Central banks should not target house prices

The worldwide fall in interest rates over the past two decades has caused a runaway boom in house prices. Therefore, it makes sense to raise interest rates so houses become affordable again. The first of these statements is almost certainly true — but the second does not follow. It would in fact be a disastrous mistake.

New Zealand’s government recently told its central bank to consider the impact on housing when it sets monetary policy. The Reserve Bank of New Zealand rebelled and said it will do no such thing, but as people across the world struggle to afford a house, there was a wave of sympathy for the idea. To see why the RBNZ was correct, however, consider what would happen if a central bank tried to target house prices.

A fall in interest rates makes a given flow of rent (if a property is let out) or accommodation (if it is owner occupied) more valuable. Owners discount that cash flow using the risk-free rate, so there is little doubt that the proximate cause of rising house prices in many countries over the past couple of decades is cheaper money. If lower interest rates made house prices go up, then quite logically, higher interest rates will make them go down again.

But central banks did not cut interest rates to zero and launch massive programmes of asset purchases out of some perverted desire to raise house prices. They did so because they judged it essential to meeting their mandates of stable prices and full employment. If they tried to stabilise house prices instead, by how much would they have to raise interest rates?

The answer is: a lot. The economists Òscar Jordà, Moritz Schularick, and Alan Taylor studied the sensitivity of house prices to interest rates across 14 countries and 140 years of history. They found that a 1 per cent rise in interest rates reduces the ratio of house prices to incomes by about 4 per cent. In New Zealand, for example, that ratio has risen by about half in a decade, implying a double-digit rise in interest rates to stabilise it.

If that seems too abstract or implausible, then imagine simply keeping interest rates at New Zealand’s 2000-09 average of 6 per cent, instead of the current 0.25 per cent. Any advanced country following such a policy during the past decade would have experienced massive currency appreciation, slumping investment and a collapse in exports. That would translate to lower growth, weaker incomes, high unemployment and quite possibly a spiral into deflation.

What if interest rates were just a little bit higher? Then house prices would not be noticeably lower and there would still be some extra unemployment. Anybody arguing for higher interest rates to control house prices should explain why this is a good trade-off — or at least acknowledge that the trade-off exists.

Hiking interest rates would cause a lot of collateral damage to the economy. But it would not in fact do much to help younger people struggling to get on the housing ladder.

Consider four individuals. First, a young worker made unemployed by higher interest rates is more likely to lose their home than to buy one. Second, a young buyer relying mainly on debt to buy a house will find the cost of a mortgage has gone up roughly in proportion to the falling price of the asset.

Third, there should be a group of more comfortable buyers — young professionals, perhaps — who find the overall reduction in demand has made homes more affordable. But the real beneficiaries would be in group four: savers with money in the bank. They would get a nice, high interest rate without having to take any risk. Far from being a policy that helped young people struggling to own a home, the main winners would be old and prosperous.

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Higher interest rates would bring down house prices by suppressing demand across the whole economy. If this is really what people want, one could get a more targeted result by putting a tax on houses, and using the proceeds to cut income tax. For example, a tax on property values of 3 per cent a year would bring down house prices even more effectively than a 3 percentage point rise in interest rates, because existing homeowners would have to pay as well. For that reason, of course, such a tax is political poison.

Another option is to target particular groups of buyers, as New Zealand is doing now by cutting mortgage interest relief for landlords. That reduces investment demand. Governments can also tax foreign owners, to limit buying from abroad, or regulators can require bigger deposits, to cut off the marginal first-time buyer. Setting higher loan-to-value ratios may be wise and necessary for financial stability reasons, although that is a separate matter to housing affordability.

Fundamentally, all of these policy ideas — higher interest rates, taxes, or restrictions of various kinds — are about reducing demand for housing. But how does suppressing demand for something people want make us better off? When demand for something rises, the only sane, logical, sustainable, free market response is to make more of it.

The politics may be uglier than blaming central banks, but for New Zealand and other countries wrestling with expensive housing, there is only one real answer: tackle nimbyism, cut planning regulations and let people build more houses. 

robin.harding@ft.com

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