The UK economy remains remarkably resilient. Provisional Office for National Statistics data for Q2 2007 shows an annual growth rate of 3 per cent. This level is above the UK trend growth rate, one year after the Bank of England commenced its monetary tightening policy. The service industry, which accounts for over 70 per cent of UK gross domestic product, remains the key driver of the economy. The two most rapidly expanding sectors are business services and finance, and transport, storage and communications. Both sectors grew at an annualised rate in excess of 5 per cent in Q2. The construction sector is expanding at an annualised rate well in excess of 4 per cent. There has also been a moderate pick up in the manufacturing industry, in part related to the economic recovery in continental Europe, the UK’s principal market for export of traded goods. The muted response of the UK economy to monetary tightening can be partly explained by the large time lag between the announcement of Base Rate increases and their full impact on the economy. It normally takes 12-18 months for the full impact of Base Rate increases to work through the economy. We predict that the economy will experience a very gradual slowdown in the second half 2007 and 2008. Our UK growth forecast next year is 2.5 per cent.
Base Rate rise to 6 per cent on the cards
The most significant comment in the latest Bank’s Quarterly Inflation Report is that CPI will be slightly above target in two years, based on the early August level of market rates. Inflation risks were stated as being ‘a little on the up side’, with reference to the high rate of capacity utilisation. This indicates that the Bank of England is preparing the ground for one final 0.25 per cent rate increase. Governor King acknowledged the need to assess whether inflation risks identified in the report will crystallise. This indicates that the Bank is in no hurry to increase Base Rate – a view justified by the decline in July CPI to 1.9 per cent. The most likely date for any increase is November. Next year we expect the Monetary Policy Committee to gradually loosen the monetary reins, with Base Rate falling to 5.50 per cent in Summer 2008. International factors continue to be the key driver of longer-term rates. Despite the slightly more aggressive UK monetary stance, period rates have fallen. This reflects severe credit problems in the US associated with high default rates on non-prime mortgage debt. Short term, there may be a further moderate reduction in period rates. We can then expect an upturn in UK longer-term rates to a peak in November, 0.25 per cent above current levels. Next year we predict the underlying trend in period rates will be a gradual downward trend.
Mortgage market retains momentum
The mortgage market is remarkably resilient. Gross lending is running at a level just over £30 billion a month, which is the average level over the past eight months. There has been a recovery in net lending, to £9.5 billion in June. The level of mortgage approvals is relatively stable at £32 billion, as is the number of approvals at 115,000. The stronger than expected level of activity reflects the fact that UK economic growth remains above trend. When the UK eventually slows, we expect the underlying level of gross advances to ease back to £28 billion per month, before returning to the £30 billion plus level in Spring 2008, as borrowers anticipate Base Rate reductions. The most resilient areas of the mortgage market are re-refinancing and buy-to-let, while first-time buyers represent a high percentage of total mortgage business. We are relatively upbeat about prospects next year, and predict that seasonally adjusted gross advances will, on average, be in excess of £30 billion per month, producing a total gross lending figure of £390 billion in 2008.
Annual rate of house price inflation gradually slowing
Currently, the headline rate of house price inflation no longer provides a clear indication of what is happening in the housing market. The monthly and quarterly rates of house price
inflation provide a much better indication of housing market sentiment. The annual rate of house price inflation, based on the Halifax index, rose to 11.2 per cent in July. This is expected to fall significantly in the coming months as the high monthly increases recorded in the late Summer and Autumn of 2007 steadily drop out of the annual calculation. The average rate of house price increases, based on the past four months’ Halifax data, is in the region of 6 per cent per annum. A similar monthly picture is apparent from Nationwide data. Next year, we predict that average house price inflation will be in the region of 5 per cent. While the government’s recent housing supply initiative is welcome, it will not completely solve the challenge of house price inflation, given the current strength of the UK housing market, including the large backlog of excess housing demand.
