THE Bank of England’s decision to raise interest rates to 4.5 per cent last week made eminently good sense. At a time when jobs are plentiful, the economy is growing by 3per cent in real terms, consumer prices are rising by about 2 per cent and house price inflation has rocketed to 20 per cent, it is hard to demur from the Monetary Policy Committee’s judgment. But how much more tightening is likely before this monetary cycle is over and what sort of impact should we expect on the economy, especially on the irrepressible housing market?
Viewed from a macroeconomic perspective, the MPC should have no serious trouble in steering Britain’s economy between the Scylla of excessive property inflation and the Charybdis of unnecessary unemployment and disappointing economic growth. Such are the benefits of an active demand management policy, run by a competent, independent central bank in a flexible economy. I have always believed that interest rates would rise to between 5 and 5.5 per cent by the spring of next year, that consumption growth would slow a little while exports would accelerate and that the upshot would be an economic growth rate stabilising at about 3 per cent for the next two years. And events so far seem broadly consistent with these conjectures.
But the fact that the British economy should continue to do reasonably well in the year ahead, despite further monetary tightening, does not mean that homeowners and property investors will also prosper. If we focus specifically on housing, a modest fall in prices seems inevitable in the final stages of the property cycle, even if the MPC achieves its avowed objective of managing a “soft landing” for the present boom. Such a price correction is bound to prove painful for the small minority of homeowners and investors who buy over-priced houses near the climax of the boom.
Whether this climax has been reached already will only emerge with hindsight. But it seems undeniable that a risky period for property investors began with the re-acceleration of house prices in March and April. I say this as one of the few economic commentators who has consistently taken a fairly optimistic view about the property market in Britain, arguing against the alarmist forecasts of 20 per cent price declines that were first issued by the prophets of doom three years ago. And even today, I do not believe that the outlook is negative for anyone who is prepared to take a genuinely long-term view on housing. If reported house prices were to fall about 5 per cent below their present level and then remain flat for two years or so, this would be no disaster and would still leave the prospect of a tax-free capital gain for anyone who buys a house at today’s prices and lives in it for five years or more.
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Anyone buying a house today should bear in mind, however, that the widely reported house price indices understate the true risks of investing in the property market. Not only do they exclude home improvements and transaction costs, such as stamp duty and estate agents’ and mortgage fees, which tend to eat up any capital gain under 10 per cent. Even more importantly, they do not reflect the knock-down prices that must often be accepted by forced sellers who have to move house for financial or personal reasons at a time when the property market has turned weak. In sum, for people uncertain about their willingness and ability to stick with a property investment for at least the next five years, this is probably no longer a good time to buy a house.
Now let me explain why I have turned so cautious on housing. Since the MPC is not raising interest rates any more aggressively than I had long expected, my newfound caution is attributable less to the outlook for monetary policy and the economy than to the state of the property market itself.
The renewed enthusiasm for property purchases this spring, in direct defiance of the clear upward trend in interest rates, looks like a classic case of a speculative blow-off at the top of a bull market.
Such last-minute surges are common at the end of long upward trends, when fearful investors, who had resisted buying throughout the bull market, finally capitulate, throw caution to the wind and buy an asset simply because it has been going up, even though the economic fundamentals have started to go wrong.
This is what happened in the last phase of the stock market boom in early 2000. Investors ignored the Federal Reserve Board’s somewhat belated decision to tighten US monetary policy, after persuading themselves that technology shares were a totally new kind of investment which would prove immune to higher interest rates. Britain succumbed to a similar state of psychological denial during the 1988 Lawson boom, when interest rates soared to 15 per cent without apparently dampening the enthusiasm of home buyers.
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In the end, though, economic fundamentals invariably prevail, which is why “don’t fight the Fed” is one of the most durable sayings among seasoned investors on Wall Street. Rising interest rates are not, on their own, sufficient to trigger a price decline, either in the stock market or in housing. But when rising interest rates are combined with prices that are far above historic norms and high levels of borrowing among investors, a correction of some kind almost invariably lies ahead.
This sort of correction will presumably threaten the British housing market sometime soon. I have been careful in choosing two of the words in the previous sentence: “correction” and “soon”. I think that what lies ahead is a modest and temporary reduction in prices, rather than a sharp fall, as in the early 1990s, or the sort of long slump, lasting a decade, seen in Germany and Japan. I also believe that house prices may continue to rise for a few months before they succumb to the inevitable downturn. Both of these propositions depend on my view that house prices in Britain are not (yet) as absurdly overvalued as almost everybody seems to believe. The evidence for this controversial view is presented in the charts.
The first shows the most conventional measure of property valuations — the ratio of average house prices to average earnings, nationally and in London. This ratio is now much higher than it was in the Lawson boom.
But this chart also includes a third line, which is rather less alarming. It relates house prices to personal disposable incomes, arguably a more relevant measure than average wages at a time when more people are living on investment or self-employed incomes and when many families rely on multiple incomes to pay the mortgage. The second chart shows that, in London at least, the property boom has already begun to subside — the ratio of house prices to incomes is falling.
The third chart shows that, because of the dramatic decline in interest rates since the early 1990s, houses are still surprisingly affordable, even for 100 per cent mortgage borrowers in London. Of course, the cost of servicing a mortgage will increase, with interest rates now rising. But even an increase in base rates to 5.5 per cent (which I consider unlikely) would still leave the measure of mortgage affordability represented by the bottom line in this chart 20 per cent below its long-term average and no higher than it was four years ago.
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The fourth chart examines the widespread belief that house prices have risen much faster than other assets. This is simply not true. In the past 30 years house prices have appreciated about as much as equities. And this is not surprising. A house is a productive asset and a stake in the British economy in much the same way as a portfolio of shares. In the long run, houses are therefore likely to appreciate at a rate comparable with long-term economic growth.
In the long run, therefore, British property should remain a sound asset. But all long-term trends include short-term setbacks. Thus for short-term investors or for anyone who may be forced to sell out in a year or two, this summer does not look like a good time to buy.