Interest rates are part of UK Monetary Policy.
In the UK the objective of Monetary policy is the control of inflation. The Bank of England Monetary policy have an inflation target of CPI = 2%. Inflation can vary by 1% either way. In short the MPC’s primary objective is to keep inflation between 1% and 3%.
This means that when setting interest rates, in theory, they look only at inflationary pressures. Other objectives like economic growth, unemployment and the housing market do not directly effect interest rates.
Every month the MPC meet to decide whether interest rates should change. They look at future inflationary predictions if inflation is likely to rise above the target they will increase interest rates. To predict inflation they look at over 35 different economic statistics. One of these statistics includes house prices.
Effects of Rising House Prices on UK Interest Rates
If house prices were rising rapidly it would be likely to cause inflationary pressures. This is because as house prices rise, there is an increase in consumer wealth. Therefore homeowners could remortgage their house. Through Remortgaging they can have equity withdrawal which can then be spent in the general economy. This extra wealth and spending can cause high levels of spending, economic growth and therefore inflation.
However it is worth noting that higher house prices don’t necessarily cause inflation. This is because there are many factors affecting aggregate demand in the economy; house prices are just one factor. For example in the UK since 1998 house prices have been rising at an average rate of almost double figures. This has been a major contributor to rising consumer spending in the economy. However, because of economic weaknesses elsewhere, growth has been close to the long run trend rate (average sustainable rate of growth) This means that inflation hasn’t occurred even though house prices have been rising rapidly. For example there has been weakness in the manufacturing export sector – reflected in a current account deficit.
This shows a limitation of Monetary policy. To keep the economy growing at the average rate of 2.5% it has been necessary to allow a boom in house prices and rapid growth in consumer borrowing. The UK’s economic growth has thus been unbalanced.
Effect of Falling house prices on Interest Rates.
If the housing market was to go into decline it is likely to put downward pressure on interest rates. This is because a fall in consumer wealth would have a significant adverse impact on consumer confidence and consumer spending. Falling house prices would cause consumer spending to fall. Therefore inflationary pressures would fall, thus allowing the Bank of England to cut interest rates.