When housing bubbles burst, misery results. Prudential curbs on lending must be introduced now to cool an overheated market
Economic View: Monetary policy is now too loose, given that the economy seems to be growing at a rate of about 4 per cent
Thursday 08 May 2014
So what will stop the house price boom – prudential controls on lending, or higher interest rates? Actually, it will probably be a bit of both but the more effective the former, the less the burden will be on the latter.
Something has to stop it. In the long run the only sensible policy will be to build more homes, at least 250,000 a year, and build them in the places where people want to live. But in the short and medium-term something has to cap the rise for all sorts of reasons. You cannot have prices rising by 10 per cent a year when incomes rise by 2 per cent without grave social and economic consequences. When the bubble inevitably bursts, misery results.
Yet the immediate outlook is for another year of rising prices. Not only do very low interest rates make the cost of servicing housing debt quite affordable; the latest survey from Royal Institution of Chartered Surveyors suggests that the present very strong run of prices has at least another 18 months to go, and its members expect 6 per cent annual increases for the next five years. You can see the link between Rics surveys and prices over the past 20 years in the graph: strong survey data gives a lead indicator of what might happen to prices.
Everyone is worrying about this. The Organisation for Economic Cooperation and Development is worried, the Bank of England is worried, even the Chancellor is worried, notwithstanding the modest push from Help to Buy – though on a one-year view rising house prices may not be bad news for the Coalition. So what will happen?
The first question is what effect new prudential rules on lending will have. In a nutshell, lenders have to assure themselves that the loan they are making is in the self-interest of the borrower and that they will be able to service the loan. Now you may think that this would be the most elementary thing any lender should do before making a loan, and until about 20 years ago this was generally what they did. That went from the late 1990s onwards. Now it is being revived and in the past couple of months there has been a slackening in the pace of new mortgages. There will probably be further curbs on home lending in the next few weeks – they are under discussion.
Will we also need higher interest rates? Yes, of course, but the issue is one of timing. If these curbs have failed to check the housing boom by the autumn, the first increase in rates will probably be brought forward to November. There are further reasons why this might be necessary; for example as the increase in construction costs, which currently seems to be running at 15 to 20 per cent a year, starts to feed through into inflation more widely. If, on the other hand, there are signs in the autumn that house prices are topping out and inflation remains below target, the first increase in rates will be delayed until next year, probably February.
The more important message that Mark Carney, the Governor of the Bank of England, and some other members of the Monetary Policy Committee have been seeking to get across is that even when rates do start to rise, the increases will be modest. The new normal for short-term rates might be in the 2 to 3 per cent region, rather than the 4 to 5 per cent range that they were generally prior to the crisis. That makes some sense for the business community and if you go back to the 1950s or early 1960s, before the great inflation took off, this would indeed be normal. The signal it gives to home buyers, though, is that they are reasonably safe remaining highly geared, or in plainer language, over-borrowed.
You don't want to have interest rates higher than they need to be, and the rise in sterling (now only a whisker below $1.70 and close to its year's high against the euro) has the effect of tightening policy. But some of us believe more generally that monetary policy is now too loose, given that the economy seems to be growing at an annual rate of around 4 per cent and putting on jobs at a rate of around one million a year. This is well above the long-term sustainable trend and while it is great to be mopping up spare capacity, it is worrying just how quickly that capacity, for example in construction, is being used up. I suppose there is not much practical difference between an increase in rates coming in November or coming in February, but I think it is important for the Bank to signal that it cares about asset inflation as well as current inflation. Andy Haldane, soon to become the chief economist there, made some thoughtful remarks a few days ago on the need to pay attention to asset prices. Expect his concern to become a more important influence in framing monetary policy in the months ahead.
So what will happen? A middle-of-the-road view would run like this: there will indeed be further rises in house prices for another year or two, but at some stage this combination of greater prudential curbs on lending, plus somewhat higher rates, will put some sort of ceiling on overall price levels. However UK prices, particularly in London and the South-east, will remain high by world standards. Even if planning controls are eased, which they will be to some extent, demand will remain strong.
Politicians will respond, so schemes such as the Help to Buy one will remain in place for some time, a point made by Lombard Street Research in a paper out yesterday. Eventually the market will plateau, and the sooner that happens the less likelihood there is of yet another bust.
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