Relax, the Bank of England Simply Cannot Hike Interest Rates

 | Jun 29, 2017 | 8:00 AM EDT
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If central bankers now are scrambling to undo the market damage caused by their remarks, they only have themselves to blame. Central banks have supported asset prices for so long that the markets have grown accustomed to being taken by the hand to ever-rising valuations. Any hint that a central bank won't oblige is bound to spark jitters.

Already, many market participants were worried that the monetary authorities were overstepping their mandate.

"The central banks around the world, they no longer view their mandate as only balancing inflation and unemployment. They view their job as preventing asset prices from going down a lot. This was never a job that central banks were supposed to be doing," Gershon Distenfeld, director of credit at AllianceBernstein, told Real Money.

The British pound enjoyed one of its best days since the Brexit vote on Wednesday, June 28, strengthening against the dollar after Bank of England Governor Mark Carney hinted that the bank's Monetary Policy Committee (MPC) might lose its patience if inflation stays too long above target.

"Some removal of monetary policy stimulus is likely to become necessary if the tradeoff [between inflation and growth] facing the MPC continues to lessen and the policy decision accordingly becomes more conventional," Carney said in a speech.

These words show that Carney is trying to portray the Bank of England as a monetary authority only interested in inflation and unemployment. But he may find it difficult to act. (For an excellent analysis on why the market reactions to central bankers' statements are so strong, head over to our sister site Real Money Pro and read this article by Tom Graff. If you are not a subscriber of Real Money Pro and want to become one, click here for details.)

If in the U.S. the Federal Reserve keeps a wary eye on the stock market, as household wealth depends on it, in the U.K. it is the housing market that is responsible for most of the wealth effect. And the U.K. housing market says it's really not the best time to raise interest rates.

Since the financial crisis of 2007-09, the U.K. government and the Bank of England have acted in concert to prevent a crash of the all-important residential property sector. Their intervention has worked so well that home prices have reached new record highs, at least in London and the south-east of England.

The Bank of England itself, in its Financial Stability Report, highlights just how important the residential property sector is to the British economy: "Housing accounts for nearly half of the total assets of U.K. households. And around two-thirds of house purchases are financed by mortgage debt."

The average price of a home in the U.K. is £211,301 ($274,479), more than 20% higher than in the first quarter of 2007. Prices in London and the south-east of England have been rising at a much faster pace than elsewhere. In London, the average home price was in April this year 73% higher than in April 2007, at £482,779.

The Bank of England's financial stability report blames a lack of building for the big increase. It notes that since a peak of 426,000 homes built in 1968, the number of homes built each year has more than halved while the population has kept increasing.

"The main drivers of housing supply are not under the control of the Bank of England or the FPC, and are partly related to the planning system," the financial stability report says.

However, one factor behind house price rises -- the interest rate -- has been under the central bank's control, and real negative interest rates have added fuel to the already-raging fire.

In their search for profit in a low-yield environment, banks increasingly have lent interest-only mortgages to buy-to-let landlords, who have accumulated many properties that way. The Bank of England admits, in its financial stability report, that "the size of the buy-to-let segment of the mortgage market has almost doubled since the period before the crisis."

It is true that since April last year the growth in buy-to-let mortgage lending slowed because the government started to withdraw some of the tax relief it offers to landlords, but the sector still could prove vulnerable.

There already is anecdotal evidence that arrivals of workers from the European Union are slowing due to uncertainty after the Brexit vote. Rents have been falling in London over the past few months in another sign that the housing market is weakening. In the London luxury property sector, prices have fallen by almost 7% since the Brexit vote in June 2016.

In this context, an interest rate hike would be the last blow for the flagging residential property sector. The Bank of England simply cannot afford to do it.

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