Impact of Change in Interest Rates on Asset Prices - Essay Example

Impact of Change in Interest Rates on Asset Prices A Review: Introduction The Purpose of this study to have a look at the influence of interest rates on various asset prices at the very outset. The study also makes an attempt to come out with the factors that are directly responsible for an interest rate change and the policies of Bank of England or for that matter any Central Bank. It also makes an attempt to go deep into the factors that can influence property prices, besides a change in interest rates. The study also deals with the monetary policy of the Bank of England and its role in regulating the interest rates and inflation. So the purpose of the study covers a wide purview of Bank of England's monetary policy and tools used to contain inflation and regulate property prices and also the various factors that are responsible for a change in property prices. Explanation Any government has the power and responsibility to regulate the economy of a country and not only does it regulate the economy, it has a vital role to ensure that the economic condition remains stable. It is the responsibility of the government to ensure that all the aspects of economy maintain a stable level so that the country can grow and expand. Government regulates many things in an economy including inflation, exports and imports, prices of many vital commodities, and many important economic aspects. For example Government of England has entrusted the job of determining the monetary policy, in the hands of Bank of England. Bank of England looks into many other big issues. One of the most important issues is that of ensuring monetary stability in the economy, which can be achieved through a combination of stable prices of goods and services across the economy coupled with a low inflation level and level of confidence of the investors in the currency of the country. The Bank comes out with the monetary policy in order to ensure a certain key objectives like, delivering price stability with a low inflation level coupled with an objective to support the Government's economic objectives of growth and employment. Price stability is taken care of, by the Government's usual inflation target of 2%. There is a need to contemplate the crucial and critical role played by price stability in achieving the aforesaid economic stability, and in providing just the right conditions for a sustainable and longer living growth in output and employment. Chancellor of the Exchequer announces the Government's inflation target every year in the annual Budget statement. Though The 1998 Bank of England Act enables it to set interest rates independently, however, The Bank does hold accountability to the parliament and the wider public, which can not be refrained from. The legislation provides the government the power to instruct the bank on the interest rates issues for a limited period of time during emergency, for the sake of national interests. (How Monetary Policy Works) A target of 2% does in no way mean that inflation will be held at this rate constantly. That would be neither possible nor in any way desirable. Interest rates would be changing all the times, causing unnecessary volatility in the economy. Even then it would neither be possible nor feasible to keep inflation at any predetermined level, say 2% in each and every month continuously. Instead, the committee aims to set interest rates so that inflation can be brought back to target within a reasonable and imaginable span of time without creating undue instability and volatility in the economy. The government is also entrusted with the job of regulating property and commodity prices. To have a look into this in detail, we may need to analyze the factors that are generally responsibly for a rise in property prices. Before buying a house property, any buyer's first job is to assess the price of the property depending on the location, as location as a non-economic factor plays the biggest role in determining property prices all over the world. Once a buyer comes out with a reasonable price, they can offer the same to the seller. The price offered by them, however, can be based upon the market price or the price based on the utility of the property. If they offer price based on the utility of the property, they are offering a price based on their estimate that was deducted logically keeping in view all the factors. Assessing the price of a property is not an easy job, there are three main methods besides the economic factors that determine value, namely "Comparable Sales Method", "Income Approach" and the "Cost Approach" (Property Valuation for Home Buyers), but these methods are just a tool for a prospective seller to determine the price of the house they are going to sell and this price definitely influences the price at, which the transaction actually takes place. Let us now analyze how the concept of value plays a role in determining the prices and what factors influence value. As mentioned in the article, value is subjective and differs from person to person. Value of a beautiful flat in a very posh locality can differ from person to person. Someone who likes to lead an isolated life will not value such a property as much as they value a deserted place down the countryside. The price of a beautiful flat in a top location may be inflated because of factors like, institutions in that area, economic zone of that area, wage levels in the area, and building zones and environmental legislation. These prime factors give rise to a mismatch in demand and supply, which eventually inflates the prices. The point to be taken note of, here, is that prices deducted by the forces of demand and supply will always be different from the prices deducted on the basis of value. The approaches mentioned above evaluate the prices based on value, hence it was important to be familiar with the concept of value. Talking of the demand and supply concept and how this works to influence prices, we can divide the demand and supply conditions into two parts, first when it is a sellers market and second when it is a buyers market. (Demand and Supply for Housing). In a sellers market there is more demand and scarce supply, which makes it a fine proposition for sellers, as they can wait for their prices to come. In a buyers market, however, the demand is less and property available in the location is more. This phenomenon gives rise to a buyers market, as they can in such a scenario, wait for their prices to come, needless to say that these prices are far too low than the actual prices. Now the question arises that, what happens when there is a shift in the demand curve in a particular market. Let us assume that there is a sudden surge in demand because of an increase in population in that area or because of the change in income of the residents of that particular area. The surge in demand will push the price up, which will then settle for a new demand curve, in other words, there will be a shift in the demand curve, but as soon as the inelastic supply equals the new demand, the price will again come down. The phenomenon is explained with the help of a diagram below. (Demand and Supply for Housing) In the diagram shown above, there is a rise in price when price moves from P1 to P2 this has taken place due to the shift in the demand curve, where it has moved from D1 to D2, D1 stands for Demand 1. This shift may happen due to a number of factors, one of them may be a sudden increase in population, as mentioned above. As a result of a new demand curve, the price has also move up from P1 to P2. An important point to note here is that, while the price has moved up along with the demand, quantity sold has not changed that much, when compared. This is because of the fact that the supply for property is always inelastic due to the time gap between the change in price and the increase in supply. Other reasons behind a change in property prices can be Mortgages. A mortgage is the money borrowed to buy a house, as for most people buying a house is not easy. Over the years mortgage market has picked up greatly and the current scenario is totally different from the one that existed in the beginning. Mortgages were supplied only by the building societies. Building societies were non-profit institutions and encouraged only the members for the grant of loans, so the people who were members and had contributed to an extent for a considerable period of time got loans easily and account with building societies became the only means to get mortgages. Soon these societies had to compete with the banks and other financial institutions specialized in granting housing loans. This price war resulted in a greater demand for owner occupied houses and consequently the demand for houses grew stronger, resulting in a substantial increase in price. (The UK Housing Market - Factors Influencing the Housing Market: Mortgages) Besides the above-mentioned factor of mortgages there are other factors like stamp duty and planning that affect the market for housing. Mortgage interest relief at source (MIRAS) was a tax concession to owning a house. It reduced the house owner's liability to income tax as the money spent on the interest on mortgage was considered to be tax-free. This made borrowings cheaper and as a result there was a huge demand for housing and the prices shot up. With the introduction of MIRAS in 1990 many people were exempted from stamp duty. (The UK Housing Market - Factors Influencing the Housing Market: Stamp Duty and Planning) Role of Government in Regulating Prices: . Government regulates many things in an economy including inflation, exports and imports, prices of many vital commodities, and many important economic aspects. Government intervenes through its central bank to regulate the prices of many commodities, similarly it also regulates the prices of houses like any other important commodity. Bank of England has the responsibility to keep a check on asset prices including the prices of houses. The bank has a monetary policy and uses the same to regulate mechanism of the economy. Like when it decides to change the interest rate, the government is trying to check the overall expenditure of the economy. A change in interest rates is mostly used to contain inflation, which is the result of lavish expenditure by the country. The bank sets a fixed interest rate at which it lends money to financial institutions and depending on this interest rate, individual banks and other financial institutions set up their own interest rates, which apply to the whole economy. The point to be noted here is that, this interest rate set by the Bank of England is so effective and powerful that it chips in greatly to regulate the whole economy. It affects the stock and bond prices and also influences the asset prices through out the country. This interest rate also regulated the savings in an economy, which eventually results in capital formation and reinvestment. It is note that when interest rates are high, people prefer to invest money in government deposits that are less risky in nature than the stock markets and similarly high interest rates boost up the savings. Lower interest rates make asset and real estate prices go up, as people start ignoring conventional saving instruments and make use of the high growth ventures like shares and houses, which pushes up their prices. Interest rate change also affects exchange rates, as an increase in the interest rate in UK will yield better returns to the investors compared to their overseas ventures. This phenomenon usually makes sterling assets attractive, which pushes up the value of the currency vis a vis other currencies, and a stronger pound sterling would mean less money would be shed on imports and less quantity of exports will take place as there will a lesser demand for products made in UK because of the currency being strong. It is interesting to have a look at the process of how the bank sets interest rates. The primary step in this direction starts with the estimates of the money flow that takes place between the government and the bank, and the bank and commercial banks. The Bank of England makes sure to rectify all the imbalances, which arise along the path on a daily basis. There can be two phases to the money flow that takes place between the system, first, when more money flows from banks to the government and second, when more money flows from government to the banks. In first case, Bank of England's liquid assets come down, which affects the short-term instruments of money market. And in the second case the market finds itself with a cash surplus. The Bank of England is the bank of the government as well as the bank of all the financial institutions and commercial banks, so it chooses the interest rates for the funds to be provided each day, and this interest rate is passed through the financial system, which influences the interest rates of the country. (How Monetary Policy Works). Any increases in oil prices is expected to feed through into inflation over the next few years, and the gap between the value of imports and exports is growing to record levels, prompting expectations of a decline in the value of sterling, which is a welcome sign for the exporters but will hit the importers, as they will have to shell out more money for importing their raw materials leading to a further increase in inflation. Any decision is taken after considering the condition of the whole economy and all sections of the society at large and there are several other methods to tackle the prices of properties, but it will always be better to increase the rates at a slower but steady pace, rather than giving a monetary shock. Rising Inflation, if not tackled properly and at the right time may create a cycle, wherein the inflation keeps rising due to no change in interest rates. A detailed diagram given below will help to gain a better insight into the concept. The above diagram explains the concept of system regulation. It shows that the official rate, which is set by the Bank of England, influences many parts of an economy such as market rates, asset prices including the house prices, expectations, and exchange rate. This gives rise to demand, which is the sum total of domestic plus external demand, which in turn gives rise to inflationary pressure resulting in inflation, another important point shown, which deserves a mention is the relationship between the exchange rate and import prices, or the price paid for imports. As explained above, the stronger the exchange rate the lesser the price paid for imports and the weaker the currency the higher the price paid for imports. (How Monetary Policy Works) Read More