Key Rate and Interest Rate Development

David Miles and Vladimir Pillonca (2007) state that the level of the interest rate is one of the most powerful drivers for house prices. A low lending rate can enable people to borrow more, while a higher interest rate will make it more expensive to finance housing and can subsequently lower the demand. The lending rate consists of the key rate set by NCB, with an additional margin set by the individual banks. It is essential that the lending rate follows the changes in the key rate, because if the key rate is decreased and the lending rate does not change, the intended purchasing power of the households will not be changed (Holberg Fondene, 2013). The lending rate represents the price you pay to be able to finance your housing (Bolius, 2014). The installments, together with

interest, determine the amount of the monthly income needed to service the household debt. The lending rate is thus affecting household’s opportunity to invest in housing.

A country’s monetary policy decisions thus have a great impact on the housing market. Through the monetary policy the central bank use the key rate as an instrument to regulate the money supply. NCB states that “NCB's implementation of the monetary policy, in accordance with the first paragraph, shall be oriented towards low and stable inflation. The operational target of monetary policy shall be annual consumer price inflation over time close to 2.5 percent”. Hence, we see that Norway has a policy that evolves around adjusting the key rate with regards to the country’s inflation target (NCB, 2004). A change from an expansionary monetary policy (decreasing the rate) to a contractionary monetary policy (increasing the rate) can influence the house price development. The impact on the house prices is both directly and indirectly. A change in the official interest rates (key rate) directly affects the money-market interest rates and indirectly the lending and deposit rates to bank customers (ECB, 2016).

The lending rate is also closely related to the debt-level of households, increasing the importance of changes in the rate. Consequently, if the interest is high, the overall economy will be sensitive to cyclical changes and external shocks. Hence, with an increase in the interest rate, together with a high debt-to-income ratio, households are more exposed. Changes in the interest rate will generally affect more households than a rise in the unemployment rate will do (Debelle, 2004).

In Figure 8.5 the development of the real house price index in Oslo is compared with the key- and real interest rate for the same period. The interest rates are obtained from SSB and consist of average numbers from several banks. It is however important to be aware that lending rates are set by the individual banks, leading to possible deviations between the rates. The average numbers can therefore be somewhat misleading and not be fully representable for the actual lending rate development. The key rate is retrieved from NCB, and are available from 1982-2015.

Source: NCB (2015a), Eiendom Norge (2015a), SSB (2015d), Appendix 11

Up to the summer of 1993 the interest rate on the bank's overnight loans (D-loans) was NCB’s key rate, while after 1993 the key rate has been the folio rate (NCB, 2015b). We see that the key rate and consequently the lending rate, has had an overall decreasing trend. The increasing real interest rates in the end of 1980’s and start of 1990’s impacted the price of housing negatively. However, from 1987 until 1992 the key rate and real interest rate moved in opposite directions. This can be explained by the Banking Crisis in 1988, which caused the banks to increase their lending rate, and thereby affected the demand for housing in a negative way. NCB lowered the key rate in order to stimulate economic growth, which resulted in the significant change in 1992. When the Norwegian economy stabilized after the Banking Crisis, the interest rate declined rapidly, with increased demand for housing and pressured prices as a consequence.

The extremely low interest rate in the last 10-15 years seems to have had a great impact on the substantial growth in house prices and will in all probability continue to do so. Analysts have spiking speculations as to how the interest rate level will develop and if the current development is sustainable in the long haul. Most economists believe the lending rate will continue to decline in the coming years, but some believe the possible decline is limited based on the level we have today (Langberg, 2015). In 2015 Norway had an average key rate of 1.05 percent, which is the lowest it has ever been in the time period. At the last monetary policy meeting in March 2016, the key rate was lowered to 0.5 percent (NCB, 2016a). The European Crisis contributes to keeping the key rate unusually low, although Norway’s economic growth has been good, which isolated should indicate a higher key rate. The fall in oil-prices in Norway has caused the NCB to lower the key rate, in order to increase competitiveness internationally, causing lower lending rates in banks (cf. ch. 8.1.1). As Norway is not unaffected

Figure 8.5 Development in Real House Price Index, Real Key Rate and Real Interest Rate 1980-2015

by the development in the rest of the world, the key rate is kept artificially low (Qvigstad, 2013). The implications of changes in interest rates will be elaborated further in the next section.

The Effects of a Changed Lending Rate

We generally distinguish between short- and long-term interest rates when we evaluate mortgages with security in housing. Often the current economic situation in the country is a major determinant of the short-term interest rate, where the central bank’s monetary policy has a great impact. The long-term interest rate reflects the expectations in important macroeconomic factors, such as inflation and growth. A positive growth expectation will typically increase the interest rate, while the rate will normally decline if the economy is crawling or standing still. To which extent the rate will increase or decrease, is depended on whether a change is expected or not (Bolius, 2014).

As households in Norway are more indebted than ever (cf. ch. 8.2.1), they are more exposed to interest rate risk, especially if the prevalent mortgage rate are variable (floating) (Debelle, 2004). According to SSB, more than 9 out of 10 have floating interest on their loans in 2014 (SSB, 2014a). The majority of households in Norway are thereby affected by short-term interest changes, which consequently can affect the demand for housing. Further, a lending rate below the expected inflation, as some predict in Norway in the coming years, can cause the demand for housing to increase substantially. Consequently, the level of house prices can be pressured to long-term unsustainable prices which can collapse when the interest level is normalized (Beim, 2015). Grytten (2016) further emphasize this problem in Norway. The increasing inflation, together with low interest rates can cause a negative real interest rate, leading people to borrow more than they are able to pay back.

An increased lending rate can cause problems to service the loan, with a forced sale of the housing as a consequence. This will result in a higher supply of housing, whereas less people are able to buy because of more expensive financing. Hence, it will have a negative effect on demand and prices, which can create turbulence in the housing market as well as in the overall economy. It is however important to emphasize that most banks in Norway does not grant loans unless the lender is able to service an increase in the lending rate of 5 percent (cf.

ch. 8.2.2). In the case of a continuing declining lending rate, as most analysts predict, more people will be able to buy housing, increasing the demand for housing and therefore increasing prices.

On the other hand, there has been a strong development in the disposable income in Norway (cf. ch. 8.1.2), and margins of most households are greater than in the past. However, there is a limit to how much the lending rate can increase before it will affect the households more than they can handle.

Conclusively, for the Norwegian housing market, and consequently the housing market in Oslo, we consider the low lending rates to be a very important fundamental factor for the house price development. A low lending rate supports high house prices, as more households are able to service a higher mortgage when investing in housing and subsequently increase demand and press the prices upwards. Grytten (2016) believes that Norwegian banks will follow the key rate from NCB and maintain the low lending rates of today in the future. In addition, banks offer a 10-year fixed lending rate of around 2.8-3.5 percent, indicating an expectation of a low rate for a long time (Norskfamilie, 2016). Only taking this sole factor into account means that the housing price level will likely continue its increasing trend. However, in the worst case, if the lending rate increases, the house prices might fall considerably. At the same time, we see that both the disposable income of households and household margins has increased.