The Effect of Interest rates on Housing and Shares

Readers Question: Hi, Please could you explain this question. Contrast the likely effects of monetary policy decisions on the price of housing and shares.

Monetary Policy involves changing interest rates to try and influence aggregate demand and target low inflation and high growth.

If inflation was increasing above the governments inflation target, they would increase interest rates to reduce inflationary pressures.

The Affect on Housing

Higher interest rates increase the cost of mortgage interest rate payments. Therefore, it makes it less attractive for people to buy a house. If interest rates increase too much, some people may not be able to afford their mortgage payments and default on their mortgage. This means they will have to sell their house. This effect will be to reduce demand for houses and therefore lead to lower house prices.

Note: In the US, many people took out risky mortgages in the period 2001-06. These mortgage payments were a high % of their disposable incomes. Therefore, a small increase in interest rates from 2% to 4% had a serious adverse effect on the US housing market. In France or Germany, these kind of mortgages are less common and therefore, higher interest rates would have much less impact on house prices.

Also if economic growth and demand for houses was very strong then higher interest rates may not reduce demand for housing and house prices could continue to rise, especially if there was a shortage of supply like in the UK.

See also: Effects of higher interest rates 

The Affect on Shares.

Higher interest rates could lead to slower economic growth and this may lead to lower share prices. Lower growth will lead to lower profits and  lower dividends making shares less attractive. Also higher interest rates make bonds and securities relatively more attractive than dividends from share prices.

However, the impact will be much less than in the housing market because interest rates don’t directly affect the cost of holding shares (like a mortgage which is directly related to interest rates).

Also, higher interest rates will not always cause lower share prices as there are many factors which affect share prices in addition to interest rates. Share prices depend on market confidence, expectations of future growth and general market sentiment. Often stock market sentiment is not related to current economic conditions like the 1987 stock market crash in the middle of an economic boom.