Stephen King: Put your hard hats on when housing topples

Although the cost of borrowing has gone up, the ability to service that debt has also risen

If the markets are to be believed, the last few weeks have seen a sizeable shift in the challenges facing policy-makers. Last year, the US couldn't generate jobs. It's doing so now. Last year, Japan struggled to show a sustainable recovery. The signs are a lot better today. Last year, the UK economy was still vulnerable to weakness elsewhere in the world. That threat now seems to be lifting.

Given all this more positive news, it is hardly surprising that markets sense the winds of change. Bond yields have risen rapidly in recent weeks, driven higher by upside surprises on US economic data. I've been quite sceptical about the US recovery to date, but I have to admit that things look firmer today than they did a month or so ago. On top of the job gains, retail sales are booming again and the latest inflation figures might suggest that pricing power is returning.

Of course, one month of stronger data provides no guarantee of lasting economic health. Inflation is higher partly because of higher oil and other commodity prices, which could point to a squeeze on profits later in the year, hardly the stuff of healthy economic recovery. The eurozone still looks totally miserable. And, as I argued in last week's column, strength in the first half of this year could be replaced by weakness later on, either because the effects of current policy stimuli begin to fade (the US) or because policies will become more restrictive (China).

One part of the world, though, that seems to be in particularly good health at the moment is our very own UK. Growth is strong, inflation is under control, unemployment is remarkably low and, so far, the boom in house prices has shown no real signs of drawing to a close, despite the frequent warnings of economists and others. But it is precisely because the UK is in this position that the policy challenges facing the UK authorities are a little different from those elsewhere in the world.

If growth is strong in the US, the Fed need not act immediately: although jobs are being created, the unemployment rate is still a lot higher than it was a few years back, so the threat of excessive inflation still looks remote. The concept of growth being too strong in Japan is a strange one: having had virtually no growth over the past decade, no one is planning to bring the latest economic expansion to an end prematurely. Were growth to be strong in the eurozone, there'd be confusion all round: politicians would be uncorking the champagne while the high priesthood that is the European Central Bank would be trying to ram the corks back in, meanwhile telling everyone to put their hair shirts back on.

In the UK, though, decisions have to be made now, not later: there is no room for a hypothetical discussion or scenario analysis. The UK is unique among the major industrialised countries in having both avoided a recession and enjoyed a prolonged period of decent domestic demand growth. So when the global economy starts to recover, the UK is faced with a risk of too much growth, too soon. Which explains why the Bank of England has been one of the first central banks in the world to raise interest rates.

I am sure that other central banks would like to be able to enjoy the certainty of the UK's position. The UK's challenges, though, are increasingly looking more, rather than less, troublesome and, as usual, a lot of the debate centres on house prices. Fears of house-price declines are all very well but consumers still have reasons to be optimistic, sufficiently so to suggest that the house-price bubble may have room to inflate further.

To understand why, it is worth thinking about the key drivers for house prices. There are lots of long-term drivers - housing supply, demographics, divorce rates and the like - but, in the short term, the demand for housing is dominated by two factors: the cost of borrowing and people's income expectations. Raise the cost of borrowing and, eventually, if mortgage rates rise far enough, house-price inflation should come to an end. Raise income growth, though, and house-price inflation will continue for that much longer.

Last year there was a chance that house-price inflation would slow not because of higher interest rates but, rather, because of a squeeze on incomes. With the world economy weak and with UK companies complaining about a lack of profitability, house buyers were in danger of wilting because their incomes were looking less reliable.

In reality, though, house buyers showed, and continue to show, little sign of wilting. Part of the reason is good old-fashioned myopia combined with a lack of understanding about the principles of capital repayment: I wonder whether those people who take on interest-only mortgages fully recognise that, unless they save even more, they will not actually own their house in 25 years' time. But the other factor, surely, was the impact of looser fiscal policy, which boosted public spending and, at the same time, created jobs in the public sector.

The problem now is that the increases in interest rates delivered to date by the Bank of England have been followed by a re-acceleration in income growth, so that although the cost of borrowing has gone up, the ability to service that higher cost of borrowing has also risen. Last week's labour market data suggest that the efficacy of the interest-rate increases seen so far in slowing the housing market has not been great.

On the ILO measure, 183,000 jobs were created in the three months to February. Of these, only 38 per cent were created in the public sector, suggesting a new lease of life for private companies. Wages, including bonuses, rose 4.9 per cent, the fastest rate of increase since the beginning of 2001. And, within this, most of the work was being done by the private, not the public, sector. After adjusting for the effects of inflation (see chart), there has been a clear upward shift in wage growth relative to last year's insipid performance.

On most measures, the housing market looks vulnerable. But, as long as incomes surprise on the upside, we may still be some way from seeing the declines in house prices that many fear. The Bank of England faces an increasingly difficult task: it needs to deflate a housing bubble which is in danger of getting bigger, not smaller, in coming months. And no central bank has yet come up with a way of deflating a bubble without leaving economic blood on the streets. In the short term, look forward to more rate increases and, perhaps, a bigger bubble. Longer term, put your hard hats on as the housing market topples over, because it is in danger of toppling from an ever-greater height.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com