The Base Rate determines the cost of mortgage borrowing and consequently the affordability of housing at any point in time. So what are the prospects for interest rates in the coming 12 months? Will the Monetary Policy Committee (MPC) cut Base Rate and give the housing market a further fillip? Will rates be held at 4.50 per cent, implying the housing market will stagnate? Or is the MPC’s fear of inflation so marked it will raise the Base Rate to 4.75 per cent (or more) and risk bringing the housing market to a sudden, sharp decline?
The majority of MPC members believe 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 sees 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 12 months.
The Confederation of British Industry (CBI) paints a markedly upbeat picture of retail activity and even the official figures from the Office of National Statistics show the growth of sales volumes at 2.1 per cent in November is at its highest level since February.
The recent strength of the housing market adds to this view that consumer demand is recovering. This is particularly noticeable in indicators of house prices. Nationwide’s index recorded a rise of 0.5 per cent in December, the sixth consecutive monthly increase and the annual increase rose to 3 per cent from 2.4 per cent in November. The Halifax index points to an even stronger market with a 1 per cent rise in December, giving an annual rate of increase of 5.7 per cent. These monthly increases come after a period of some 15 months when prices showed very little change.
Activity figures
This upturn in the housing market is also reflected in activity measures. Mortgage approvals rose to 115,000 in November compared to a low point of 82,000 recorded at the start of 2005. Mortgage lending has also been hitting record levels. Plus survey data from the Royal Institute of Chartered Surveyors has been consistently more optimistic about prospects. A small majority of surveyors now expect prices to increase when as recently as last May the overwhelming consensus of opinion was that house prices would fall.
This pick-up in the recent figures for the retail and housing markets must certainly have averted fears of a continued weakening in the economy and quietened those who have been calling for an aggressive easing of monetary policy.
Retailers have been among the most vocal in looking for a renewed stimulus to demand. But their appeals have more to do with the competitive state of the retail sector than with the level of demand as a whole. Analysis of the retail sector by economic consultants Oxford Economic Forecasting (OEF) concludes this market is going through a fundamental realignment. After several years of very strong growth, the number of new stores that have been opened has run ahead of the sustainable level of growth in consumer spending. Consequently while retail sales volumes have been holding up, profit levels have been under severe pressure. From the retailers’ point of view demand is inadequate.
In line performance
But of far greater importance from the MPC’s viewpoint is the economy looks as though it is performing fully in line with its expectations. The Chancellor of the Exchequer, with some support from the Bank of England, has focused on the role of oil and fuel price rises in limiting consumer spending power over the past year.
On the basis of this argument the economy remains fundamentally sound. As oil prices stabilise, or even fall from their peak levels, real income growth will rise and this will support a further increase in consumer spending. This in turn will help to revive the rest of the economy, particularly investment demand. All without any need to change interest rates.
But as OEF warn, the recent recovery in the data does not necessarily indicate consumer spending is about to rise strongly for a prolonged period as the Chancellor would hope. The most recent data only covers the Christmas period and sales may not continue at the same pace as 2006 progresses. Consumer spending continues to face several important challenges.
The Chancellor may focus on the role of oil and fuel price rises in limiting consumer spending power over the past year. But there are many analysts, and not just Gordon Brown’s political opponents, who believe the Chancellor places too much emphasis on those factors which lie outside his control. It is undoubtedly the case that increasing tax rates have contributed to the slower growth in post-tax incomes. This has weakened consumer demand and will continue to do so over the coming year. Consumer spending may rise over the next twelve months but this growth is not likely to be sufficient to bolster the rest of the economy.
Labour market
One aspect of the economy beginning to cause concern is the labour market. The number of people claiming unemployment benefits has risen by 88,200 since February and the unemployment rate has risen to 4.9 per cent in October. This compares to 4.7 per cent as recently as July.
The weakening of the labour market is probably the main reason behind the subdued growth in wage rates. In the year to October average earnings (excluding bonus payments) rose by 3.7 per cent compared to their recent peak of 4.1 per cent in July.
It certainly does not appear the Bank of England’s great fear that employees will respond to higher energy costs by bidding up wage rates will prove justified. Rather it seems the continued inflow of workers from the new countries of the European Union are having the effect of keeping wage rates down.
The subdued labour market leads to an expectation that there will be few strong inflationary pressures in the UK. The latest consumer price inflation figures support this view with the annual inflation rate dropping to 2.1 per cent in November from 2.3 per cent in October and 2.5 per cent in September when the impact of higher petrol prices was at its greatest.
Interest rate prospects
So where does this leave the prospects for interest rates? Certainly there is no one at the moment who is pressing for an increase in Base Rate. Inflationary pressures are negligible. The key question is whether the MPC will move to cut rates and if so when.
One MPC member, Stephen Nickell, is already on record as believing a 25 basis point cut in rates is appropriate because of the potential weakness of investment demand and export growth. What will have to happen for Nickell to persuade a further four members of the Committee to support his argument?
This is dependent on any one of three things. First, if the consumer price inflation rate continues to fall markedly. This seems unlikely. The impact of higher energy prices will not disappear from the economic system that quickly. Secondly, the weakness of investment and export demand which Nickell has identified becomes much more obvious. This is a significant possibility but is not likely to be manifest in the short term.
This leaves consumer demand. If as OEF’s analysis suggests the labour market is weakening and current tax rates continue to take a higher proportion of income then the strength of the Christmas sales period will not be sustained. It seems unlikely the MPC will cut rates in February. But by May this weakness in demand will be apparent and Base Rate will be cut to 4.25 per cent. And given the Bank’s cautious stance it is likely to be the only change in rate during the year.
What does this imply for the housing market? Not a lot. A single 25 basis point reduction in interest rates is unlikely to be sufficient to have a major impact on affordability and mortgage demand. On the other hand any cut in rates provides a boost to confidence and, as such, will prevent the current high levels of demand collapsing.
Peter Charles is chief economist at Mortgage Express
