House Prices and Central Bank Policy in the United Kingdom

Assignment Brief

• Did a house price boom proceed the most recent recession?

• Does the central bank in the country you have chosen include house prices (or equivalent) in the measure of inflation which underpins their inflation-targeting regime? If not, then what is their justification?

• Does the data you have collected suggest their choice (of whether to include house prices or not) has impacted their ability to fulfill their mandate (i.e. keep the economy at target)?

• Using central bank websites to collect data on monthly policy rates and mortgage rates between 2000 and 2012, plot the data on graphs, and comment on the banking mark-up: does it change over time? How? Why?

Sample Answer

House Prices and Central Bank Policy in the United Kingdom

The financial crisis of 2007–2008 was not an isolated event but followed a period of rapid growth in asset prices, particularly in housing. In the United Kingdom, house prices rose steadily from the early 2000s until the onset of the recession. In 2000, the average house price stood at around £85,000. By 2007, this had more than doubled to approximately £180,000, representing an increase of over 110% in just seven years. This strong expansion, often called a housing boom, created both confidence and risk within the financial system. When the recession struck in 2008, house prices dropped by nearly 20% within two years, leaving many households facing negative equity and banks with large exposures to risky lending. It is fair to conclude that a house price boom did indeed precede the most recent recession in the United Kingdom.

The Bank of England (BoE) is responsible for monetary policy and bases its decisions on an inflation-targeting framework. The measure used is the Consumer Prices Index (CPI), which does not include house prices. Instead, it captures elements such as rents, energy costs, and goods and services consumed by households. The Bank’s reasoning for excluding house prices is that the property market is highly volatile and often influenced by structural factors such as planning restrictions, demographic shifts, and investor demand. Directly including house prices in the inflation index could lead to unstable policy reactions and frequent interest rate adjustments, which may harm the wider economy. From the Bank’s perspective, monetary policy is more effective when focused on overall consumer prices rather than asset values.

This approach has both strengths and weaknesses. On one hand, CPI inflation between 2000 and 2012 was mostly kept within or close to the 2% target, suggesting relative stability. On the other hand, the failure to monitor house price growth as part of the official target arguably allowed financial risks to build up unnoticed. In practice, while inflation remained steady, the housing boom encouraged high levels of borrowing and speculation. This created vulnerabilities that became clear during the financial crisis.

To explore this further, it is useful to examine data on the policy rate (set by the Bank of England) and mortgage rates over the same period. Using illustrative numbers, in 2000 the policy rate was around 6.0%, while average mortgage rates stood at 7.5%. By 2003, the policy rate had fallen to 3.5%, with mortgage rates at 5.0%. This narrowing of the gap reduced the cost of borrowing and stimulated demand for housing. In 2007, just before the crisis, the policy rate was 5.5% while mortgage rates averaged 6.5%, keeping borrowing costs relatively low despite rising house prices. During the crisis itself, the policy rate dropped sharply to 0.5% by 2009, while mortgage rates declined more slowly to about 4.0%. This widened the difference between the two, showing banks increased their mark-up to cover risks and rebuild balance sheets.

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