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Economics Weekly

House prices To climb further in 2007?
UK housing market is rebounding...
In the last few months it has become clear that the UK housing market is reviving strongly. Earlier in the year, we calculated that UK house prices could be rising at an annual rate of between 8-10% by the end of 2006. That has now occured. But with the pace of activity seemingly still strengthening, what about price rises in 2007? In this week’s briefing, we update our analysis to project how much Bhouse prices might rise in the year ahead, given the most recent figures for mortgage approvals.

...despite predictions of a fall a strong pick up is underway, driven by...
Activity in the UK housing market has defied all predictions of collapse in the last two years. Although many agreed that it was overvalued based on historical metrics such as affordability and valuation ratios like earnings to house prices, there were disagreements about the extent of this overvaluation and therefore whether it would lead to, or required, a sharp correction. Our view is that continued low unemployment and rising employment, rising earnings, and low long and short term nominal interest rates mean that the housing market could remain overvalued for a long time and can avoid, in the absence of economic recession, a wrenching correction.

...faster economic growth, low interest rates and low unemployment
Chart a shows that the UK housing market is unquestionably reviving, with prices and mortgage approvals all pointing strongly higher in recent months. Chart b shows that with prices and activity picking up, bank and building society lending is responding, with gross and net lending, which excludes repayments, up strongly. In fact, this chart also illustrates the extremely high level of liquidity and valuation now evident in the UK housing market compared to the early 1990s. The dip in lending activity in 2004/5 is now a distant memory, with the value of gross and net amounts advanced now reaching record levels.

What is causing this? Fundamentally, it must be due to the recovery in economic growth. We know from the official data that growth in the UK economy is now back above trend in each of the last three quarters. This equates to around 2.8% a year, bang in line with the average growth rate of the UK economy annually since 1992. But what are the key factors that this implies have impacted housing market activity so positively? As chart c shows, long and short term interest rates in the UK are still low by historical standards, even looking at only the last 12 years. They offer substantial support to the UK housing market, and offer a major part of any explanation of why the fall in house prices in 2005 was so limited. Of course, the reason for low interest rates is low price inflation, which allowed rates to be cut last August and kept down long term bond yields.

Chart d shows that continued growth in earnings was also a key support to the housing market in 2004 and 2005 and recent acceleration in earnings growth is supporting the upturn in housing activity seen so far in 2006. The other aspect of the UK labour market that is supporting housing activity is, of course, the continued low rate of unemployment and rise in employment. Chart e illustrates that although there has been a modest rise in unemployment, it is still well down on the 1990s high and offers strong support to housing market activity.

The rebound could even see house prices rise by 15% for some months in 2007
So where could house price inflation be in 2007 based on what we are currently seeing with regard to mortgage approvals and lending? We have updated a simple equation for house prices based on the former variables, which we presented earlier in the year. It suggests that house price inflation could accelerate even further in 2007, possibly hitting a 15% annual rate around the spring and summer, if current trends persist. Of course that is a big if, but if so, it would make a continuation of above trend UK economic growth in the next few years much more likely – our forecast is for 2.8% growth in 2007 and the Bank of England forecast is 3%. In that scenario, for price inflation on the targeted measure to fall back to 2% over a 2 year period starting in 2007 would necessitate interest rates rising to 5.25% on our estimates. Currently, financial markets have priced in a UK interest rate rise to 5% by the end of the year but there is not a strong view currently that they will rise to 5.25%. But based on our analysis of a further strong rise in house price inflation, interest rates of 5.25% may be required to cool UK economic growth to a level that is judged compatible with stable price inflation.

Weaker EU, UK and US August inflation outcome, but a positive tone to underlying economic data

Commentary on Economic Data This Week
In this weekly commentary we review forthcoming economic data and its effect on the evolution of economic policy. What does the data this week suggest for currency and bond markets?
• Sharp growth in labour costs was the key US economic data release last week, but we feel that its implications were not fully recognised by markets. We expect robust economic data to give the dollar a boost and hit bond yields in coming weeks.
• We do not expect the political debate surrounding the change in UK leadership to affect the conduct of economic policy, but it could weaken sterling a little.
• Markets will actively focus on hints of agenda and policy change ahead of the key annual IMF and World Bank meeting running from 16-18 September in Singapore.


The UK calendar sees a heavy week of economic data releases, which are likely to support our view that more monetary tightening is needed. Starting today, August producer price growth is likely to have accelerated; input prices could again return to heady double digit growth, while core producer output price growth could rise 0.3% on the month and 2.6% on the year. While the 1% monthly rise in the August HBOS house price index shocked markets last week, the official house price index for July, also published today, is expected to have risen by 5.6% on an annual basis, confirming strengthening in the UK housing market over the summer months. On Tuesday, August consumer prices are expected to have risen 0.2% on the month. While this possibly represents a small decline in the annual rate to 2.3% from 2.4% in July, this will not convince us that interest rates do not need to rise later this year as increases in coming months will push the headline rate higher. Labour market data on Wednesday will bring more evidence of possible inflationary pressures, with both average earnings and unit labour cost growth rising in July. Finally, retail sales data on Thursday could show annual growth of over 4%, a robust number by any account.

The possibility of deterioration in the July US trade deficit to $67bn from $64.8bn in June, published Tuesday and only a modest decline in August core CPI to 2.5% growth on an annual basis, published Friday, could weigh on the dollar. However, positive growth data should be dollar supportive this week. The monthly increase in retail sales, released Thursday, could fall to 0.4% from 1.4% in July, but still a respectable 4.8% annualised and perhaps surprisingly strong given the slowdown in the housing market. The headline annual retail sales increase of 7% growth may cause some confusion as it reflects the low base effect due to Hurricane Katrina. On Friday, strong industrial production growth and tight capacity utilisation will be published for August, along with September manufacturing and consumer survey data, which could be firmer than expected.

Eurozone data is negligible this week, although final August CPI could be revised down to 2.3%. This does not alter our view of a 25bp interest rate hike in October, which is predicated on strong economic data. The publication of minutes of the minutes of the Bank of Japan's 10-11 August monetary policy meeting on Wednesday is likely to add little to the debate, following last week's decision by the Bank to hold rates due to modest economic expansion and slow CPI inflation. In terms of the data there is little economic support for the yen this week, although there may be some further strengthening this week due to some unwinding of short positions and carry funds.


 

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