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Monday February 18, 2008 - 13:08:51 GMT
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Economics Weekly - Is the UK housing market on the verge of collapse?; Weekly economic data preview - Focus on BoE and FOMC minutes

Economics Weekly  18 February 2008

Is the UK housing market on the verge of collapse?

The UK housing market is slowing sharply...
The UK housing market is slowing sharply and this has led to fears that it could collapse, pushing the economy towards recession. But UK consumer debt levels are at a record high and some slowdown in the growth rate of that debt accumulation is necessary in order to prevent an even sharper correction in house prices in the years ahead. Our analysis suggests that growth in UK house prices in 2008 and 2009 will be below the rate of growth of household income, and so there will be some slowdown in the rate of growth of mortgage debt, though it is unlikely to fall back from its current high level of 130% of annual household income.

…making the economy vulnerable to a downturn...
This means, in turn, that economic growth in the next decade may be closer to the 40 year average of 2.5% a year rather than the 10-year average of 2.9%. To some that will feel like a poor performance but in fact it is almost unavoidable if the UK economy is to avoid an even sharper correction in the future. With record levels of household debt, a current account deficit of around 4.5% of gdp and a budget deficit of 3% of gdp, any significant economic slowdown would be very traumatic and should be avoided at all costs.

House prices are slowing, not collapsing…
As chart a shows, UK house price inflation at the completion stage is slowing after rising quite strongly to a peak of just over 12% p.a in 2007. The most recent figure is of a rise of just over 9% in the year to December 2007. This still qualifies as a fast pace of house price inflation, especially compared with income growth of under 5%, which therefore suggests household mortgage debt ratios are rising, and so in no way is a collapse underway. A quick look at the level of house prices, as exemplified by the index of house prices on the official measure, shows that there has been an inexorable rise in house prices since 1997. Indeed, the level of house prices on this basis has trebled in the last decade. This is clearly unsustainable and will eventually end, either in a controlled way or uncontrollably, i.e. a crash. In this context, a slowdown in house prices should be welcomed, not condemned as a sign of imminent economic collapse.

…and mortgage debt is at a record level…
A look at chart b shows that UK outstanding mortgage debt is now some £1.2trn, or 130% of annual disposable income as shown in chart c, with household consumer credit borrowing standing at over £200bn. This is why UK house prices are now so unaffordable for those on average incomes: the rise in house prices has been faster than the rate of growth of incomes in every year since 1996, apart from a pause in 2005. From a multiple of just over 6 times incomes in 1997 it has risen to nearly 13 times incomes in 2007, see chart d. No wonder there has been such fast growth in buy-to-let markets – too many people cannot afford to buy and have to rent. This is one reason why this segment of the housing market will not collapse, even with the rise in interest rates since the low of 3.5% and the slowing of house price inflation since its peak in 2007. The extent of the rise in unaffordability and of household mortgage debt to income ratios is a sign of the need for a correction in UK house price growth relative to income. Hence, it seems strange for the modest slowdown seen so far in house prices to be hailed as bad news for the economy, rather than the easing of an unsustainable rise that it actually is.

…driven up by lack of housing supply
But it is worth noting that one of the reasons for the rise in house prices has been the relative lack of house building in the UK compared with the rise in household formation. The latter represents the rate of demand for physical properties in the UK; the former is the number of housing starts by the private sector. Chart e shows that one of the key reasons underlying the rise in mortgage debt is, since 1999, the excess of demand (household formation) for housing over housing supply (housing starts). Further, and more worrying, this mismatch between supply and demand has not narrowed in this period; in fact, it has widened, with nearly twice the demand for properties compared with the supply in 2006. It is no wonder that house price inflation has been so high in recent years. This mismatch between demand and supply represents one of the key issues that need to be addressed before UK house prices can stabilise. But, in addition, it also underlines that lack of supply is one of the reasons why house price inflation will not collapse in the UK in the next few years, unless the economy enters a deep recession.

House price inflation will average just 1-2% in the next 2 years
So what does our forecast of UK house prices show for 2008 and 2009? Chart f shows that we are looking for house price inflation to slow rapidly this year and for there to be a modest fall in the level of house prices in the second half of 2008 and in the first half of 2009. However, house price inflation will still rise by an average of around 1-2% this year and by about ½% in 2009. In the final quarter of this year, house prices might be 2% below the level of 2007 but 2.3% higher in Q4 2009. We view this as a healthy correction and in no way as a collapse. Indeed, this will not be too far off of the experience of house price inflation in 2005.


Weekly economic data preview  W/c 18 February 2008

 Focus on BoE and FOMC minutes

• The Bank of England publishes the minutes of the 6-7 February MPC meeting on Wednesday. We expect a unanimous vote (9-0) to cut Bank rate to 5.25%, with the small risk that a committee member may have voted for a sharper 0.5% reduction reflecting the downside risk to economic growth in 2008. However, UK data this week should underline why the MPC will continue to proceed cautiously, with money supply still growing at a double-digit pace and retail sales rebounding in January. The last set of monthly public finances data ahead of the Budget on 12 March will attract attention.

• In the US, the Fed publishes the minutes of the 29-30 January FOMC meeting on Wednesday. Financial markets will be particularly interested in the latest staff economic projections, last updated in November 2007. With attention currently focused on the slowing economy and weak housing market, understandably the latest data on housing starts and initial jobless claims may attract most market attention this week. However, we forecast headline CPI inflation accelerated to a two-year high in January, indicating inflationary concerns should also not be overlooked. US financial markets are closed for the Presidents' day holiday on Monday.

• Focus in the euro zone this week will be on the latest manufacturing and services PMI data for February. After the surprisingly sharp fall in the services index last month, dropping to a 4 1/2 year low of 50.6, we look for a small rise but feel a stronger rebound is also possible. A reading below the key 50 level would raise market expectations of lower euro zone interest rates. We expect a modest fall in the EU-15 manufacturing PMI to 52.6, reflecting weaker export orders. Data last week showed falling exports behind the first monthly euro zone goods trade deficit for 16 months in December 2007.

• Canadian data this week are expected to underline the case for further interest rate cuts, particularly with annual core inflation forecast to fall for the seventh successive month in January. Bank of Canada incoming governor Mark Carney will make his first public speech on Monday. Elsewhere, it is a relatively quiet week for key economic data and events.

The key message from last week's Bank of England Q1 Inflation Report (QIR) was that, based on prevailing market interest rate assumptions (Bank rate at 4.5% at end-2008), annual CPI inflation will overshoot the official 2% target over the 2-year horizon. In addition, the QIR showed a particularly worrying trajectory for inflation in the short term, with a significant risk that it may break the 3% upper limit, requiring an explanatory letter from the BoE governor to the Chancellor. This suggests the debate at the February MPC meeting will have centred on how to balance this upside inflation risk against the downside risk to growth. With broad agreement on the committee of the need for lower interest rates, and reflecting the swift change in sentiment from an 8-1 vote to keep Bank rate on hold at 5.5% only in January to a cut to 5.25% in February, this suggests the decision is likely to have been unanimous this month. We expect UK economic data this week to support the case for the MPC to remain cautious about easing policy too soon. After falling in December for the second time in the past three months, we forecast retail sales rebounded in January, mainly reflecting aggressive discounting on the high street. Despite the onset of the credit crisis, UK money supply growth rose at its fastest pace in over a year in December and annual growth is predicted at 12% in January.

Although a relatively quiet week for data from the US and EU-15, figures such as housing permits and initial jobless claims in the US and the EU-15 'flash' PMIs of manufacturing and services activity could elicit strong market reaction, particularly if weaker than consensus estimates. There are also some prominent Fed and ECB speakers taking to the stage this week.
Jeavon Lolay, Senior Economist

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

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.



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