Commenting, Paul Diggle, property economist at Capital Economics, said: “The Office for Budget Responsibility’s house price forecasts seem to imply a structural shift in the sustainable house price to earnings ratio and a return to peak of the market mortgage servicing costs.
“We would not rule out some rise in the equilibrium level of house prices relative to earnings over the past decade, but remain sceptical that the current gap can be sustained.
“The OBR has forecast house price growth of 5.9% this year, 1.6% in 2011, 3.9% in 2012 and 4.5% thereafter. Combined with the OBR’s forecasts for average earnings, these forecasts imply that the ratio of house prices to earnings (HPE) is set to stabilise at 5.3.
“The long term average HPE is 3.7, meaning that 5.3 looks high by historic standards.
“The support to prices in the OBR’s forecasts does not appear to be coming from ultra-low interest rates. The OBR’s forecasts for the 3-month LIBOR imply interest rates rising more quickly than we expect.
“We think that interest rates will remain on hold until at least the end of 2011.
“We have used the OBR’s 3-month LIBOR forecasts to calculate a consistent profile for mortgage interest rates, assuming that the current high spread between LIBOR and mortgage interest rates is gradually eroded. The combination of house price growth and increasing interest rates means that mortgage payments as a proportion of post-tax income will increase to 45% by 2014.
“This is 10 percentage points higher than at present, and just below affordability levels at the peak of the market.
“The OBR seems to be suggesting that there has been a structural shift to a sustainable HPE that is over 40% higher than the historic average.
“The cause of such a shift is likely to be the structural undersupply of houses in the UK. But… structural undersupply is not a good explanation of the recent behaviour of house prices internationally, and therefore is not an adequate explanation for high prices in the UK.
“Furthermore, the OBR’s forecasts seem to suggest that the availability of credit won’t present a barrier to house price growth. But given our belief that the economic recovery is set to be weak, and employment and wage growth slow, we expect lenders to remain cautious.
“In addition, the uncertainty over the mortgage funding outlook, and the likelihood of regulatory reform increasing capital requirements, means that we think a renewed tightening in lending standards remains a real risk.
“Our own views incorporate the belief that even if the sustainable level of house prices has risen, it has not risen as far as implied by the OBR forecasts.
“As such, in our view it is too soon to rule out the possibility that the HPE falls back to its historic norm in due course.
“In short, given our views that the economic recovery will be slower and the labour market weaker than the OBR expect, we do not believe that the HPE can be sustained at a level 40% above its historic average.
“As such, the OBR’s house price forecasts also look overly optimistic.”
