An increase of just 1 per cent in the global risk-free interest rate could see house prices drop by 18 per cent, the Bank Underground claims in a blog post.

The post states that home ownership costs falling while the risk-free interest rate has dropped (with the return on equity and capital remaining consistent) “more than explains” house prices increasing to the tune of 160 per cent between 1985 and 2018.

The work builds on a post made in early September last year, in which members of the Bank Underground team explained their findings that ultra-low interest rates and CPI inflation were the cause of growth rather than it being an issue with supply and demand.

Bank Underground is a blog used by Bank of England staff to publish views that don’t necessarily coincide with the BoE’s.

The model that Bank Underground uses to come to its latest conclusion first assumes that any decline in the risk-free rate is both unanticipated and expected to persist – which it proves is the case by showing that the yield for a 10-year index linked gilt is almost the same as the expected rate in 10 years’ time.

It then supplies a condition – that rental yield must equal the cost of home ownership. As rents grow with improved income and earnings, so do house prices alongside income growth. However, in the case of an unanticipated change in the interest rate, house prices move “in a sharply different way” to incomes.

This is because, Bank Underground says, in the short-term, supply is unable to adjust to a shock in home ownership costs. If total demand for both rental housing and owner-occupied remain constant and the user cost of housing also don’t change, only an increase in house prices can occur to offset the decrease in the risk-free interest rate.

Bank Underground concludes that if the risk-free rate increased by 1 per cent, an 18 per cent fall in house prices would be the result, and that if it reverted to 2011 levels (that is, 0 per cent rather than the -2 per cent seen at the end of last year), house prices could fall by 31 per cent “across many years.”