* Residential property prices rise 0.7% in January
* Current price levels are sustainable
* Exclusion of property prices from Consumer Price Index could loosen monetary policy
Commenting on the figures Alex Bannister, Nationwide's Group Economist said:
"The price of the average UK property rose 0.7% (seasonally adjusted) in January, less than half the increase a month earlier. The year-on-year change in property prices slowed to 14.3% (the lowest level since March 2002) from 15.6% in December. January's rise in property prices represents a slowdown compared with recent months and on an annualised basis is equivalent to 8.7% growth. We expect price growth to ease over the first half of the year but it is too early to call with any certainty whether the housing market has yet moved into a phase of lower price inflation. Taking the last three months together, prices have risen by more than one percent per month, broadly in line with the trend rate of growth last year. The same positive trend is not true of property sales with 109,000 properties changing hands in December - 11% less than a year ago. This confirmed that 2003 had the lowest number of property sales, at 1.39m, since 1998. However, despite low overall turnover, demand for property, especially by existing homeowners, remains strong.
"While the trend in property prices remains strongly upward, the economic backdrop to the market has been mixed recently. Real take-home pay (pay after allowing for tax and inflation) is unchanged from a year ago and November saw the first in what is likely to be a series of borrowing cost increases. Survey evidence suggests consumers are now less confident in their financial outlook and in making major purchases. In contrast, UK and US economic growth now looks more encouraging and the continued decline in unemployment (now just 908,000 compared with almost 3m in late 1992) has been supportive of property prices. Looking forward, we see the labour market remaining positive and any increases in base rates having only a relatively small negative impact. However, if rates rise more sharply than expected then those currently entering the market would be hardest hit. We caution borrowers not to over-stretch themselves. Our forecast for UK property price growth during 2004 remains 9%."
Prices continue to rise, but is the current level of house prices sustainable?
There are still commentators who think the market is set for a fall given that the ratio of house prices to earnings is now at a record high of 7.2 (1), compared with 7.0 at the height of the eighties boom. While this certainly confirms that in real terms property prices are at their highest-ever level; it is not necessarily an indicator that the market is overheated and ready to decline. One key difference is the level of activity. Unlike the eighties, the majority of current buyers are not over-stretching themselves to get on the market despite the high level of house prices. This means that a ratio based on average earnings misses the fact that the incomes of those actually buying property are considerably above average. Other valuation benchmarks exist and while the house price-earnings ratio is the most quoted, we believe that the level of mortgage payments relative to take-home pay and the ratio of property prices to rents are insightful and also better guides to the sustainability of property prices.
Both measures (see chart 1 — in pdf below) are considerably less "overheated" than in the late eighties. The ratio of property prices to rents has risen, but remains well below the eighties peak partly because average rents have risen by an average of 6% per annum over the last eight years. As tenants, by definition, have no claim to future property price growth they base their willingness to pay on their incomes and future earning prospects. This means rents give a reasonable view of the underlying value which people derive from living in their property. The higher the ratio of prices to rents the more likely that property market valuations are feeding on themselves rather than being determined by the underlying value people derive from living in property. In other words, the higher the ratio the more likely the market is to be overheated.
The difference between the cost of buying and renting, which had widened during the eighties boom, narrowed sharply as interest rates and house prices fell during the early nineties. Since then rising house prices have caused some widening in the differential between the initial cost of buying and the cost of renting but not a widespread shift from buying to renting. Of course, rising interest rates and house prices could lead to a divergence in the two measures this year. However, the financial market currently expects rates to stay low relative to the past with the base rate rising to around 4.75% by the end of 2004 and with 5, 10, 15 and 30-year interest rates all at c5% they may not stray too far from that level over the next few years.
Change to inflation target could lead to looser monetary policy
In the Pre-Budget report the Chancellor confirmed the change in the inflation target to 2% on the Consumer Price Index (CPI, also known as Harmonised Index of Consumer Prices; HICP) measure from 2.5% on the RPIX measure. The Government argued that the move did not represent a loosening of monetary policy despite the CPI measure not being directly affected by house price inflation. Over the last eight years CPI inflation has averaged 0.9 percentage points lower than RPIX inflation. Around 0.4-0.5 percentage points of the difference is due to how the indices are calculated - hence why the CPI target is 0.5 percentage points lower than the old target. However, the inclusion of housing costs in the RPIX means that every 5% of house price inflation adds around 0.25 percentage points to RPIX inflation. Going forward, for the new and the old targets to be equivalent house price inflation will need to be at or near zero (in line with the current Bank of England forecast). If house price inflation is above zero in two years time, as seems likely, RPIX inflation could well be more than 0.5 percentage points above the new CPI and base rates below where they would have been under the old RPIX target.
(1) Calculated using net rather than gross pay as it is a better measure of buyer's available resources.
