Strategy & Operations » Governance » Economics: Home truths

Dennis Turner

The housing market is never far from the press headlines or the thoughts of
policymakers. Continuing price rises, a jump in earnings multiples, pressures on
affordability following base rate hikes, the furore about HIPs, the proposed
changes in the planning laws and concerns about the buy-to-let sector are just
some of the recent newsworthy housing-related topics.

Sustained media interest, of course, reflects the pivotal role housing plays
in the feel-good factor, which matters greatly to politicians and to the
confidence of consumers – the key spending sector in the economy. The housing
market has always exercised an influence on the economy disproportionate to its

There can be no doubt that house prices have been rising rapidly, although
the rate depends largely on which source is used. The Halifax Index (perhaps the
most commonly used) jumped by 160% between 1997 and 2006, with 20% a year
between 2002 and 2004. As a result, the house price earnings ratio has soared,
from four times in 1999 to a staggering 6.7 in the first quarter of this year.
But affordability has been kept in check by lower interest rates. Although
repayments, as a share of income, have been edging up, they are still well down
on the peak of the late 1980s and early 1990s.

What seems to have happened is that as interest rates came down, purchasers
were able to borrow more money, and these funds found their way into a housing
market in which the number of houses was rising much more slowly. No surprise,
then, that prices went up.

Now that the path of interest rates has been reversed (rates have gone up
from 3.5% to 5.5% in this cycle, a 57% increase in interest charges), the rate
of price increases is moderating across the country; not falling, but slowing.
But it is the legacy of the much higher borrowing at lower rates that is causing
concern and reviving memories of the last housing crash. Then, as now, the
worries are as much for the pace of economic activity as a whole as for the
housing market itself.

The housing market will be insulated to an extent by the fact that the rate
of household formation is continuing to outstrip housing starts. With an
officially estimated 223,000 new households each year, and housing starts
lagging at fewer than 200,000 a year, the pressure of excess demand on supply
will help keep price changes in positive territory, at least in certain parts of
the country (London and the south east, in particular). But now that interest
rates have stopped falling, house price increases should be more in line with
the growth of earnings if affordability is to stay at current levels.

On balance, the housing market as a whole looks set for an orderly slowdown
(price rises easing and the number of transactions falling) – a soft landing
rather than a rout. But if one part of the market is vulnerable, it appears to
be the buy-to-let sector. Industry sources estimate that 11% of the loans
advanced in 2006 were to people intending to rent the properties rather than to
live in them themselves. This compares with just 3% in 1999. The potential for
rent increases is now, however, constrained by sluggish earnings growth at a
time when interest rate rises are pushing up debt servicing costs. On top of
this squeeze on margins, a slowdown in prices increases is limiting capital
growth. Not surprisingly, alternative investments are looking more attractive.

It is the effect of housing on the economy as a whole that will interest the
MPC and, in this context, it is worth remembering the brick-and-elastic-band
analogy. Managing the economy with interest rates is a bit like trying to drag a
brick across a tabletop using an elastic band. You can tug on the elastic for
ages and nothing happens, but then all of a sudden it shoots across the tabletop
and smacks you in the face.

The MPC has been tugging on the band by putting interest rates up four times
since last August. Is the brick now moving or, because of the leads and lags,
does it have to tug harder? That is the judgement the MPC has to make.

As far as the housing market is concerned, the fact that in 2006 only 2% of
mortgages were on standard terms at floating rates (and around two-thirds were
fixed) complicates the authorities’ view. Most of those who took out a mortgage
in the first nine months of the year, therefore, have a degree of insulation
from the policy tightening. And, since average positive equity is still more
than twice the value of average debt (even though those with equity and those
with the big debts will be different people), there is still considerable
borrowing and spending capacity in the system.

The MPC, therefore, has to wonder whether it has to tug a bit harder to
dampen down inflationary pressures. But if it does, the brick might start to
move too quickly. Spotting turning points in the economy is the most important
and difficult part of the job. We are at about that point now.