Higher rates will weaken the UK’s economy via the housing market

After 10 consecutive interest rate hikes, the Bank of England is balancing the need to control inflation with the risk of increasing rates too far. The policy tightening is likely to weigh heavily on growth via the U.K. housing market, according to Goldman Sachs Research.

Overall U.K. price inflation was 10.1% in January, according to official data, well above the 2% target. However, quoted mortgage rates have risen substantially during the period of policy tightening, and the effect may be felt well beyond the property market. Our economists estimate that policy tightening could have a 2% effect on real GDP (adjusted for inflation) by the end of 2024 through housing-related effects alone.

“The U.K. faces considerable mortgage refinancing risks because most mortgages are fixed for five years or less, whereas most mortgages are fixed for longer periods in the U.S. and the Euro area. This raises the possibility of a sharp growth drag via the housing market,” GS Research’s James Moberly says. “Our analysis reinforces our view that the Bank of England will end the hiking cycle with a 25-basis point hike in March, given the size of the demand drag already in the pipeline.”

In a recent report, GS Research identified three ways the current hiking cycle could affect both the U.K. housing market and broader economic output:

1. Residential investment: Using a statistical model, GS Research found that the effect of persistently high interest rates on investment in residential property will amount to a drag of around 15% by the end of 2024, which equates to a 0.7% decline in the level of real GDP.

2. Mortgage affordability: GS Research estimates that the U.K.’s “effective” mortgage rates, which account for the actual interest paid, will rise to 4.1% by the end of 2024 (up from 2.3% at the end of 2022.) Moberly says this is likely to have negative effects on household spending, potentially contributing to another 0.7% reduction in the level of real GDP by the end of 2024. On top of that, Bank of England deputy governor Ben Broadbent recently argued that households’ overall net financial wealth has decreased sharply since post-pandemic peaks. This means households’ spending may respond more strongly to changes in disposable income from higher mortgage payments.

3. House prices: GS Research forecasts that policy tightening will reduce the level of U.K. house prices by 7% by the end of 2024. This again is likely to contribute to a fall in household consumption; previous studies suggest a 10% decrease in housing wealth in the U.K. is associated with a 1.4% fall in spending, Moberly says. GS Research estimates suggest that falling house prices could reduce real GDP by 0.7% by the fourth quarter of 2024.

Together, these three channels could contribute a total decline on real GDP of 1.2% by the end of 2023, rising to 2% a year later. By comparison, GS Research estimates that the European Central Bank’s hiking cycle would reduce Euro area real GDP by 1.2% via these housing-related channels. 

“Our research suggests that policy tightening will strongly affect demand through the housing market,” Moberly concludes. “This finding supports our view that policy rates will peak at 4.25% after a final hike in March, as the Monetary Policy Committee balances the need to bring inflation back to target with the risks of overtightening.”