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A tale of two inflations

Higher consumer price inflation is often bad for house prices.
March 25, 2022

Although everybody is worrying about inflation, there’s one type of it many people like: house price inflation. This was 12.6 per cent in February according to the Nationwide, and 10.6 per cent on the Halifax’s measure, and yet few people – or at least few with a voice – think this a problem.

But it raises the question: what’s the link between house price and consumer price inflation (CPI)?

You might think the two go together. Both can be signs of loose monetary policy or booming demand.

True, sometimes they do. In 1988-89, for example, we saw both rising CPI inflation and high house price inflation. More often, though, the two actually diverge. In fact, since 1991 there has been a negative correlation between annual CPI inflation and annual house price inflation – of minus 0.44 on the Nationwide’s measure. There has also been a negative correlation (also of minus 0.44) between CPI inflation and house price inflation in the following 12 months. For example, low and falling CPI inflation in the early 2000s, in 2015-16 and in 2019-20 was associated with and led to rising house prices, while high and rising CPI inflation in 1989 and 2007-08 led to house prices falling.

There’s a simple reason for this. The Bank of England responds to higher CPI inflation by raising interest rates – and higher interest rates typically mean lower house prices. True, fewer mortgages are now linked to Bank rate than there used to be. But this doesn’t overturn the story. Fixed-rate mortgages are rising because gilt yields have risen – and they’ve done so in anticipation of the Bank raising rates.

Of course, the Bank now might be slow to raise interest rates, and rightly so given the fragility of the economy. But this doesn’t necessarily protect house prices. We should think of these as being the net present value of future rents (or the rents we save by owning our own place). Obviously, this value falls if interest rates rise because future rents are then discounted more heavily. But it can also fall if future rents fall. Which they will if incomes drop: even in London, there’s a limit to how much rent people can afford.

Lower real incomes should mean lower real house prices. Yes, the acute problem of a squeeze on incomes caused by higher gas and oil prices will fade away next year if futures markets are right. But the chronic problem caused by weak productivity and rising relative prices of services and energy might not.

Of course, this doesn’t necessarily mean that house prices will fall in nominal terms: they can fall in real terms by not rising as much as CPI inflation.

History and theory both therefore tell us the same thing – that high and rising CPI inflation could well lead to lower house price inflation. Granted, this process will be restrained by the fact that an ongoing lack of supply will support prices – but this is hardly a sign of a well-functioning market.

Personally, I’m happy with this prospect. It is only for a minority of home-owners that house prices are wealth at all: those planning on trading down; using their mortgage as loan collateral; or using home equity release schemes. And for the economy and society generally, high house prices are a menace: they increase debt and hence financial fragility and depress productivity by shifting resources to a sclerotic part of the economy and by increasing commuting times. If higher CPI inflation does lead to lower house price inflation it would thus be a welcome development. Every cloud has a silver lining.