Detached view suggests caution in housing market

Friends and colleagues are often surprised when I admit I do not own a property. In Britain, with one of the highest owner-occupation rates in Europe, this is seen as something sinister, and perhaps devious. Their concern is compounded when I admit having been generally bullish about house prices in recent years, reflected in my professional forecasts.

What being part of the 10% minority of the population who rent privately does afford me is a certain "detached" emotional viewpoint when assessing the housing market. Moreover, at times such as now when housing - or, more correctly, housing debt - is dominating the headlines, this housing sangfroid could come in useful.

In recent years, we have witnessed the "recapitalisation" of the housing market. In order to understand what is meant by this, we need first to accept that housing is a good with inelastic supply or, in other words, there are not many new ones built. Supply is limited. As such, a small shift in demand can have large consequences.

The second point is that in 1997 the Bank of England was made independent in the boldest move the Labour party has made since it took office. In my opinion, the success of this cannot, and should not, be understated. Although inflation and interest rates were trending lower before the monetary policy committee was set up, it has been successful in "locking in" this improvement, such that the markets (and increasingly, the public) expect inflation to stay around its 2.5% target.

One important corollary of this success has been the decline in mortgage rates, reinforced by aggressive competition among lenders, especially for new mortgages.

Using data from the Council of Mortgage Lenders, the last year when the offered mortgage rate on new loans was above 7% was as far back as 1993. Since the Bank was made independent, this rate has averaged just over 6% and is now close to 5% (and falling). The significant point here is that such low levels are below households' prior expectations.

As the years have progressed, families have become accustomed to "permanently" lower mortgage rates and factored this into their borrowing calculations. Households have taken out larger mortgages and bid up the value of the housing asset to offset the lower cost of financing this asset (akin to discounted cash flow modelling).

Simplified equation

Throughout the 1990s, since the recession, the cost of paying a typical repayment mortgage (as a percentage of earnings) was below its average of the last 20 years (hence my bullish house price forecasts). Until very recently, and the latest round of interest rate cuts, this payment had been moving rapidly back to its normal level. Why? Because of the rise in house prices. In other words, the average house price (and mortgage) was rising sufficiently quickly to offset the saving from lower interest rates.

The above argument is of course simplified and stylised, but it does help explain why different measures of housing affordability produce different conclusions. Sure, as a percentage of incomes, house prices (and mortgages) have risen beyond that seen in the late 1980s boom. However, paying that mortgage in the present low interest rate environment is not such a problem. At present, with the Bank of England's base rate at 4%, there are some impressively affordable mortgage rates on offer. Should we all then be leveraging up even further? Not necessarily.

There are two further points to consider. First, interest rates are unlikely to remain at their very low levels; the neutral base rate is perhaps 1% above today's level. If the MPC is keeping rates below that, it is for a reason, namely the weakness of the global economy. With this week's data showing a rise in unemployment (and probably more to come) households should be cautious in over-extending just because of the fantastically low mortgage rate offers.

Running debate

Second, and more generally, low interest rates are there because of low inflation. There is a running debate as to whether households are aware of the persistent value of the real debt that is being taken on. In the past, high inflation (and hence earnings growth) has quickly eroded households' mortgages in real terms, at the price of high and volatile interest rates. This time round there is a nice benefit in terms of low mortgage payments, but that debt takes longer to diminish.Remember the word mortgage literally translates from French as "dead pledge".

The main point here is that the house price boom of recent years was an understandable, rational and justified reaction to declining interest rate expectations. However, it may well have run its course. Further large price rises could quickly look unsustainable. Remember some economists are worried about what happens when the MPC next needs to increase interest rates, as the global economy recovers.

Households need to take care when assessing their debt levels, and remember that low inflation carries risks as well, albeit less transparent ones. Nonetheless, I believe the housing market does generally look well underpinned, and those who have made money in recent years deserve my applause. As for myself, perhaps next year will see me finally capitulate to the mortgage classes. Some of these offers do look very attractive.

Ciaran Barr is UK chief economist of Deutsche Bank

ciaran.barr@db.com