Houses as Collateral: Has the Link between House Prices and Consumption in the U.K. Changed?

I. INTRODUCTION Significant attention is paid by policymakers in the United Kingdom to the relationship between house prices, the business cycle, and inflation, on account of the pronounced procyclical pattern of house prices. Are house prices a symptom of macroeconomic conditions? Or are there important feedback effects from house prices to real variables? As this paper shows, the data suggest that there is a strong comovement of house prices with consumption and with consumer durables expenditures in particular. A deeper look at the data seems to indicate that house prices are not a source of fundamental shocks, but are part of the transmission mechanism by which changes in short-term interest rates affect consumption, the output gap, and hence inflation. It is important for policymakers to study how this transmission mechanism works, and this is one objective of our paper. There have been numerous studies of the relationship between housing and consumption in the United Kingdom. (1) However, these studies have tended to be partial-equilibrium analyses, which are inappropriate for examining the monetary policy transmission mechanism in the macroeconomy. Another important set of questions concerns the implications for monetary policy of the structural changes taking place in the United Kingdom's retail financial markets--starting in the early 1980s and still continuing today. As documented later, the market for credit cards and unsecured loans has seen a large number of new entrants. Increased competition in retail credit markets is likely to have widened the availability of credit and reduced its price. In the mortgage market, a wider range of products has become available, and it has become easier for consumers to withdraw housing equity to finance consumption. It is important for policymakers to understand whether these structural changes in retail financial markets have affected the relationship between monetary policy and housing variables. To address these questions, we apply the financial accelerator model of Bernanke, Gertler, and Gilchrist (1999)--or BGG--to the household sector. The BGG model is a dynamic general-equilibrium model that focuses on the macroeconomic effects of imperfections in credit markets. Such imperfections generate premia on the external cost of raising funds, which in turn affect borrowing decisions. Within this framework, endogenous developments in credit markets--such such as variations in net worth--work to amplify and propagate shocks to the macroeconomy. In our model, we show that a rise in house prices increases the value of collateral available to households. This stimulates consumption and housing investment by making it easier and cheaper for households to borrow against the value of their home. Therefore, fluctuations in house prices amplify fluctuations in consumption and housing investment over business cycles. Because house prices affect households' borrowing decisions, structural changes in the market for retail financial services--such as those that have occurred in the United Kingdom over recent years--are likely to have affected this element of the transmission mechanism. Using our model, we simulate the impact of financial innovation in the United Kingdom. Also examined is the effect of recent improvements in households' ability to access housing collateral. We show that this increases the response of consumption to a monetary policy shock, but reduces the response of housing investment and house prices. In the second experiment, we simulate the effect of developments in unsecured consumer credit markets. Here, we demonstrate that the effects of a monetary policy shock are reversed: the responses of housing investment and house prices are larger, but the effect on consumption is dampened. Our experiments suggest that the overall change in consumption associated with a given change in house prices is likely to have risen relative to the past. …