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Forex Market News - Economics Weekly - UK house price inflation at a peak and will slow by end 2007; Weekly Economic data Preview - UK and US inflation data to impact interest rate debate

Economics Weekly:

UK house price inflation at a peak and will slow by end 2007


The UK housing market is strong, with annual house price inflation at 12.1% on the official measure in February and by anything between 10% and 15% on other measures, see chart a. Short term interest rates are now at their highest level since May 2001 and standard variable mortgage rates are similarly rising, from 5.50% in 2003 to nearly 7.50% today. So, is housing activity at its peak and where will house price inflation be at end of 2007? Our housing model forecast accurately in 2006 that residential house price inflation could reach double digits this year, now it suggests that house price inflation will be in single digits by the end of 2007.

Is the UK housing market now at a peak?
The UK housing market has been supported by a number of key economic factors in the last 2 years, which have allowed it to defy predictions of a sharp decline and instead showed a sharp recovery. But some of these positive forces are now either going into reverse or fading. For instance, real income growth of UK households is now falling, interest rates have risen sharply, mortgage rates are higher (see chart b) and employment gains are not as strong as they were. However, this is not to suggest that there will be a collapse in house prices - in the absence of sharply falling employment and a steep drop in nominal disposable household incomes, this is highly unlikely - but the pace of increase should now ease back. An additional factor that has kept housing demand strong in the UK has been the growth in the number of households, now estimated to be well above 200,000 a year for the next decade, compared with housing completions of just 160,000 last year. This implies a shortage of housing of the sort desired by the changing composition of household formation, i.e. not enough single units in some areas and not enough family homes in others.

After a sharp recovery, a number of key factors are now working against further strong increases…
Chart a illustrates that the rise in house prices in the past two years, on official and other measures, has been fairly robust. However, this pace of increase now seems unsustainable, if one looks at some of the other factors now working against it. One factor is clearly housing affordability, or rather rising unaffordability. This is shown up by chart c, which depicts average earnings growth deflated by retail price inflation (i.e. real earnings) set alongside the annual percentage change in UK house price inflation. Usually, rising house price inflation occurs when real earnings are increasing relatively quickly, but at present this is not the case. Real household earnings are now falling as a result of the recent rapid rise in retail price inflation, and the inability of average earnings growth to keep pace with it. In the year to February, annual retail price inflation was 4.6% whereas average earnings grew by 3.6% in the same period, implying a fall in real earnings of 1%. If this trend persists, then house price inflation must begin to tail off, as the average household will increasingly be unable to get on or go further up the housing ladder.

...there are signs that house price inflation is at or near its peak and could be down to single digits by end year
Another key factor that has been supporting house price inflation has been rising employment, but, although still increasing, employment is now slowing, see chart d. This implies that house price inflation will be under downward pressure in the months ahead from this source. As mentioned earlier, downward pressure will also come from the rise in interest rates, see chart e, which have been rising since August 2006 and stand 1 percentage point higher at 5.5% or 22% up on a year earlier. Is there evidence that housing market momentum is beginning to be lost, despite the recent increase in prices? The short answer appears to be yes. Chart f shows the Royal Institute of Chartered Surveyors (RICS) survey of estate agents and their responses to questions of new buyer enquirers, new instructions and agreed sales. The chart shows that momentum in all these areas is waning from the high points reached in late 2006, but it also suggests that a spring revival may be currently underway. However, given the rise in interest rates and the other factors we have analysed, there has to be a question mark over whether a spring pick up will take these variables back to their 2006 peaks.

What does our model of house prices suggest?
Recently, the model has been suggesting rather faster house price inflation than has actually turned out to be the case, but nevertheless a good fit still exists. Chart g shows the strong link between mortgage approvals and house price inflation since 1992. Using this relationship, and taking account of net mortgage lending, our model suggests that house price inflation will slow by the end of the year, see chart h. But the slowdown is likely to still leave house price inflation rising by between 7% and 9% a year. UK house prices will not collapse due to recent trends in income, employment, average earnings or if interest rates stay at 5.5%. In fact, the overall message is that the housing market is resilient and interest rates may have to stay around current levels to ensure that it cools.

Trevor Williams, Chief Economist

Weekly Economic data Preview

UK and US inflation data to impact interest rate debate

• A heavy schedule of UK economic data to be released and the BoE Inflation Report are set to have a big impact on financial markets expectations for interest rates in the near term. Producer prices are due on Monday, consumer prices are due on Tuesday. Unemployment and wage statistics are due on Wednesday when the BoE will deliver its latest projections for growth and inflation in the Q2 Inflation Report. The week will conclude with retail sales data for April on Friday.

• A raft of statistics are also due in the US where market focus will be on consumer prices on Tuesday and residential construction figures on Wednesday. The trend in these remain central to the Fed's strategy on interest rates. Core inflation started to moderate towards the end of Q1 but higher energy prices and stronger corporate pricing power suggest that the scope of a further decline in core inflation in the short term may be limited. Housing starts and building permits rose in March and are forecast to have declined in April, partly due to cold weather.

• Focus in the euro zone will be on the preliminary estimates of Q1 gdp due on Tuesday. Economic growth is forecast to have slowed to 3.0% from 3.3% in Q4 2006, but means that the economy is still growing above trend which is likely to give the green light for a 0.25% rise in euro zone rates in June. Q1 gdp figures are also due from Japan on Thursday but should not persuade the Bank of Japan into raising interest rates on the same day.


The rise in UK CPI inflation to 3.1% in March left the Bank of England (BoE) with no alternative but to raise interest rates to 5.50% last week. At the heart of the debate whether interest rates will have to rise again is the trend in CPI inflation in the coming months. April CPI inflation will be released tomorrow and is forecast to have eased back below 3.0% to 2.7%. RPI inflation is forecast to have fallen back to 4.5% from 4.8%. The results, if confirmed, could herald a trend reversal which, in our projections, means that CPI inflation will drop to 2.2% by August. Under these circumstances, we disagree with current market perceptions that interest rates will rise to 5.75% this year. Producer prices for April are due this morning and may show a 0.5% rise. The annual rate is forecast to have slowed to 2.5% from 2.7% in March. Concerns about the level of spare capacity were also cited by the BoE for the rate rise last week. It is in this context that market participants will judge the April unemployment and wage data on Wednesday. The labour market started 2007 on a very solid footing and this has contributed to a fall in the total claimant count of 37,000 in Q1, the best result since Q2 2004. Against this backdrop, it is no coincidence that wage growth has also picked-up. Average earnings growth rose to 4.6% in February, hitting the BoE's 4.5% reference target for the first time since April 2005. A further rise to 4.8% could be on the cards if the buoyant rate of private sector pay growth is sustained. The Inflation Report is the seminal event on Wednesday for it will outline the BoE's latest projections for growth and inflation based on the current market profile of interest rates. With this in mind and governor King last week pledging to improve communication, the subsequent press conference may give a better idea of whether the Bank believes interest rates need to rise beyond 5.50% to bring inflation back to 2.0%. Retail sales data for April will conclude the week on Friday; anecdotal evidence from the British Retail Consortium suggests sales may have registered a 3rd consecutive monthly gain.

An important week of US data releases lies ahead and as ever will impact on the dollar and perceptions of interest rate policy. The Fed last week reiterated that inflation remains its predominant concern and with this in mind it will be the core CPI data on Tuesday that could prove to be the highlight. Core inflation has decelerated in Q1 but not yet sufficiently to lead the Fed to abandon its anti-inflation bias. The fact that companies are still in a position to raise prices whilst petrol prices are at an 8-month high does not augur well and means inflation relief in the short-term may be limited. Housing starts and building permits for April will be published on Wednesday and may give a first glimpse of construction activity at the start of Q2. Residential construction took a heavy toll on Q1 gdp and any improvement in economic activity in the coming quarters may depend on a recovery in housing. Other US releases this week include industrial output and capacity use, another barometer of inflation. Weekly initial claims are due on Thursday and will be scrutinised for information on employment trends in April.

Preliminary Q1 euro zone gdp on Tuesday is forecast to top earlier and more conservative forecasts thanks to strong growth in exports and business investment. Household consumption may also have strengthened, except for Germany where the rise in VAT to 19% may have deterred shoppers. We expect annual Q1 euro zone growth to have slowed to 3.0% from 3.3% in Q4 2006.

Kenneth Broux, Economist

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