Bank warns of fall in house prices as economy slows

House prices will suffer a "modest" fall over the next couple of years, the Bank of England warned yesterday as it cut its forecast for economic growth.

House prices will suffer a "modest" fall over the next couple of years, the Bank of England warned yesterday as it cut its forecast for economic growth.

In its first explicit warning of a fall in property values, the Bank said the level of house prices relative to buyers' earnings was "unsustainable".

The warning came in the Bank's key quarterly forecast, which cut its GDP forecast from three months ago and moved the risk to both growth and inflation to the "downside". In August it said the risks were balanced. However it balanced the outlook with a forecast that inflation would edge above the Government's 2.0 per cent target in three years.

The report failed to settle the argument in the City over the next move in rates, with some saying it pointed to a peak in rates while others said it left the door open to further rises. The Bank said: "The Monetary Policy Committee's central projection implies that house prices may fall modestly for a period, a somewhat weaker prospect than in August."

Mervyn King, the Governor, said the ratio of prices to earnings growth was about 60 per cent higher than the long-term average. "In terms of when (house price falls) might start, I suppose you can say last month," he said, referring to reports by Halifax, Nationwide and estate agents showing a drop in prices.

But he played down the impact on the wider economy, saying research by the Bank showed the link between house prices and consumer spending, and particular "big ticket" items, had broken down. It published a graph showing that while house price growth had jumped from zero to 25 per cent since 1996, consumer spending growth had barely accelerated - and fallen in terms of durable goods. He said: "We have not seen very rapid house price inflation feed through to consumer spending and if that was true when prices were rising then it may be true in the next few years."

It said steeper falls in house prices or a larger impact on spending would cut both growth and inflation.

Nick Stamenkovic, at RIA, the bond broker, said the Bank was sending a clear signal that rates had peaked at 4.75 per cent. He said: "If the housing market continues to weaken it will be very difficult for the Bank to justify a rise because it could tip the market over."

The Bank said there were further downside risks from rising oil prices, a sudden correction to the US current account imbalances and further falls in high street prices. Mr King said although the economy was close to capacity, the link with inflation had been "surprisingly weak". It offset this with an equal number of upside risks. These included a less marked slowdown in house prices and a boost to inflation from the rise in UK manufactured goods prices.

Some economists said worries over wage inflation, currency depreciation and an economy running at full throttle would be enough to keep rate rises on the table. George Buckley at Deutsche Bank, said: "We do not believe the report necessarily closes the door on a further rate rise."

Mr King repeatedly resisted invitations to congratulate himself for achieving a slowdown in house prices, low inflation and sustainable growth. He said: "This is not a time for opening bottles, it is a time for the MPC to keep its eye firmly on the ball." His comments came as a House of Lords committee said the MPC's forecasting record revealed a "systematic and persistent error".

The Economic Affairs Committee, chaired by Lord Peston, said: "It is remarkable that the MPC consistently over-predicted inflation until 2002, and after that consistently under-predicted it. Did [that] lead to higher rates than were necessary?"

It also implicitly criticised recent appointments to the MPC, saying there had been a "decline" in the quality of their research.