Does housing protect us from inflation? This is the question posed by fears that it is about to rise significantly; a team of economists led by the University of Buckingham’s Tim Congdon recently warned that it could exceed 5 per cent in the next few years.
The answer is: probably not.
Which might surprise you. Bricks and mortar are physical assets which should hold up well when the value of money falls. What’s more, some of the things that cause consumer price inflation should push up house prices, such as easy credit, consumers’ optimism about their future incomes, or a tight labour market and rising wages. And, indeed, a belief in property as a hedge against inflation can be self-fulfilling; if enough people share the belief, fears of inflation will indeed raise demand for houses and hence their prices.
And, indeed, house prices have protected us from consumer price inflation over the long run simply because they’ve risen faster than consumer prices – three times as much so in the last 40 years.
Life, however, is not lived in the long run but from day to day. Over shorter periods, the link between consumer prices and house prices is weaker than you’d expect – and sometimes negative.
My chart shows this. It plots three-yearly changes in house prices against three-yearly changes in consumer prices. It’s true that the house price boom of the early seventies coincided with rising consumer price inflation. Other than that, though, there’s little evidence that house prices rise strongly when inflation is higher. Our highest inflation rates – from 1973 to 1976 – saw house prices fall in real terms. The house price boom of the late 80s began as inflation fell but burst as it rose in 1990. And the great housing boom of the early 00s came during a time when inflation was at a 40-year low.
In fact, since the Bank of England was given operational independence in 1997 there has been a strong negative correlation between house prices and consumer prices – of minus 0.63 for three-year changes in them and minus 0.49 for annual changes. In recent years it has been low consumer price inflation, not high, that has been best for house prices.
There’s a simple explanation for this: interest rates. Higher interest rates, and expectations thereof, are terrible for house prices. As nominal interest rates rise, house prices fall and vice versa: since 1984 there has been a correlation of minus 0.84 between the five-year gilt yield and the ratio of house prices to earnings. This is partly simply because higher mortgage rates raise the cost of buying a home. But it’s also because higher rates increase the discount rate applied to the future benefits of home ownership – be they rents received if you are a landlord or rents saved if you are an owner-occupier.
If higher inflation causes interest rates to rise – or even just the fear that they will – house prices will tend to fall.
Hence the pattern in my chart. In 1987 falling rates in response to lower inflation helped trigger a house price boom that was killed off by rising inflation and rising rates in 1989-90. And in the early 00s lower rates caused by lower inflation fuelled another boom.
Hence also why inflation was good for house prices in the early 70s. The government actually cut rates in 1970-71 as inflation rose – and so house prices took off.
All of which tells us that the response of house prices to consumer price inflation depends upon monetary policy. If it accommodates higher inflation then house prices will hold up. But if it doesn’t, they won’t.
In the near term, this is encouraging for property investors. The Bank of England has promised not to raise rates until there is “clear evidence” that it can achieve its 2 per cent inflation target “sustainably”. Which suggests that it will not raise rates immediately if inflation rises in the next few months: this is very likely because last year’s petrol price falls will drop out of the annual data.
In the longer term, though, it is less comforting. Unless the government changes the inflation target, the Bank would raise rates in response to inflation staying above 2 per cent – let alone rising to the 5 per cent feared by Professor Congdon. This would very likely hurt house prices.
We should not, therefore, look to property as protection against higher inflation. Which is why investors should fear inflation. The problem isn’t so much that it is likely to rise very far, but that we have so few reliable protections against the danger that it might do so.