Sunday, January 02, 2005
Warning signs but no crash
Posted by David Smith at 11:00 AM
Category: David Smith's other articles

CAN IT LAST? Can we have another good year of economic growth without much inflation, or are we reaching the end of an extraordinary run? What could happen at home or internationally to derail the economy? Where did it all go right, and how easily could it go wrong again? At this time of year, when forecasts are as thick on the ground as empty champagne bottles, it would be easy to turn the page. To prevent ennui setting in, let me ask myself 10 tough questions about the outlook for the year, and then try to answer them.

Will house prices end the year higher or lower?

This is tougher to answer than you might think. A house-price crash is very unlikely. It takes a lot to send prices tumbling 20% or 30%, most notably a surge in unemployment associated with full-scale recession and far bigger interest-rate hikes than we have seen. But what about a more gentle fall, of 2%, 3% or 5%? Even some optimists see small falls over the next 12 months. I would not rule it out, although a rise of 3% to 5% is more likely.

Will interest rates rise or fall?

A split has developed among forecasters. Those who expect a hard landing for the housing market are looking for aggressive rate cuts from the Bank of England, to 4% or below. Others believe it will have to raise the base rate from 4.75% to 5% or even 5.5%. My view is that the Bank will be in no rush to change in either direction but that by the end of the year we will see a small fall, to 4.5%.

In America, the Federal Reserve has raised its key Fed Funds rate five times so far, to 2.25%. Another five hikes, to 3.5%, seem to be on the cards. In euroland the outlook is too grim for the European Central Bank to be thinking of rate hikes. Its key rate should stay at 2% all year.

Will taxes go up?

Figures released just before Christmas put the Treasury even more out on a limb in its insistence that Gordon Brown’s “golden rule” will be met. There is a sporting chance that the rule will have been broken beyond repair by the time of the expected May election. But the chancellor will maintain his Micawberite belief that something, notably tax revenues, will turn up. Pre-election tax rises are an impossibility. Post-election they look certain, although the government will probably wait until the March 2006 budget.

Will Brown still be chancellor?

There are several possibilities here. Labour could lose the election, still likely to be on May 5. Tony Blair could win but unconvincingly, bringing forward his handover to Brown by several years. Or Blair could win big, emboldening him to move his chancellor to another post, on the grounds that eight years at the Treasury, comfortably a modern record, is enough for anybody. This would be particularly humiliating for Brown, not least if his successor were to make a play of having to clear up the fiscal mess he had inherited. On balance I expect Brown to be still in his job on December 31.

Will the dollar fall further?

Yes, but not much. The troubled greenback probably has another 10% to fall. In recent days the euro has hit an uncomfortable $1.36, while sterling is just a few cents away from $2. Expect the action to switch to Asia, where the focus will be on the vexed question of whether the Chinese will revalue the renminbi. They should do so this year.

If sterling climbs above $2 it will not be for long. The current account deficit, an annualised £28 billion in the first nine months of 2004, is heading for £32 billion this year. That will help restrain sterling against the dollar and push it lower against the euro.

Will the stock market rise?

A year ago many pundits expected share prices to fall. My view was that we still had a way to go to get back to fair value after the prolonged bear market. That is still the case. The global economy is growing at a fair pace, as are company earnings. I would look for 5,250 for the FTSE 100 index by the end of the year, a rise of almost 10%.

Will the global economy be strong?

Last year was the best year for world economic growth for three decades. This year there will be some moderation in growth but not a dramatic slowdown. Thus, America should grow by about 3.5% (down from 4.5%), and Japan by 2% (from 3%). Chinese growth will ease to 8% from well over 9%. Asia, excluding Japan, will grow by about 6.5%, down from just over 8%, despite the consequences of the devastating tsunami. Europe is again the worry. After failing to hit 2% growth in 2004, euroland may manage only 1.5% this year.

Will oil prices fall?

The strength of oil prices, which hit $50 a barrel and threatened to go higher, was one of the big surprises of 2004. Even more surprising, perhaps, was the muted impact on the world economy. It used to be thought that the sustainable price of oil was between $22 and $28 a barrel; now it is between $32 and $38. Prices are currently a few dollars above that but should settle in the mid-thirties this year.

What about growth in Britain?

Our economy rarely grows at more than 3% for two years in a row. It last happened in 1997 and 1998. After 3.25% growth in 2004, expect a still-healthy 2.75% this year. That should keep unemployment trundling lower, to 750,000 on the claimant count and 1.25m on the wider Labour Force Survey measure.

Will inflation stay low?

Yes. There are two views about inflation. One is that it will take off if spare capacity is used up, particularly in the labour market, unless action is taken to slow the economy. The other, which I tend towards, is that low inflation is now ingrained and that it will take a lot to rekindle it. Britain has had low inflation (averaging 2.5% on the Bank’s former target measure) for 12 years. On the new measure, the consumer price index, inflation will still be below its 2% target at the end of the year, probably at about 1.75%.

All this looks too good to be true, but then Britain’s economy has done better than expected in recent years. It is possible to conjure up scarier scenarios involving a dollar collapse, a dive in house prices, terrorist attacks and huge tax rises. But why worry unnecessarily?

PS: I ended the irritating jargon competition two weeks ago by declaring “no brainer” the clear winner, but the entries have kept flooding in. Some people have been irritated by Christmas cards, and not just those Tony Blair sends out. One that gets to me is “Season’s greetings”, which always looks clumsy. What does it mean anyway? Winter greetings? Greetings for any religious celebration between November and February?

Some readers have also responded to my suggestion that the best use for irritating jargon is for bingo purposes, shouting out when a conference speaker comes up with enough of the worst offenders. Their objection is that I have provided a bowdlerised version of the true game, whose proper name is Bulls**t bingo; Bulls**t being what you should shout out. There is, however, an element of self-preservation in this. Having accepted one or two invitations to give talks during 2005, that’s the last thing I want people to be shouting out just as I’m getting into my rhetorical stride.

From The Sunday Times, January 2 2005


"But why worry unnecessarily?"

Isn't that what economists are normally paid to do?

Posted by: Giles at January 3, 2005 12:49 AM

A house price crash IS quite likely.


1/ Unemployment: the figures are masked by

Over-education: most people are in uni from 18-21+ the time when people are most likely to be unemployed.
Fiddles: after 3 weeks unemployment, you go on a course, and are signed OFF the list.
Mal-Employment: We have 800,000 extra state employees, all not doing too much, (and all on final salary schemes!) Gordon has started to feel the laffer curve, and revenue will not be increased by increasing tax. The MalEmployment con, cannot continue for long, and soon alot of council non-jobs will be competing for work in the wealth creating part of economy.

2/ Inflation:
Fiddled This has been high, but the Govt say it's low figures ignore Rent, Mortgage interest, council tax, travel costs etc. They do include that DVD player that was made in China, the one you buy once every two years!

3/ Debt:
The UK public is in debt, the state is in debt, Debt is consumption brought forward temporally. We pay it back in the future, and just paying the interest will erase economic growth.

4/ Prices:
No-one I know can really afford to buy a house, and I know some VERY well off people. Transactions are LOW, FTBs are priced out, BuyToLet will lose you money. So where is the money for price rises going to come from?

5/ Bubble Economy: The definition of a bubble is that people are buying for the capital appreciation not the yearly return. This is the housing market to a Tee.

The housing prices have to fall at least 30% to return to their average. Unless there's a "New-Paradigm" like the Dot-com boom ;)

Posted by: Rob Read at January 3, 2005 01:12 AM

In response to Giles:
Good point. It depends how dismal you think the dismal science should be.

Posted by: David Smith at January 3, 2005 11:17 AM

In response to Rob:
I don't agree. The only period of significantly falling nominal house prices we have seen in the UK was in the late 1980s and early 1990s. The peak-to-trough fall in prices then was 13% (on the Halifax and Office of Deputy Prime Minister measures). In normal circumstances house prices are "sticky downwards". I also believe that the house price-earnings ratio is no longer a reliable measure of housing valuations. Valuations are stretched but so are people's expectations. I suspect the people you know aren't opting for what used to be the usual practice in getting onto the housing ladder - buying in a cheap, often grotty area just to get started on the process.
That's anecdotal. The upshot of my argument is that it takes a lot to produce a big fall in house prices. If the Bank of England lost control of interest rates or the economy was to slide into recession (try finding an example of a house-price crash without a general recession) and I might change my mind.
By the way, there's a lot of misunderstanding about the inflation measures, for which the government has only itself to blame. I agree with you about the CPI but a more reliable measure, the RPI excluding mortgage interest payments (an appropriate exclusion) only has inflation at 2.2%.

Posted by: David Smith at January 3, 2005 11:27 AM

The only period of significantly falling nominal house prices we have seen in the UK was in the late 1980s and early 1990s

Before then this was considered impossible. It happened once and it can NOW more easily happen again.

In normal circumstances house prices are "sticky downwards"

Homes are sticky downwards. Rapidly non-performing => loss-making amateur Buy To Lets are a completely different story. This is why a fall is MORE likely than before. A fall in employment in London, could increase the rental voids in BtL sucking yet more money out of the economy to cover the mortgage gap. BtL losing money might decide to sell forcing down prices.(Anecdotally New Years Eve was very quiet in London, people just aren't going out and spending.)

getting onto the housing ladder - buying in a cheap, often grotty area

There ARE NO cheap areas, just expensive grotty areas. FTB are disapeering and will be extinct soon. What market increases valuations with no new entrant money appearing?

Basically I think we are about to go into recession.

Debt will cause the recession or more accurately, the inability to continue to take on debt will cause a drop in spending, causing a drop in employment, repeat feedback loop, the interest payments will also not help.

Your opinion boils down to "New Paradigm Beleiver", I still see no justification for changing the new way of valuing houses?

Posted by: Rob Read at January 3, 2005 05:05 PM

I think that there were nominal prices fells in the 30’s and 1890’s as well. Still one thing that is worth mentioning when discussing house prices is immigration. Current net immigration of 200k per annum far exceeds the construction industry’s ability to build houses and hence puts upward pressure on house prices, particularly in the South East. However its also important to note that immigration flows can reverse quite quickly net inflow of 200 thousand can turn to an outflow of 200 thousand if entrance visas were suddenly restricted. And this is quite possible – it the Tories get in they’re bound to tighten up the granting of visas almost immediately and a major terrorist attack might have the same effect on Labour. So I think there’s a possibility of a crash driven by immigration.

Posted by: giles at January 3, 2005 07:31 PM

There were indeed nominal house price falls in the 1930s. Interestingly, the peak-to-trough fall was 13% then too according to ODPM data. But this was a time of huge economic dislocation, the Great Depression and, most importantly, general deflation. It is worth noting that out of the wreckage came a housebuilding boom. Think of all those 1930s' semis. Anybody who expects a UK recession is right to predict a housing crash. Those who don't have their work cut out. The immigration point is a good one.

Posted by: David Smith at January 3, 2005 09:06 PM

"inflation that has lasted a long time disorganises the economy"

The question of house price adjustment can only be answered if a reasonable analysis of the disorganisations to the economy is made.
To date I have not seen, nor read much about the disorganised economy that is the UK. However signs are there. (credit boom, FTB out priced, ...)

can you advise ?

Posted by: Ryan Dallas at January 4, 2005 01:03 PM

I think the quote refers to Alan Greenspan's famous dictum that central bankers should aim for a rate of inflation that is low enough to not distort economic decisions. High house-price inflation has led to some distortions, probably encouraging a higher rate of growth of consumer spending than would otherwise have been the case. I wouldn't say, however, that it has "disorganised" the economy.

Posted by: David Smith at January 4, 2005 03:30 PM