Where would UK property prices be without QE & ZIRP?

In response to the 2008 global financial crisis the government in Britain slashed interest rates to 0.5%, a policy known as ZIRP (zero interest rate policy), and embarked on a £375 billion program of QE (quantitative easing). These measures arrested the fall in property prices and have since provided them with a significant boost. The question is, where would UK property prices be without QE & ZIRP?

In response to the recession and threat of depression in the wake of the 2008 global financial crisis, the government in Britain slashed interest rates to the lowest level in more than 300 years. Interest rates have remained at 0.5% for 26 months and this phenomenon is now known as ZIRP (zero interest rate policy).

ZIRP has several objectives. First and foremost it is designed to provide relief to those with large debt service payments. It is also designed to encourage people to go out and spend in the hope that this will stimulate economic growth.

In addition to slashing interest rates, the Bank of England also embarked on an unprecedented program of QE (quantitative easing) in which they printed £375 billion and injected it into the economy via the banking system.

Both QE and ZIRP were designed to counter the natural process of debt repayment (debt deleveraging) that is taking place in the private sector. That’s because as households and businesses underconsume in order to pay back the debt accumulated in the years leading up to 2008, economic output (GDP) falls. Significant also is the fact that as the debt is repaid, thanks to fractional-reserve lending, the supply of money/ credit in the economy contracts causing deflation. Deflation is deemed bad because when it occurs the value, or purchasing power, of money (in the form of both savings and debt) increases making it harder to repay debt.

The question this article tries to answer, is where would house prices in Britain be today if policymakers had chosen not to intervene with QE and ZIRP?

As the chart below shows, property prices in the UK declined from an October 2007 peak of £186,044 to a low in February 2009 of £147,746, a fall of 20%. However, this decline was arrested by QE and ZIRP, as well as other government policies such as the NewBuy Guarantee scheme and the Rent to HomeBuy scheme. The question is, by how much?

Average UK house price: January 2000 to May 2013 (Click on the chart for a larger version)

Average UK house price: January 2000 to May 2013 (Click on the chart for a larger version)

Source: Nationwide House Price Index. Note: The Price of a typical UK home increased by 0.4% in May to £167,912.

Historically, i.e., looking at interest rates since the Bank of England began recording them in 1694 rates have averaged around 6%. Over the last 70 years however, interest rates in the UK have averaged 9%. Were interest rates set by the free market, there can be no doubt that they would be very much higher than the current 0.5%.

Interest rates are the price of money, and like any other price, they are set by supply and demand. Today, for the most part, consumers and businesses are hunkering down and therefore the demand for money is relatively low. This would suggest low interest rates. However, a lack of available capital, as we have today, would suggest relatively high rates.

An examination of peer-to-peer lending services such as Zopa and RateSetter suggests that interest rates should be in the 5-6% range. This tallies with historical evidence which shows that interest rates tend to be around 2% above the rate of inflation, and inflation, as measured by the Retail Prices Index (RPI), is currently 2.9%.

If interest rates today were 5%, it would suggest that the typical standard variable rate (SVR) among mortgage lenders would be considerably higher than the current 3.99% (Halifax figure), perhaps as high as 8%.

Given then, that to a very large degree, property prices in the UK are being held up by ultra-low interest rates, what would happen if the typical monthly mortgage payment were to double? The answer is likely that property prices would experience a sharp re-pricing to bring them much more in line with historical, rational valuations.

By almost any measure property prices in the UK are considerably overvalued. A 2 bedroom flat in Leicester for example, costs around £250,000 – more than nine and a half times the average annual UK salary, while the equivalent property in Birmingham will set you back £500,000.

According to Nationwide the average home in the UK now costs £167,912. However, the ONS (office for national statistics) puts the average wage at £26,500, which means that the typical home buyer needs to borrow 5.07 times his or her salary in order to buy it (assuming a 20% deposit).

If property prices were to fall such that the house price to income ratio returned to its historical and prudent 3.5 level, then the average UK home would need to fall in price from £167,912, to £111,300 – a fall of 33.7%. This would bring the 2 bedroom flat in Leicester down to £188,000 and the Birmingham property down to £375,000.

The bottom line

History tells us that sooner or later policymakers will have to stop QE and let interest rates return to normal levels. When they do, it seems likely that the property market will experience a considerable revaluation. However, it’s worth bearing in mind that what’s referred to as “the property market” is actually made up of several different markets, and it is likely that properties such as those in prime central London would be far more insulated than those in other less affluent regions.

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