. The problem is a lot of debt in the UK is held by people outside the UK and they are not going to accept the debt being inflated, hence what will happen to the currency.

[Without_a_Paddle]

It would be nice to start running some figures. Assuming that someone on an average salary buys an average property, and "reasonable" wage inflation, how will they afford the next rung on the ladder? An actual simulation will show to what degree any "ladder" still exists.

Billy Shears

FWIW here is a quick scenario for a couple living in my area. (SW)

Couple currently live in 3 bed semi. Bought for £100k in 2000.

But they had £30k equity from their prev (2 bed terrace bought in 1994) house when they bought in 2000.

So their mortgage in 2000 was £70k. (£500pm)

6 years down the line (i.e. today) they owe £61k of the £70k because they went repayment mortgage.

They sell the semi for £185k today to buy a 4 bed detached for £280k.

They have saved/invested £20k since 2000 (i.e. towards a deposit).

So the new mortgage will be 280-185+61-20 = £136k.

If they do a 20yr repayment loan @ 4.8% fixed (for 5 yrs) they will be paying £880pm for the 4 bed detached.

This will be for a couple in their early 40s earning decent (average?) wages of £25k pa each.

Monthly joint takehome pay = £3000

Mortgage = 30% of takehome pay.

The ladder still exists here, I'm afraid.

NB. I forgot you have to include stamp duty on the £280k house so the mortgage would be around £144k. (assuming you stick the duty onto the mortgage)

This would bring the monthly repayments up to £935pm.

Edited April 17, 2006 by Without_a_Paddle

[BillyShears]

FWIW here is a quick scenario for a couple living in my area. (SW)

Couple currently live in 3 bed semi. Bought for £100k in 2000.

But they had £30k equity from their prev (2 bed terrace bought in 1994) house when they bought in 2000.

The ladder still exists here, I'm afraid.

I was thinking of FTBs getting on the bottom rung of the ladder today, not someone who bought their current house 5 years ago and their first house 12 years ago. That someone who bought in 1994 is able to move up the ladder is not very useful in predicting whether the ladder still exists for FTBs now.

Billy Shears

[Time to raise the rents.]

The real rate of interest right now is around 1%, if that. And this is too high?

I used to think the government would just try and inflate the debt away, the problem is this will only work for UK held debt. The problem is a lot of debt in the UK is held by people outside the UK and they are not going to accept the debt being inflated, hence what will happen to the currency.

It's 2.5% & another 1-2% can be added to account for lenders margins. So a 3.5% to 4.5% real interest rate is high.

[Come On Down]

FWIW here is a quick scenario for a couple living in my area. (SW)

Couple currently live in 3 bed semi. Bought for £100k in 2000.

But they had £30k equity from their prev (2 bed terrace bought in 1994) house when they bought in 2000.

So their mortgage in 2000 was £70k. (£500pm)

6 years down the line (i.e. today) they owe £61k of the £70k because they went repayment mortgage.

They sell the semi for £185k today to buy a 4 bed detached for £280k.

They have saved/invested £20k since 2000 (i.e. towards a deposit).

So the new mortgage will be 280-185+61-20 = £136k.

If they do a 20yr repayment loan @ 4.8% fixed (for 5 yrs) they will be paying £880pm for the 4 bed detached.

This will be for a couple in their early 40s earning decent (average?) wages of £25k pa each.

Monthly joint takehome pay = £3000

Mortgage = 30% of takehome pay.

The ladder still exists here, I'm afraid.

These people are in a much more beneficial position as they bought first in 1994, when house prices were VERY low, and then again in 2000 when they were still very low compared with today. So they have been well established on the ladder for some time - and sufficient wage increases for the last 12 years has helped their cause (with higher inflation). I dont think a FTB today will be in as good a position in 5 years to move up to a semi from a terrace, and then to a detached in 7 more. Nope.

[padders]

It's 2.5% & another 1-2% can be added to account for lenders margins. So a 3.5% to 4.5% real interest rate is high.

Only if you believe that inflation is anywhere near 2.5%, which it clearly istn't - but then you don't live in the UK so you wouldn't know that so your ignorance on the matter can be excused.

[Without_a_Paddle]

I was thinking of FTBs getting on the bottom rung of the ladder today, not someone who bought their current house 5 years ago and their first house 12 years ago. That someone who bought in 1994 is able to move up the ladder is not very useful in predicting whether the ladder still exists for FTBs now.

Billy Shears

Oh I see...

Well that rather depends on future house prices and wage inflation.

Which nobody, and I mean NOBODY seems to be able to predict with any reliability.

But assuming we get 0% 'real' wage inflation (wages and houses grow at 4% yoy) so house prices stay stagnant in real terms ( I don't think anyone expects them to go UP much further in real terms) then:

<<<<<<<<<<<<<<<<<<buy terrace<<<<<<<<<<<<<<<<<<<<<<<<<<

Buy 2 bed terrace today at £130k = £110k loan (with £20k deposit) = £630pm

In 7 years the debt shrinks to £90k.

<<<<<<<<<<<<<<<<<< buy 3 bed semi <<<<<<<<<<<<<<<<<<<<<<<

Today's 3 bed semi = £185k.

In 7 yrs it could be £245k. (4% yoy)

Your house will be £170k (4% yoy)

New mortgage = 245-170+90 =£165k

Allow £20k discount for saving for a deposit

New mortgage = £145k (£148k with stamp duty added) at 6% rate =£955pm (not bad)

<<<<<<<<<<<<<<<<<<<<buy 4 bed detached<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<

Go another 7 years and the debt will be down to £125k.

4 bed detached today at £280k will be £485k in 14yrs' time (4% yoy)

Your 3 bed semi will sell for £322k (4% yoy)

your new mortgage will be 485-322+125-30

(assuming £30k deposit saved)

=£258k

Assume rates are at 7% and you go for 20yr repayment

That will be £2000pm in 2020 (ouch!)

This is still more expensive than today's couple in my previous example.

They pay £935pm in 2006

Allow 14yrs wage inflation at 4% and you get £1620pm to compare with £2000.

So using this ultra crude projection shows that it will get tougher on your second rung.

This assumes no fall in house prices in real terms.

I think most people agree prices will fall in real terms (inflation adjusted) at some point in the next few yrs.

So you will probably be OK on the 2 rung of the ladder.

Of course, if we get high inflation at some point then my figures above turn to mush...

Note: For someone in their mid 30s who is still an FTB the above figures do look quite daunting.

You'd be 69 before you'd bought that 4 bedder outright....

Mind you the couple across the street from me are just retired and have just paid off their 3 bed semi (bought 25yrs ago) and they seem happy enough.

Edited April 17, 2006 by Without_a_Paddle

[Guest]

High inflation?

In this low inflation environment, plenty of people are being outsourced.

Can't imagine what a high inflation environment would do.

[MarkG]

Exactly. In a country where input price inflation is high and wage inflation is low so costs can't be passed on, any further inflation due to low interest rates would force companies to cut non-essential costs ever further: which means sacking more British workers and shipping their jobs abroad.

And as we know, high unemployment leads to a house price boom.

Oh, no, it doesn't, does it?

[RichB]

Dangers of the housing market delusion

By Martin Wolf

Published: April 17 2006 03:00 | Last updated: April 17 2006 03:00

Do higher house prices make a country richer? The answer is simply "no".

Miracle Economy and the great British delusion of wealth?

lol.... just as I got to this statement Tom Petty started singing 'Free Falling' ....

[patprimer74]

Now, I know that today's value of that first house they paid £900 for in 1968 is around £115,000. That's an increase of 127 times in 38 years.

If I started today and bought their house at £115,000 and inflation increased its value by the same amount over the next 38 years, you're looking at a rubbish 2-bed terrace being worth £14,605,000.

It's laughable.

Laughable, indeed. But, all those years ago people would have said exactly the same i.e. 'it's laughable that my £900 house will, within my lifetime, be worth £115k - don't be so bloody daft!!'

It happened, all the same. Not that I'm suggesting it would ever happen again, of course.

p

[MarkG]

For the long run it's usually a fairly safe bet that the thing most people don't believe will happen is the thing most likely to happen.

When my parents bought their house, no-one thought that it would increase in price by a factor of two hundred, but it did. Today when people buy a house most expect it to at least double in price every ten years... so it probably won't.

[Without_a_Paddle]

The reality is that with YOY stealth tax rises (fiscal drag with personal tax allowances and council tax rises to name but 2) and low inflation, the burden will persist for a much longer time. Couple this with some small interest rate rises in the future and someone who bought in 2003 could have the same debt burden in real terms in 2010 or beyond.

I don't see that being the case assuming they went for a repayment loan as most do.

If they borrowed £100k in 2003 the debt would be down to around £83k by 2010.

If they wanted to keep payments low in 2010 they could remortgage. If rates went up to 7% then they could remortgage the £83k loan to keep the monthly payments the same as today.

Don't forget there will be 7 years of wage inflation (currently at 4% yoy) to reduce the impact of the repayments.

If they overpaid the mortgage by £100pm they would only owe £73k in 2010.

If they overpaid the mortgage by £200pm they would only owe £62k in 2010.

Knowing what they know today I bet quite a few people would have bought 3 years ago given the chance to turn the clock back...

[Michael]

Unless house prices crash back down to £900 for a 2 bed Terrace!!

even in inflation-adjusted terms that £900 house would only be about £18000 to-day

[Flat Bear]

even in inflation-adjusted terms that £900 house would only be about £18000 to-day

Exactly

Warwickshire Lad

I keep saying this to people all the time, but I don't think it really sinks in. The British public are morons and basically don't get it.

I think it would be well demonstrated by a couple of repayment schedules.

For example, here is approximately what my parents bought and when, starting from their £900 house and then borrowing further/moving "up the ladder" as wage inflation ate away their debt through the 70s/80s.

1968 - £900 - 2 bed Terrace

1973 - £4000 - 2 bed Bungalow semi

1981 - £17000 - 3 bed Terrace

1982 - £40000 - 3 bed new-build semi

1990 - £68000 - Detached bungalow

Now, I know that today's value of that first house they paid £900 for in 1968 is around £115,000. That's an increase of 127 times in 38 years.

If I started today and bought their house at £115,000 and inflation increased its value by the same amount over the next 38 years, you're looking at a rubbish 2-bed terrace being worth £14,605,000.

It's laughable. More publicity/education is needed on this point.

It needs to be demonstrated that, quite simply, THE LADDER DOESN'T EXIST ANYMORE.

And why do you think it was a rubbish 2 bedroom terrace? Your parents were probably very proud of it when they bought it. What do you want? What do you think you should be able to afford?

Do your parents agree with your snobbish views?

A lot of posters on this forum, im sure, would think a 2 bed terrace perfect, as long as it was "reasonably" affordable.

Forget about real, nominal, imagined etc etc inflation, the important inflation rate is wage inflation coupled with any universal cost changes such as taxation etc. and then more temporary influences such as money availability/cost and economic conditions, then overall factors such as supply/demand. Taking everything else out apart from wage inflation (because nothing else has changed sufficiently) then simply look at wages/property price ratio then and now. If you do this for a number of dates you will find the ratio higher now (within last 2 years) than ever before, so houses are more expensive now. But dont think houses were ever cheap, your parents (probably) would still have had to pay mortgages and these amounts at the time would have felt enormous.