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The hidden risks of rising rates and high house prices

Until recently, mortgage holders across advanced economies seemed safe in the knowledge that interest rates would stay put for some time. For the entirety of some of their lives as homeowners, there has barely been a hint of problematic inflation, let alone a suggestion that central banks would raise rates quickly to stop it. The worry was not unmanageable repayments, or falling prices, but finding enough money for a deposit to keep up with a market that showed no signs of slowing.

Many now find themselves revising these expectations. The Bank for International Settlements — the so-called central bankers’ central bank — has warned that rising interest rates could make existing debt burdens difficult to cope with and cause house prices to fall. Some have wondered whether housing debt represents the next “Minsky moment”: a term used to denote the point at which debt-fuelled asset bubbles unwind to cause economic collapse.

Much ink has been spilled in an effort to explain the long housing boom in advanced economies. The availability of cheap money with which to buy property has undoubtedly been a significant factor. Rates have been kept low in an effort to boost wages and growth. The side effect of these measures has been turbocharged demand for housing which ran head-on into supply constraints in many big cities.

If this boom is about to meet its own “Minsky moment”, an out-and-out crisis should be avoidable. While some banks could be overexposed to housing, regulators have not been ignorant to this risk. Stricter capital requirements should better insulate banks — unlike in 2008 — while some authorities have also been on the front foot, restricting the ability of households to become too highly leveraged.

Still, regulators cannot afford to be sanguine. Many mortgage borrowers who purchased over the course of the boom will be in significant debt — keeping up with house price inflation has been costly. While these high-leverage loans may not make up a large proportion of banks’ books, they are the kind that could go bad as borrowers struggle to keep up with higher rates, record increases in energy prices and other cost-of-living pressures.

Even if broader financial turbulence can be avoided, falling prices would not pass by without any impact. Economists have long speculated that households’ willingness to spend has some relationship to wealth as well as income. If house prices fall markedly, some decline in consumption is likely. Any shortfall in spending due to this so-called “wealth effect” may also be exacerbated by individuals devoting a greater proportion of their income to debt repayments as rates rise, and less to purchasing goods and services in the broader economy. Unwinding housing bubbles can also have deep ramifications in communities where defaults, or mortgage stress, may be more concentrated.

There are more benign possibilities. If inflation is brought under control, increases to long-term rates — which tend to inform mortgage rates — may be tempered. Many households could cope in this situation by using the buffer of savings they accrued during the pandemic. House prices may not fall as far as feared, or even at all.

That does not mean the risks are not real. Supporting growth and staving off economic crisis through years of “cheap money” was an understandable choice. As a new age of monetary tightening dawns, central banks and governments alike must hope that the housing debt built up in the previous era does not weigh too heavily on the prospects of the next.

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