Sunday, June 13, 2004
Can the Bank let the housing market down gently?
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

YOU wait a long time for a rise in interest rates and then several come along at once. When the Bank of England began increasing rates last November, it had not done so for nearly four years. Now we have had four small rises in seven months, and two in consecutive months.

Last week I argued that the volatility of oil prices was the only thing that might deter the Bank’s monetary policy committee (MPC) from raising rates. By Thursday this had died down — there was even a supermarket petrol price war led by Asda, so the MPC had no reason to delay.

How many more rate rises will there be? The parameters were neatly set out two months ago in an interview with this newspaper by Paul Tucker, the Bank’s executive director for markets and a member of the MPC. He said that the “neutral” interest rate in Britain was probably 5%-5.5%.

The neutral rate, at which monetary policy neither stimulates nor constrains the economy, cannot be set in stone. There will be times, as now, when rates are below neutral, and times when they are above. But as I have said before, we shall do well if rates do not rise above 5%, but I would be disappointed if they reach 5.5% or more.

A move from last year’s low of 3.5% to 5.5% would represent the most aggressive tightening cycle by the Bank since the late 1980s. Since then, a more typical trough-to-peak move in rates has been 1.5 percentage points.

These days central bankers are in the eye of the storm. They take the decisions that most influence markets and carry the can if things go wrong.

In America, the stock market has presented Alan Greenspan with his toughest challenge. His warning, eight years ago, of “irrational exuberance” in share prices, was followed by one of the most exuberant stock- market booms in history (followed by a technology bust).

Today the Federal Reserve chairman is trying to avoid nasty reactions by telegraphing his rate moves to the market, with the first small increase from the present 1% generally expected on June 30.

In Britain the Bank’s big headache, since not long after independence in 1997, has been the housing market. Each time it has cut rates for broad economic reasons, to keep inflation on track to achieve the target, housing has taken it as a green light. The most telling example was after the 9/11 attacks on America.

That was the only time, so far, that the monetary policy committee (MPC) had cut rates outside the normal monthly sequence of meetings, and it did so again over the following two months. MPC members thought they would do well to stabilise consumer confidence. Instead, through the housing market, they produced Britain’s own version of irrational exuberance.

In the past few months, the market has laughed in the face of the Bank as it has tried to cool the economy with higher interest rates. In November the Halifax estimated house-price inflation to be 14.1%. Last month it was 20.4%. Over that time prices have risen more than 13% and the average house is now worth £157,849, up £18,000.

That has left the Bank, which was expecting house-price inflation to be easing to zero by now, puzzled and not a little bruised. Just as Greenspan was criticised for identifying irrational exuberance but not stopping it, so the MPC finds itself criticised for allowing the housing boom to roll on.

The Bank does not claim omniscience on housing; in fact it admitted to a good deal of ignorance in last month’s inflation report, identifying three housing-related factors subject to “very great uncertainty”. They were: “First, the degree to which current house prices, relative to earnings, are above a sustainable level. Second, the nature of any adjustment back to a sustainable level. Third, the impact of movements in house prices on consumption.”

On the face of it, the answer to the first question is simple. House prices stand at 5.3 times annual male average earnings, according to the Halifax. That looks high. The peak in the boom of the late 1980s was 5.02 in May 1989.

The recent low point, when we should all have mortgaged our grandmothers to pile into housing, was 3.01 in March 1996. The long-run average for the house price-earnings ratio on the Halifax measure is 3.7. House prices, it seems, are overvalued by 43%.

The trouble with that way of valuing housing, however, is that it leaves too much out. It does not take into account that there are many more two-income households, that the availability and cost of mortgages has radically changed, and that we have moved into a much more benign economic environment, with interest rates, inflation and unemployment low.

Another way of valuing housing, undertaken by Goldman Sachs in a new paper, is by reference to rents. House prices have gone up sharply but so, according to official figures, have rents. Goldman Sachs’s valuation model, based on rental yields (the return on housing) and long-run interest rates, suggests that prices are not much overvalued — in sharp contrast to the traditional valuation method.

That is comforting, but perhaps by not as much as first seems. Goldman’s economists suspect that long-run real interest rates, at under 2%, are abnormally low at present. Factoring in a return to a more normal level of 2.75% produces the result that house prices are 17% overvalued and that, from next year, they will begin a three-year fall.

There are not many optimistic house-price forecasts around now. Some lenders, such as the Nationwide, favour the “years of stagnation” argument, in which housing is stagnant even as earnings rise. Several economists are in the “short, sharp shock” camp, predicting a speedy fall of up to 30%.

The Bank will be keen to avoid that, and I think will do so. But it will be less concerned about a gradual drop in prices or a period of stagnation, not least because MPC members will be able to argue, then as now, that their brief is not to target house prices.

Letting the housing market down gently, while acting to control inflation, is the Bank’s biggest challenge for the coming months.

PS: English eyes will be on France and their footballers today but spare a thought for Germany. Unemployment is rising again in the Federal Republic, despite the upturn in the global economy. Last month the jobless total rose by 9,000 to 4.37m on a seasonally adjusted basis, the fourth successive monthly rise. Unemployment stands at 10.5% of the workforce.

The German economy is picking up but not rapidly enough to make a dent in unemployment. Forecasts from Consensus Economics are for 1.6% growth this year, 1.7% next. That is weaker than France and at least a percentage point below Britain (3.1% and 2.7%) each year.

Germany’s underperformance, in fact, is starting to look chronic. Britain has grown faster for the past decade, France since 1997. Even Italy has done better over the past three years.

With Japan having come out of a long economic slumber, Germany now stands alone as the poorest performer of the leading economies. Who would have thought we’d be applying the label “sick man of the world economy” to Germany? Last year, when I looked at the country’s Agenda 2010 reform programme, it appeared that the government was finally getting to grips with the labour market and other rigidities that are hampering performance. But the momentum for reform has slowed and Gerhard Schröder is heading for a drubbing in today’s European and regional elections.

It does not look at all good.

From The Sunday Times, June 13 2004