Rising real incomes, together with building society windfalls, lower taxes and the best affordability for 25 years mean prospects are brighter than at any time since the late 1980s.
The forecasts from Deutsche Morgan Grenfell, the German-owned investment bank, chime with the "golden scenario" expected by Ernst & Young's latest economic model, showing consumer spending growing at its fastest rate for eight years. Spending is forecast to grow at 4 per cent in 1997, up from 2.7 per cent this year. Both Deutsche and Ernst & Young expect the strength of the housing market and high street to lead to a rise in interest rates next year, especially if the Chancellor is tempted to drop the cost of borrowing even lower this year for political reasons.
Paul Droop, chief economist at the Ernst & Young Item club, an independent economic modeller, warned:
"Interest rates will almost certainly need to rise in 1997 if the UK is to turn the bright short-term outlook into enduring low-inflation growth. Any further interest rate cuts this year will only make these subsequent increases all the more important."
Ernst & Young sees an improving housing market as being an important factor in an acceleration in the UK economy's growth rate from 2.2 per cent this year to 3.3 per cent in 1997. Falling interest rates, tax cuts and improving export market conditions, as Europe recovers, are expected to revitalise the economic environment over the next 18 months and allow unemployment to fall below 2 million.
Although inflation is expected to fall below the Government's target of 2.5 per cent by early next year and to average around 2.25 per cent during 1997, the anticipated robust consumer recovery could see inflation rising above 4 per cent in 1998. Ernst & Young believes the Government will need to raise interest rates to 7 per cent by the autumn of 1997 to keep a lid on rising prices.
According to Deutsche Morgan Grenfell, the signs of housing recovery have been building steadily this year, with the Halifax house price index up 10 per cent on an annualised basis so far this year and mortgage approvals at a seven-year high.
The Halifax index has risen for 10 consecutive months, so that prices in May were 4.6 per cent higher than a year ago. That represents the highest level of house price inflation since October 1989.
Deutsche's report, which is published today, added: "The question now is not so much whether the recovery can be sustained, more what type of recovery it will be and what chance there is of a return to a housing boom."
Factors acting against a boom similar to those experienced in the early 1970s and late 1980s include changing demographics, cuts in tax breaks such as Miras and a hangover from the sharp fall in house prices in the early 1990s which led to 330,000 homes being repossessed, 650,000 households being unable to keep up with mortgage repayments and 2 million living with mortgage debts higher than the value of their homes.
Despite fewer first-time buyers and greater caution among buyers and lenders, however, the bank still expects prices on average to rise by 6 per cent this year, 8 per cent in 1997 and almost 9 per cent the following year.
The greatest potential for house price growth lies in Greater London and the South, where Deutsche calculates values are lowest compared with their long-term equilibrium level. While houses in the West Midlands are within 5 per cent of the long-run relationship between prices and incomes, in London they could be as much as 30 per cent undervalued on that measure.
As a result, Deutsche forecasts average price rises in the capital of 11 per cent in both 1997 and 1998 after an 8.5 per cent increase this year. If Deutsche's forecasts are achieved, a house worth pounds 150,000 at the beginning of 1996 will have appreciated to pounds 200,000 by the end of 1998.
The effect of rises of that magnitude would be to almost eliminate negative equity by the end of that year.