This research note is provided by Fathom Consulting. All of the charts below and many many more, covering a range of topics and countries on both the macroeconomy and financial markets are available in the Chartbook to Datastream users at www.datastream.com. Alternatively you can access Fathom’s Chartbook at www.fathom-consulting.com/TR.
Suddenly it seems that everyone in the UK is worrying about house prices again. Well, almost everyone. We began the month with a speech from Bank of England Deputy Governor Sir Jon Cunliffe, who warned that growing momentum in the UK housing market was ‘the brightest light’ on his Financial Stability dashboard. And in a masterpiece of understatement, the OECD cautioned earlier this week that strong house price inflation had resumed in the UK, at a time when prices were ‘already above longer-term norms relative to rents and incomes’.
Talk of a bubble in the UK housing market has certainly caught the public imagination. Relative to the total number of searches made on the Google website, the number of searches that included the words ‘housing’ and ‘bubble’ reached an all-time high this month. Moreover, interest in the words ‘housing’ and ‘bubble’ was running at more than four times the level seen in the months preceding the onset of the financial crisis. In a way, the greater level of awareness ought to offer some reassurance.
To paraphrase Her Majesty the Queen, when visiting the LSE in the aftermath of Lehman’s collapse, ‘Why did nobody see it coming?’ Well, on this occasion somebody did. Help to Buy 2, unveiled in the March 2013 Budget, was a game changer for Fathom. Before Help to Buy 2 many first-time buyers, unable to raise the required 20% deposit, were effectively shut out of the UK property market. But the withdrawal by lenders, over the period between the onset of the crisis and the introduction of Help to Buy 2, of almost all high loan-to-value products, was no market imperfection. It was a prudent response to a situation in which the house-price-to-income ratio was not only substantially above its long-term average, but above the peak of the late 1980s boom. It also kept a lid on house price inflation in an environment of exceptionally low interest rates. Following last year’s Budget we warned that Help to Buy 2, in protecting lenders from the first 15% of any losses, risked making the availability of mortgage credit as easy as it had been in the run up to the crisis. The message from government to borrowers and lenders alike was clear. “Stop worrying about the high level of house prices. If things go wrong, the tax payer will foot the bill.”
As with any asset market, it does not need a pick-up in housing activity to drive house prices higher. We felt a simple belief that prices could rise again, even from those elevated levels, coupled with recognition that the government was sanctioning greater mortgage lending, would be enough to do the trick. In the space of a month, we switched from being right at the bottom of the range of independent forecasts for UK house price inflation submitted to HM Treasury, to being right at the top. And as a consequence, we revised up our forecast for UK growth considerably. UK house price inflation, at 9.1% in the twelve months to February on the official measure, is already within a whisker of the 10.0% that, following the announcement of Help to Buy 2, we expected to see by the end of this year. And growth, led by the consumer, turned around significantly around the time of last year’s Budget.
Refresh Chart Edit Chart
Refresh Chart Edit Chart
Our concerns about the destabilising impact of Help to Buy 2 on the UK housing market, and about the ability of the household sector to weather even a modest tightening of monetary policy, provided the backdrop to our Monetary Policy Forum, hosted earlier this week by Thomson Reuters in Canary Wharf. In this week’s News in Charts we describe some of the forecast material presented to those attending our Forum, and conclude by summarising the discussions that took place. It is fair to say that each of our panellists – Marian Bell, Charles Goodhart and Ian Plenderleith – appeared far less troubled by recent developments in the UK housing market than either our audience, or indeed ourselves.
In defence of Help to Buy 2?
Those who speak out in favour of Help to Buy 2 – notably the Chancellor, but there are others – often use something like the following line of argument.
1. There is a problem with housing supply in the UK. Not enough homes are being built.
2. That is evident in the house-price-to-income ratio, which is far above its long-run average.
3. Help to Buy 2, by giving builders a stronger incentive, will address this lack of supply.
We disagree with this on pretty much every level. If there is a shortage of new homes, then why is there no boom in the purest measure of the cost of housing services, namely housing rents? Relative to incomes, and relative to the prices of other goods and services, housing rents are lower now than they were in 2000. The shift up in the house-price-to-income ratio that took place after 2000 had nothing to do with a shortage of housing supply. It had everything to do with a fall in the real user cost of housing, brought about by exceptionally low real rates of interest. Absent a reduction in the quantity of housing per capita, which we have not seen, only a permanent reduction in the real user cost of housing can justify a permanent increase in the house-price-to-income ratio. Will real mortgage rates remain as low as they are today? We doubt it. And when they do rise, the fragile arithmetic supporting an elevated house-price-to-income ratio will unravel rapidly.
But let us pretend for a moment that there is a shortage of supply in the UK housing market. Could Help to Buy 2 provide a solution? In the chart below we use our UK housing market model to simulate the impact of Help to Buy 2 on housing construction. We find that, after running for two years, the scheme ought to raise the level of the housing stock by some 0.4% – equivalent to around 100,000 homes. There is a small pick-up in completions, yes, but nowhere near enough to put a dent in the price of houses.
What should policy makers do? And what will they do?
On our central forecast, UK growth comes in at 3.0% this year, driven by strong growth in consumer spending. As regular readers of this column will be aware, the output gap has already closed in our view. Against a backdrop of only modest gains in productivity, continued rapid economic growth causes unemployment to fall further below the old 7.0% threshold, putting upward pressure initially on wage inflation and ultimately on consumer price inflation. With interest rates on hold, we see consumer price inflation above target and close to letter-writing territory by the end of this year.
How should policy makers respond to this combination of rapid house price inflation, and robust economic growth that will soon threaten the inflation target? And how will they respond? Monetary policy is, of course, exceptionally loose. If we are right, both about inflation and about the output gap, a standard Taylor Rule would have interest rates at 5.0% by the end of this year. The market is expecting something far more moderate, and so are we. That is because the UK household sector is not prepared for a return to a more normal interest rate environment. Using data from the Bank of England’s own NMG survey, we find that even a modest 200 basis point tightening would put the proportion of homeowners who are stressed back at pre-crisis levels.
With a rapid tightening of monetary policy off the table, it is encouraging that those tasked with ensuring financial stability have at last started to lean against attempts by the government to boost mortgage lending. Following the Mortgage Market Review, the Financial Conduct Authority recently announced that it is now the responsibility of lenders to verify that borrowers have the ability to service mortgage debt. Proof of income will be required, alongside evidence on other outgoings. In addition, the Financial Policy Committee has requested that bank balance sheets be stress-tested against a scenario that sees interest rates rising close to 5%, and house prices falling by 35%. Banks who fail this test may be forced to change the asset side of their balance sheet, or raise more capital, or do both.
Refresh Chart Edit Chart
It has become increasingly likely that financial policy, rather than monetary policy, will be tightened first in an effort to slow down the UK housing market, and the UK economy more broadly. Will it work? We are sceptical. So-called macro-prudential regulatory policy was used by the Bank of Spain from as early as 2000. That did not prevent the formation of a significant house price bubble in that country, with prices more than doubling between 2000 and 2008, before collapsing as the crisis hit. Nor did it prevent substantial losses at Spanish banks. Even if financial policy is effective in taking some of the steam out of the UK housing market, perhaps by pushing mortgage supply conditions back towards normal, when it comes to preventing output from rising substantially above potential, it is almost certainly too little too late.
If we are right about the lack of spare capacity in the economy, and about the MPC’s reluctance to respond with an increase in Bank Rate, then at some point, perhaps towards the end of this year, sterling will fall sharply. The current account balance, which has been driven further into the red by a collapse in income from abroad, will add to the pressure on sterling.
Panel discussion
Collectively, the panel appeared unconcerned by recent developments in the UK housing market. Indeed, Charles Goodhart spoke out strongly in favour of Help to Buy, both 1 and 2, as he had done in the past. Ian Plenderleith felt that a general economic recovery was not possible without a recovery in the housing market. The general feeling, stated clearly by Marian Bell, was that rapid increases in house prices were only an issue to the extent that they threatened financial stability. But in our view, they do just that. If conditions in the mortgage market remain loose, and if Bank Rate remains at or close to its current level, we estimate that the debt-to-income ratio will pass its pre-crisis peak within two to three years. Rapid increases in house prices are an issue for us because, by and large, they go hand in hand with rapid increases in debt. And, as we learnt in the aftermath of the collapse of Lehman Brothers, financial stability issues can rapidly turn into major macroeconomic issues.
When asked to vote at the end of the panel discussion, the audience sided with us on the issue of house prices, with 78% stating that they were troubled by the return to double-digit house price inflation. On the outlook for sterling, views were mixed. A small majority felt that in twelve months’ time, sterling was a more likely to be higher than it is today than lower. However, almost half of those voting felt that it would be broadly unchanged.
Receive stories like this to your inbox as they are published. Subscribe here and follow us @Alpha_Now on Twitter. If you are looking to access Thomson Reuters data or analytics, register for a free trial.