In early 2005 the editor of a specialist Mortgage Finance magazine in the UK told me that the interest rate would peak at around 5% or lower. The lenders had allowed for this. But based on what happened to inflation in the UK and what the Fed tried to do in the USA they were all wrong. The level for mortgages should have peaked at around 7% or more.

If you read the previous page, just posted in this Blog, you will see why true interest rates (see the Glossary) have to be positive, and for Housing they may have to be positive by around 3% in the developed economies of the UK and the USA in order to reach a kind of balance between the supply and the demand and restraining the rate of inflation.

The exact figure for Housing Finance in a particular nation depends on a number of additional things, one being lending risk levels, another being administration costs, and another being the level of competition between lenders, for example.

In a growing economy, the return on Equities may be higher than elsewhere, and that may also be a factor. Long term the return from equities appears to be only slightly higher than the return from lending on housing. If you take published figures and adjust for AEG% p.a. it is equivalent to less than 5% p.a. return above the AEG% p.a. index.

So stay with the UK and the USA for now, and based upon equilibrium, or a match between supply and demand (we are using as a proxy for this the long term average rate of around 3% true interest). 

Now assume estimate the sustainable long term real economic growth rate, which has been assumed to be around 3% p.a. in the USA since the 1920s. 

If we then take AEG% as being a proxy for the total of inflation plus real economic growth, and based upon a target inflation (of prices) rate of 1% p.a. we get this forecast for mid-range nominal interest rates r% p.a:

r% = 1% (RPI%) + 3% (economic growth) + 3% (true interest at equilibrium) = 7%.

Where r% = the mid-cycle nominal interest rate for Prime (almost risk free) Housing Finance, and sustainable real economic growth is 3% and true interest at the mid-cycle is 3%.

Based upon this, in 2005 I said that 5% interest was too little. I said that the UK and the Fed may have to raise rates generally (because they all move together) by over 4% from the pre-crisis level.

And I noted that the Bank of England lost control of inflation - missed their target - when they were unable to raise interest rates by 1.25%. They back tracked to a 1% raise, not long after that. Mortgage costs had risen too fast. 

This is how a battle develops between the Central Banks' Monetary Policy Committee and the rate of inflation - they cannot raise interest rates that fast because the housing sector is going to collapse. Of course, the Fed never thought about that and went ahead anyway. Nothing much happened until their 3 year fixed rates had to be raised and they blamed it on sub prime. By the time they realised that they had got it wrong, it was far too late.

The banks held inflated property assets in their accounts and if they adjusted their value downwards to correspond with the mid-cycle rate of interest, then they would almost all be out of business.


Return on Equities:
This page on Siegel's constant and expected real economic growth gives 7% p.a. real return as the mid-point return on equities:

Here is the data taken from a series of sides, the last three slides 10 through to 12,  that I used in a lecture to universities pre-crisis. The South African Data was sent to me by the Central Bank (SARB) but it seems to contain one error when incomes rose by over 20% in a single year. In those days, prime mortgages could be offered at 2% below prime rate, but not now. Things have changed. Risk perceptions and costs are now different. Competition is not intense.

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