Daniel Albuquerque and Jamie Lenney
Rent prices have risen by 9% on average in England since the Bank of England’s Monetary Policy Committee (MPC) started raising interest rates in December 2021. Alongside this rise in prices has been a widening in the gap between reported supply and demand in the rental sector, with tenant demand continuing to rise in 2023 amidst falling supply (RICS survey). Is monetary policy causing the rise in rents? In this post, we provide evidence that temporary increases in interest rates are ultimately associated with a decrease in rental prices that follows an initial, but relatively short lived, increase in rental prices and tenant demand. These results also hold across regions in England.
Rising rents and monetary policy
The recent rise in rents will be of significant concern to the 19% of households in the UK that are private renters, for whom housing costs already take up 33% of their income on average. Despite the fact that rising interest rates have been implemented to reduce overall price inflation, monetary policy has been cited as a possible cause of rising rental prices principally through two channels. First, the resulting increase in mortgage costs has consequences for both supply and demand in the rental market: it can discourage new buy-to-let landlords, and keep future homeowners as tenants for longer. Second, housing is an investable asset, and returns on other assets are rising due to the increase in interest rates. Thus, even non-mortgagor landlords are likely to increase rents in response to rising interest rates to match the expected return on other assets.
However, empirical evidence is mixed – in the US, for example, economists at the San Francisco Fed find that rents immediately decline in response to rising interest rates, while other work has documented increases in rental prices without a subsequent decline.
So is there any evidence that monetary policy is pushing up rental prices in the UK?
Estimating the causal effect of monetary policy on the rental market
In order to answer this question we use a local projections framework with 12 lags of the variable of interest as controls. We rely on monetary policy surprises identified in the 30-minute windows around MPC announcements to estimate the effect of monetary policy on rental prices, as described in more detail by Cesa-Bianchi et al (2020). We use unexpected changes (surprises) to identify the effect of monetary policy because most interest rate changes are made in response to current and future economic conditions. Simply using all interest rate changes would mix up the effect of interest rates on rental prices with the effects of other shocks that interest rates are trying to counteract.
For rental prices, we use data from ONS’s Index of Private Housing Rental Prices from 2005 to 2019, for England. We focus on England because data for the whole of the UK is available from 2015 only. We choose to end our data sample in 2019: we exclude the Covid pandemic period, because the relationship between monetary policy and rental prices may have changed during this time; and we have insufficient lags of data to make it worthwhile including data post-pandemic.
Chart 1 shows the estimated response of housing rents to a 1 percentage point rise in interest rates. The response for England as a whole is the dark blue line with the 1 standard deviation confidence interval shaded in blue. We also plot the point estimates for each English region in grey. The point estimates indicate rental prices rise by around 1% over the 12 months following a rise in interest rates. This result is replicated in most regions in England with the exception of the East Midlands, where the central estimate shows no rise in rents. Chart 1 also shows that after around 12 months this rise begins to dissipate, and by month 22 the point estimate is below zero in all regions.
Chart 1: The response of private rental prices to a 1 percentage point rise in interest rates
Note: The blue shaded region is the 1 standard deviation confidence interval for England.
Does the response of rental prices make sense?
As noted above, since housing is an asset, when real interest rates rise the real return on housing should ultimately also rise in line with other available returns. This real return can be achieved by either rising rents or falling house prices, or some combination of the two. Using the same local projections framework as in Chart 1, Panel A in Chart 2 shows that rental yields (rent divided by house price) do indeed rise in response to rising interest rates. Panel B decomposes this response in rental yields for England between movements in rental prices and movement in house prices (the latter is calculated as a residual).
Chart 2: Response of rental yields to a 1 percentage point rise in interest rates, and its decomposition between yield and house prices movements
Note: The blue shaded region is the 1 standard deviation confidence interval for England.
As Chart 2B shows, rental prices increase initially, in line with the increase in rental yields. However, our estimates suggest that most of the adjustment is coming from falling house prices, even though that adjustment is sluggish and takes almost a full year to materialise. As house prices are slow to adjust, this puts pressure on rents to rise at first in order for landlords to make adequate returns relative to their outside option ie selling and investing in other assets like government bonds. At the same time, we find that housing transactions fall in the year following the interest rate rise (Chart 4A uses the local projections frameworks from before on UK Land registry data for housing transactions). This slowdown in housing transactions can help explain a reduction in the supply of rental housing if selling landlords take their property off the rental market but struggle to find prospective buy-to-let landlords who, discouraged by rising mortgage rates, need house prices to fall further to make adequate returns.
Using survey data on the residential market provided by RICS and household panel data from Understanding Society we can also analyse the effect of monetary policy on tenant demand. Panel A in Chart 3 uses a similar framework as used in Chart 1 to plot the response of the reported net balances of changes in tenant demand in the rental market in the RICS survey. It shows that a rise in interest rates is initially associated with a rise in tenant demand that then dissipates after around a year. In Panel B, using individual panel data, we show that the estimated probability of home ownership falls for younger cohorts in the 12 months following a rise in interest rates. This helps to partially explain the rise in tenant demand through a delay in the transition from renting to owning.
Chart 3: Tenant demand after a 1 percentage point rise in interest rates
Note: The blue shaded regions are 1 standard deviation confidence intervals.
So initially rising interest rates could well cause pricing pressures in the rental market. However, over time house prices fall due to tighter monetary policy and enable new landlords to come in and offer lower rents. At the same time, households are likely to become increasingly unwilling to accept and afford rent increases as the effect of monetary policy on their real income builds. This gradual transmission of monetary policy to broader economic activity and incomes is illustrated in Panel B of Chart 4, which uses a similar framework to that of Cesa-Bianchi et al (2020) to show an estimate for the effect of a 1 percentage point rise in interest rates on GDP. Panel B shows GDP falling gradually with the peak impact occurring after around 12 months and persisting beyond that.
Chart 4: The gradual response of housing transactions and economic activity to a 1 percentage point rise in interest rates
Note: The blue shaded region is the the 1 standard deviation confidence interval.
Rental prices in context today
The causal effect of monetary policy in any given cycle is always difficult to disentangle from other broader shocks. This is especially true today with the UK in the midst of a broader inflationary shock, and still recovering from the longer-run economic effects of Covid that upended housing markets and migration flows. It is also worth noting that there have been changes in regulations affecting the rental market. These shocks are both directly and indirectly the underlying drivers of rising rents. Chart 5 plots the rise in private rents since December 2021 alongside the rise in average earnings and the level of CPI services. Both have tracked and indeed outgrown the rise in private rental prices, meaning that the relative cost of renting on average has not risen since interest rates started to increase. Compared to our results this is somewhat surprising, as our analysis would suggest rents could be growing faster than wages or other services now. However, other shocks to the UK’s labour market or cost pressures in specific sectors make it difficult to be definitive in this statement. Overall, through the lens of Chart 5, the pressures in the rental market seem to be consistent with the broader supply constraints in the economy.
Chart 5: Rental prices relative to incomes and other prices
Note: Prices are in levels and normalised to 100 at December 2021. Earnings are average weekly labour earnings.
Summing up
This post suggests that interest rate rises decrease rental prices in the long run, but that they may initially put pressure on the rental market. In our analysis, a temporary rise in interest rates leads to temporary increases in rental yields, as happens for returns on other assets in the economy. Tenant demand rises at first and landlord supply may be dampened by rising mortgage costs and slow adjustment of house prices. However, over time, our results indicate that the housing market should adjust, causing rental prices to decline.
Daniel Albuquerque and Jamie Lenney work in the Bank’s Monetary Policy and Outlook Division.
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