Experti - early January 2007
• Bank of England surprise decision partly reflects housing market strength
• UK economic outlook remains positive despite base rate increase
• Gross lending forecast revised to £330bn in response to MPC stance
• Average house price inflation forecast to be 5% in 2007
The Bank of England Monetary Policy Committee’s (MPC) decision to raise the Base Rate reflected the recent upturn in economic growth and inflation. The timing of the move wrong-footed virtually every leading analyst, given that Base Rate moves tend to coincide with compilation of the Bank’s Quarterly Inflation Report.
It appears the Bank is focusing on the risk that short-term inflationary pressures could translate into a more prolonged upturn in inflation. The substantial increase in consumer price inflation (CPI) to 3.0 per cent per annum raises the prospect that CPI may slightly breach the upper end of the 1 per cent to 3 per cent inflation target range in the first quarter of the year. The Bank is also known to be concerned at the level of house price inflation. If it remains close to 10 per cent per annum, there may well be a further rate increase, probably in March. Any increase above 5.25 per cent is likely to be reversed towards the end of 2007.
Longer term rates have risen significantly since the MPC move, reflecting the money market view that there will definitely be one further rate increase in the current economic cycle. Expected stronger economic data over the next few weeks is likely to be reflected in a further rise in swap rates. We predict the two-year swap rate will peak at around 5.90 per cent before easing back as the economy responds to the impact of monetary tightening.
Remaining positive
The economy is currently believed to be growing at around 3 per cent per annum, although official Q4 data will not be available for some time. The economic expansion is broadly based as evidenced by recent stronger than expected industrial and manufacturing statistics. The key driving force remains the service sector, especially business and financial services.
One positive factor has been the stabilisation of the underlying unemployment rate of 5.5 per cent, despite the growth of the labour force. The UK economic growth rate is currently above trend, which means the increase in the labour force is being absorbed. As the economy slows, unemployment will rise. We believe that there will be a time lag before this factor impacts on consumer confidence. Once there is clear evidence of a slowdown in retail sales in the latter part of 2007, we expect the MPC to reduce Base Rate by a 0.25 per cent.
Robust despite rate rise
The impact on the mortgage market of the most recent Base Rate increase will be partly balanced by the recent upturn in the UK economy. The strength of mortgage demand was probably a significant factor in the MPC’s decision to raise Base Rate. Gross advances in November totalled £33 billion, while net advances were close to £10 billion. The most surprising aspect of November’s data was the strength of new applications, which totalled a record £34 billion.
We perceive the MPC move as a touch on the brakes, designed to cool the housing market. The balance of probability is that the MPC will announce one further rate increase, following which we expect mortgage applications to fall back to £27 billion per month gross and £8 billion per month net. Allowing for business agreed before the Base Rate was announced, we expect mortgage advances to ease marginally in 2007 to £100 billion net and £330 billion gross. This figure is 10 per cent below our previous forecast, and is based on a Base Rate peak of 5.50 per cent.
Inflation forecast
Average house price inflation is currently running at around 10 per cent per annum on both the Halifax and Nationwide Building Society Indexes. This level is unsustainable and was probably a key factor behind the recent MPC decision. If, as expected, the MPC tightens monetary policy by a further notch, the next 0.25 per cent increase is likely to be in March, just ahead of the peak Spring buying season.
In our view, the government should seriously consider raising the threshold for Stamp Duty significantly to support first-time buyers. We expect a gradual downturn in the rate of house price inflation this year. Our forecast average of house price inflation in 2007 is 5 per cent. Longer-term, our forecast of house price inflation for 2008-2010 is 5-6 per cent per annum.
