If there is no impetus for demand to rise and no pressure for demand to fall, the conclusion must be that the market will drift along at its current level for the next twelve months. Could this really happen? After all, the history of the housing market for most of the past forty years has been one of a successions of booms and slumps. Are things really different now?
Yes, I think they are. We are now operating in a regime where monetary policy is set by an independent body (the Bank of England) rather than being subject to the political influence of the Chancellor of the Exchequer. The consequent improvement in the implementation of monetary policy has resulted in the UK economy enjoying a stable low inflation, low interest rate environment.
Over the past three or four years, the housing and mortgage markets have completed their adjustment to this new, more benign, economic environment, with house prices now at a much higher level – in line with the lower cost of borrowing. Consequently, the only reason for any abrupt movement is if there were to be a marked change in one of the fundamental drivers of activity – interest rates, borrowers’ incomes and house prices. But none of these factors seems likely to be subject to significant change in the year ahead.
Interest rates
The majority of the Bank of England’s Monetary Policy Committee (MPC) consider the base rate to be at its correct level. The main argument supporting this view is that the UK growth rate will recover during the course of this year back to its long-term trend rate. Indeed, the MPC see signs in the latest economic statistics that this recovery is in train. There was some pick-up in consumption in November and, in general, the statements from major stores on trading during the Christmas period have been much more positive than at anytime in the past twelve months. The recent strength of the housing market adds to this view that consumer demand is recovering.
The MPC is also increasingly less concerned about the possibility of having to raise the base rate in order to head off an acceleration in the rate of price increase. The inflation rate, having hit a peak of 2.5 per cent in September, had fallen to only 2.1 per cent by November. And while it is perhaps too soon to be confident that oil prices have peaked and there will be no wage push in response to higher energy prices, there is little reason to suggest that inflation will move significantly away from its 2 per cent target.
But many economists are concerned the MPC is too optimistic about the prospects for growth and argue the base rate needs to be cut to boost demand. Indeed, one member of the MPC voted against his fellow members at the December meeting, arguing for an immediate reduction in rates. The case is based on the view that not only has the inflation rate fallen to 2.1 per cent but that pipeline inflation pressures has also eased. Furthermore, while consumer demand has shown some strengthening, other sectors of the economy remained weak. Business surveys pointed to a very weak outlook for investment and the UK’s net export performance continued to disappoint. Taken together these arguments imply the inflation rate will undershoot its target in the medium term.
But whichever of these views proves correct, there is no persuasive argument for any substantial change in base rate. Most of the economists who support the case for a rate cut are suggesting that a single 25 basis points (bp) reduction in February would be sufficient to bolster investment demand – with the possibility of a cut to 4 per cent towards the end of the year only if this initial cut proves ineffective. Such modest changes are unlikely to be sufficient to have a major impact on mortgage demand. The only significant impact that a move in base rate would be likely to have on the market this year would be if there were an unexpected increase back to 4.75 per cent.
Borrowers’ incomes
One of the prime causes of the fluctuations in the housing market in the 1970s and 1980s was the impact of inflation on incomes. It was rational then for borrowers to gear their lending to the maximum in the knowledge that inflation would soon erode the burden of this debt. The problem for these borrowers was that interest rate rises could result in a sudden sharp rise in the cost of servicing this debt. In the late 1980s the base rate rose from 7.5 per cent to 14 per cent within twelve months. It is hardly surprising in such an environment that demand fluctuated markedly. And it emphasises the difference compared to the current environment when debate revolves around whether a 25bp change in base rate will happen in six or nine months time.
For the most part, workers have benefited from steady growth in their real incomes over the past ten years. Average earnings have been rising at 4-4.5 per cent a year and prices have been rising at 2-2.5 per cent, resulting in a steady growth in real spending power of 2-2.5 per cent a year. This increase is in line with the rate of growth in productivity in the economy as a whole and can therefore be seen as sustainable.
For any individual borrower, the great risk to income is the threat of unemployment. But, in the current economic climate, even this risk is less marked than in the past. With the economy growing slightly below its trend rate, unemployment, as would be expected, has risen over much of the past year. But the rise in rate is relatively modest. And, more importantly for individual borrowers, the rise in long-term unemployment has not been significant. There are still job vacancies to be filled and most job seekers are moving off the unemployed register fairly quickly. This is in marked contrast to the 1980s when losing ones job meant a prolonged period of unemployment.
So the trend in real incomes remains supportive to housing demand. Borrowers can expect modest but steady rises in incomes and the threat of unemployment is not a reason to postpone extending borrowing commitments for most workers.
House prices
But despite the modest boost to demand from these favourable trends in incomes and interest rates, it is difficult to see any significant increase in housing market activity in the current year. And this is because of the pressures put on affordability by the high level of house prices.
There is a great deal of speculation about the level of house prices and the degree to which they are, or are not, overvalued. It is fairly easy for economists to define what they mean by an equilibrium price level. It is the point at which both buyer and seller are equally attracted to trade in the market. If prices are too low, buyers will aggressively seek to trade and bid prices up. If prices are too high, sellers will either reduce their prices or remove surplus supply from the market and thus support the higher price level. This latter effect has been apparent in the UK housing market over the past year, with prices barely changing but levels of activity markedly reduced.
But although it is possible to identify that prices are currently overvalued, it is much more difficult to assess by how much. This difficulty is reflected in the wide range of estimates of the market’s overvaluation. Simple estimates based on the long run trend of house prices to average earnings suggest the gap remains very large. More sophisticated assessments taking account of affordability factors suggest the gap is much more modest – perhaps no more than 10 per cent, and well within normal variations around the long run trend. This suggests it’s unlikely house prices will show any significant rise during the year, and even more unlikely they will show any significant fall.
Analysis of the three major drivers of activity confirms the original hypothesis that none of these factors seems likely to be subject to significant change in the year ahead. Consequently, there is little reason to believe that the market will not match last year’s levels. And with net new lending approaching £90 billion in 2005, it looks like being another busy year.
Peter Charles is chief economist at Mortgage Express
