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Economics Weekly - UK housing market will slow further in 2008; Weekly economic data preview - BoE interest rate decision - too close to call?

Economics Weekly  3 December 2007

UK housing market will slow further in 2008

The UK housing market is slowing – don’t panic!
In his opening statement to the Treasury Select Committee, Mervyn King, Governor of the Bank of England, stated that the consequences of tighter credit conditions resulting from the turmoil in global financial markets are ‘difficult to assess and are likely to be evident first in the housing and commercial property markets'. This point seems to have elicited a strong response from observers. Lance Corporal Jack Jones, in the hit comedy, Dads Army, was famous for his catchphrase, "don’t panic, don’t panic", as he ran around panicking. This almost appears to be the general reaction to a series of weaker data from the housing market in the last week. But should we panic?

UK housing market finally taking a tumble…
UK mortgage approvals fell from a downwardly revised 100,000 in September to 88,000 in October, the lowest figure since February 2005 and 31% lower than in the same period of 2006 when it was 128,000. The value of net mortgage lending also slid, to £7.3bn from a revised £9.5bn in September. Moreover, a key measure of UK house prices saw a fall of 0.8% in November. Our own model of UK house price inflation, which accurately picked up the peak this year and subsequent fall, see chart a, shows that house price growth will average about 2% in 2008 and end the final quarter only 1% higher than in the same quarter of this year. That will be lowest average house price rise since 2005, when the increase was just 1.9%. The link between house price inflation and retail sales suggests that the slowdown in price inflation that we are seeing, and expecting for 2008, will result in a real squeeze on retailers’ sales volumes and profits next year. As chart b shows, the average annual rise in retail sales volumes next year will be between 2% and 3% at best. These are the kinds of numbers that can lead to panic. But, worrying as these trends are, should we be panicking? After all is a slowdown not necessary to make property prices more affordable and prevent an even bigger collapse later on?

…house price cycles seemingly cannot be avoided – there has been three in five years…
House price cycles are normal - this will be the third price cycle in the last five years. Chart a shows that house price inflation hit a low in 2003, a peak in 2004, another low in 2005 followed by another peak in 2007. Therefore, cycles in house prices should not be viewed as at all unusual. But the last outright fall in annual house price inflation took place following the end of the last UK recession, fifteen years ago in 1992, see chart c. In that year, interest rates averaged 9.6%. Although interest rates fell in 1993 as the economy recovered, they still averaged close to 6%. This compares with the average short term interest rate so far in 2007 of 5.5%. This relatively low rate of interest will, in our view, mitigate the potential fall in house price inflation in 2008, even with the credit market turmoil in full swing. And this is a key reason for not panicking; there is ample room for monetary policy to respond to the coming slowdown.

…and the current pattern of house price inflation is evolving as would be expected given the rise in interest rates since August last year
An important question though has to be, is this house price cycle being driven even lower by the current global credit market turmoil? There is no evidence yet to suggest that it is; rather the current house price cycle is following the pattern to be expected, as seen in the last interest rate cycle. Chart d perfectly illustrates this point, as the year on year rate of house price inflation is exactly where we expected it to be at this stage of the interest rate cycle, after having been stronger than predicted for many months. The same point can also be made about mortgage approvals, chart e, which has also fallen sharply but remains above that of the last cycle. Therefore, although the fall seems to have shocked many observers, it should not have done. It is falling as expected given the rise in interest rates since August last year. In fact, the fall could have been even steeper and approvals are set to drop further in the months ahead. This will of course mean that mortgage lending will fall back further as well, chart f. But here too, lending has proved more resilient to higher interest rates than would have been expected from its path in the last interest rate cycle.

In conclusion, house price cycles cannot be avoided but they can be controlled by timely action
House prices cycles cannot be prevented, but so long as interest rates can be cut, the downside impact can be limited. It implies that the upside should also be limited by not leaving interest rates too low for too long as it will inevitably ignite a house price boom (as seems to have been the case in the US under former Chairman Alan Greenspan). The current situation suggests that UK interest rates will soon fall. We forecast that interest rates could be cut to 5% by mid 2008, mitigating the downside risk of the current house price inflation cycle to that of 2005. As chart a shows, a fall in interest rates next year will lead to a gradual recovery so that by the end of 2009, house price inflation will be rising, albeit modestly. So our message would be just what Captain Mainwaring used to say to Lance Corporal Jack Jones, stop panicking.


Weekly economic data preview 

BoE interest rate decision - too close to call?

PMI survey data ahead of the Bank of England interest rate meeting may prove crucial to the decision to whether Bank rate is cut for the first time since August 2005 on Thursday. Signs of slowing economic activity in November, particularly in the services sector, could prove enough to nudge any wavering MPC members to join their two colleagues (Blanchflower, Gieve) who voted for an immediate 0.25% cut to 5.5% last month. However, we remain of the view that inflation worries

and solid growth may keep a majority on the MPC from cutting interest rates until early next year. However, the ECB faces a different dilemma, with recent data suggestive of higher interest rates, but difficult credit market conditions indicating the need for an immediate cut. We expect rates to remain at 4% on Thursday; however the press conference could elicit a strong market reaction as ECB president Trichet conveys the outlook for policy ahead. There are some key data published in the US this week, headed by the November labour market report on Friday. We look for 90,000 new non-farm payrolls, down from 166,000 last month, reflecting the uptrend in initial jobless claims and the current uncertain economic climate. Interest rate decisions in Canada and Australia are due on Tuesday, with a cut in Canada a real possibility.

• Recent comments from BoE MPC members have focused on the uncertain near-term outlook for growth and inflation and how this is complicating their decision making on interest rate policy. Developments in global credit markets, with interbank lending rates rising further above official interest rates recently, have only added to that difficulty. However, the consensus opinion on the MPC is that growth will slow sharply next year and interest rates can be cut to prevent undershooting the inflation target. This primarily explains why two members of the committee voted for a 0.25% cut in October, questioning the need to wait for further economic evidence as argued by the majority voting for no change. Against this backdrop, purchasing managers' indices (PMI) from the manufacturing and services sector this week, on Monday and Wednesday, respectively, will provide a timely gauge of activity and could tip the balance. Although the more crucial services PMI dropped to a 4 1/2 year low of 53.1 in October, we look for a modest rise in November based on recent anecdotal evidence. However, a further fall is also possible and represents the consensus view. We believe the interest rate decision will be close and so will not be surprised if Bank rate is cut on Thursday. However, on balance and, given recent MPC member comments, we still look for a first cut in early 2008.

• In contrast to the large uncertainty around the BoE decision, the ECB is overwhelmingly expected to keep interest rates at 4% on Thursday. Although recent economic data from the euro zone, such as the stronger than expected German IFO, rise in CPI inflation to 3% in November - the fastest in over six years - and robust money supply growth, all point to higher official interest rates, rising uncertainty in financial markets has pushed European interbank borrowing costs to a six year high. This will prevent the ECB from considering a hike this month but we believe comments from ECB president Trichet at the press conference could provide a signal to its direction once financial market instability subsides. The ECB quarterly macroeconomic projections are also published on Thursday. EU-13 data this week should see confirmation of the preliminary November PMI survey data, while retail sales and producer prices may show modest rises in October.

• We expect growing speculation of a 0.5% cut in Fed funds next week to moderate after a solid set of US activity data this week. Results for regional indices suggest the manufacturing ISM may have rebounded in November from a 7-month low of 50.9. The non-manufacturing index, representing around 90% of the economy, is forecast to rise to a five-month high on the back of strong global demand. The labour market report on Friday provides the highlight of the week. We forecast 90,000 new payrolls in November. The ADP employment survey, on Wednesday, and services ISM should provide a guide to the payrolls data.

Jeavon Lolay, Senior Economist

Economic Research,
Lloyds TSB Corporate
10 Gresham Street,
London EC2V 7AE
0207 626 - 1500

<i>Any documentation, reports, correspondence or other material or information in whatever form be it electronic, textual or otherwise is based on sources believed to be reliable, however neither the Bank nor its directors, officers or employees warrant accuracy, completeness or otherwise, or accept responsibility for any error, omission or other inaccuracy, or for any consequences arising from any reliance upon such information. The facts and data contained are not, and should under no circumstances be treated as an offer or solicitation to offer, to buy or sell any product, nor are they intended to be a substitute for commercial judgement or professional or legal advice, and you should not act in reliance upon any of the facts and data contained, without first obtaining professional advice relevant to your circumstances. Expressions of opinion may be subject to change without notice. Although warrants and/or derivative instruments can be utilised for the management of investment risk, some of these products are unsuitable for many investors. The facts and data contained are therefore not intended for the use of private customers (as defined by the FSA Handbook) of Lloyds TSB Bank plc. Lloyds TSB Bank plc is authorised and regulated by the Financial Services Authority and is a signatory to the Banking Codes, and represents only the Scottish Widows and Lloyds TSB Marketing Group for life assurance, pension and investment business.</i>



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