Could a house price crash still trigger a recession?

Could a house price crash still trigger a recession?

Fingers crossed, it looks like the UK has dodged the severe recession that many had feared. But we are not out of the woods yet. Could a sharp fall in house prices still drag the economy down?

Many better economists than me have been tripped up by their forecasts for the UK housing market. For what it is worth, my hunch is that prices will fall further this year than most expect.

House prices continued to rise sharply in the first half of last year as the economy opened up again, people reassessed their property needs, especially those ‘working from home’, and borrowing remained cheap.

But the market then began to slow in the second half, as the cost-of-living crisis worsened, recession worries grew, and mortgage rates took off. By the end of 2022, house prices were falling outright. This has continued at the start of 2023.

Kwasi Kwarteng’s infamous ‘mini-Budget’ obviously did not help either. Interest rate uncertainty caused lenders to withdraw products, and deterred potential buyers, freezing the market temporarily.

Nonetheless, mortgage costs would have jumped anyway as the Bank of England returned interest rates to more sustainable levels. The same has happened in the US, where long-term fixed rates have more than doubled, and in the rest of Europe.

So what next? The consensus is that the downward trend in UK house prices will continue through 2023, reflecting a combination of higher interest rates, lower real incomes and a weakening jobs market. But housing market experts seem remarkably complacent: the median forecast in the latest Reuters poll is for UK house prices to drop by just 2.4% this year .

I would not be surprised to see a bigger fall. For a start, even a drop of 10% would only make a small dent in the gains over the last decade. According to the Office for National Statistics (ONS), average UK house prices rose by nearly 75% between the end of 2012 and the end of 2022.

Affordability is also increasingly stretched. Indeed, the Leeds Building Society recently estimated that the price-income multiple is now the highest since the institution was founded in 1875.

This did not matter so much when interest rates were low. But while rates may not rise quite as much as the markets feared last autumn, the long period of ultra-loose monetary policy is now over.

The Bank of England has estimated that around half of owner-occupiers with a mortgage will face significant increases in their repayments this year (which is about four million households).

On top of this, there are around two million buy-to-let mortgages, the vast majority of which are ‘interest only’. Landlords are likely to pass on higher interest costs as higher rents, or to sell properties thus adding to the downward pressure on prices.

Stepping back a bit, one of the main factors driving up house prices since the mid-1980s has been the fall in the real rate of return on alternative assets. Bank of England staff analysis has suggested that a sustained increase in the yield on inflation index-linked gilts of just one percentage point could lower the equilibrium level of real house prices by as much as 20%. That seems the right ballpark to me.

Even if houses remain in short supply, due to a lack of new building and continued high net immigration, prices cannot defy gravity for ever.

This creates some wider risks. The housing market is, of course, a significant part of the UK economy in its own right, both via ‘real estate activities’ and the building of new homes.

There are already signs that the housing downturn is biting. The first estimate of UK GDP for the final quarter of last year included a fall of 3.2% in new housebuilding. This sector has also weakened sharply in the United States and Germany too.

A sharp drop in house prices could also hit the economy in several other ways, including lower household wealth, weaker consumer confidence, and damage to the balance sheets of mortgage lenders. But I am still not sure that a drop of even 20% would be a gamechanger.

It is true that house price booms have often gone hand in hand with a strong economy, and house price busts with recession. And yet, as every student of economics should know, ‘correlation does not necessarily prove causation’. Fluctuations in the housing market may simply be reflections of other and bigger factors driving the economy.

The ‘wealth effects’ from changes in house prices are often exaggerated as well. Some people will gain when house prices rise, typically older homeowners planning to downsize to a smaller property, or access the equity in their home.

But many others will lose, including younger families hoping to trade up, or renters whose landlord needs to charge more. It therefore makes more sense to view a rise or fall in house prices as a change that redistributes wealth, rather than creates or destroys it. And even if prices fall by 20%, anyone lucky to enough to have bought ten years ago should still be well ahead.

As for any direct link between the housing market and other forms of spending, including those associated with moving house, the level of activity is typically more important than the level of prices. Put another way, if prices are too high, the market will dry up, and a correction to a more realistic level could actually be healthy.

In the meantime, sky-high house prices are clearly not good for spending if potential first-time buyers have to save even more for a deposit instead. If you are looking to upsize, or are a first-time buyer, a sharp fall in the price you have to pay for your new home will also go some way toward reducing your mortgage repayments, even if rates are higher.

Thinking about this year in particular, if interest rates do level out soon, the energy crisis eases, and the labour market remains firm, the UK economy should avoid a severe recession – whatever happens to house prices.

The UK banking system is also in relatively good shape to weather an economic downturn, including any hit from lower house prices, thanks to stronger capital and liquidity positions.

In short, the house price boom is surely over and the risks of a crash are high. But a sharp fall in house prices should not be enough to sink the rest of the economy.

3 thoughts on “Could a house price crash still trigger a recession?

  1. An interesting and insightful piece as usual. I am constantly surprised by the main stream media, the BBC in particular, that, when reporting on a small monthly fall in house prices, always couch it in words that suggest constantly rising prices are in some way a good thing. That (a) this is blindingly, obviously untrue for the increasingly uninvested in society and (b) totally ignores the fact that all markets are cyclical seems to pass them by, when normally they are doom mongers with regard things economic. It seems that the house price fairy economist governs attitudes to the personal investment element of owning property, making those afflicted blind to the very real property price collapses in living memory. I find this bizarre; it is almost as though it doesn’t bear contemplation, so let’s not. On your conclusion that a price crash won’t crash the wider economy, isn’t the real issue of a return to interest rate historic norms the fact that probably 25% of homeowners will end up defaulting on their mortgages with all the consequent chaos that will follow? What sensitivity analysis is done by the BoE in this respect and does it influence policy?

    Liked by 1 person

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