Bears may have it wrong on UK house prices

Economics: Higher interest rates or a shock to income growth would be needed for a fall in the housing market, writes Dan McLaughlin

These days, one never sees articles predicting a collapse in Irish house prices. It appears the bears have given up, having been wrong for so long.

The same can't be said of the British housing market, however, and the frequency of articles warning of imminent price falls there is reminiscent of Ireland in the latter part of the 1990s, when forecasts of a 20-50 per cent correction in house prices were commonplace.

I have argued of late that the conditions are not in place for a sustained downward move in house prices across the UK and it is interesting that the Bank of England's Monetary Policy Committee (MPC), which sets interest rates in Britain, is also now taking a much more relaxed view of the housing market there, having previously voiced its concern about a sharp correction.

Indeed, the MPC's growth projection for the UK economy explicitly assumes that house price inflation will decelerate from the current 25 per cent to zero in an orderly fashion over the next two years.

Yet others disagree, and two more bearish forecasts caught my attention. One is from the International Monetary Fund (IMF), and the other, closer to home, is from Goodbody Stockbrokers.

The former study incorporates a fairly standard model of house prices (similar to that which underpinned the original Bacon report on the Irish housing market) in which prices respond to interest rates and income growth. However, its simplicity has its downside as it only explains about 50 per cent of the trend in UK house prices over the past 30 years.

That aside, the study confirms one key point that underpins my own analysis - UK housing supply is unusually unresponsive to demand or price, in contrast to Ireland, so one should not look for a surge in house completions to bring the UK housing market back to equilibrium. On that basis, any fall in the market has to come from the demand side, via higher interest rates or a shock to income growth, either through lower employment or lower wage growth.

In fact, the responsiveness of prices to interest rates is shown to be very low in the model, so if income growth stays around trend level (say 2.5 per cent per annum in real terms) house prices will rise by 3.3 per cent in real terms (or around 6 per cent in nominal terms) in the long run.

Nothing bearish in that but the IMF study concludes that house prices in 2002 were some 25 per cent above that predicted by the model. One explanation is the model has broken down, but the IMF prefers to believe that a sharp price correction is likely.

The Goodbody approach differs in stressing the amount of equity present in the UK housing market, defined as the difference between the average new loan and the average price of a house. It expresses this figure as a percentage of earnings to arrive at the equity burden, which is deemed to be too high at the current level of 124 per cent. It then assumes it will correct downward as it did in 1989-1991, leading to the conclusion that house prices will fall by 6.4 per cent in 2003 and 2.5 per cent in 2004.

However, the catalyst for the decline in the equity burden in 1989 was a doubling of interest rates, and so one is still left with the need for a shock to housing demand.

Goodbody argues that the 2003 catalyst will be the high deposit required by first-time buyers but such deposits rarely come from income but through accumulated savings or from the transfer of equity from parents. Moreover the equity burden for first-time buyers actually went up from 1989-1991, which rather undermines their case, as the decline in the total equity burden was solely due to owner-occupiers.

A rise in the loan-to-value ratio will also lead to a fall in the equity burden, as indeed has happened in Ireland since 2000, from a ratio of more than 350 per cent, without triggering a price fall.

There is no merit in the concept of the equity burden as a predictor of house price trends and one is again led back to the simpler notion of a demand shock as the prerequisite for a generalised fall in house prices.

If one believes that the UK has experienced a regime shift by virtue of the creation of an independent central bank, as I do, such that interest rates have moved to a lower and more stable trend, then house prices can and will rise relative to income, just as happened in Ireland. To counter this effect, income growth has to come under serious stress and, in its absence, house price inflation in the UK may not decelerate quite as readily as the MPC believes.