House boom sparks leap in inflation

Runaway house prices are set to help send the inflation rate surging above the Bank of England's 2.5 per cent target this week, ending any lingering hopes of rate cuts, say City economists.

Inflation - measured by the new Retail Prices Index, excluding mortgage costs - is expected to reach a peak last recorded during the dotcom boom. This will be a sharp change from a year of below-target inflation, including a low of 1.5 per cent just six months ago.

Tuesday's figure will also be the fastest turnaround in monthly inflation over a six-month period since the Bank became independent. It has been fuelled by surging house prices and base effects, or statistical quirks from a year ago.

The Bank's job will be further complicated by a report from influential economists to be released tomorrow, claiming the house price bubble will burst spectacularly within 12 months. Property prices are set to fall 10 per cent from today's levels, and as much as 30 per cent from peaks they will reach some time next year, says the study by Capital Economics.

Mervyn King, the Bank's Governor-designate, has said the current rate of house price inflation is unsustainable, although the Bank itself says it believes this growth will slow to zero without prices actually falling.

The Capital study, however, concludes that a number of reasons for optimism are misplaced.

'This idea that a shortage of housing will prevent prices from dropping is untrue. Hong Kong and Japan are tiny islands with shortages, but prices still got out of kilter, falling around 40 per cent,' says Sabina Kalyan, Capital's property economist and the report's author. The study says the cost of repaying a mortgage is not as low as the 38-year low in base rates might suggest. After taking into account the abolition of mortgage tax relief, it is 'higher than in the Sixties and Seventies, and only slightly lower than in the Eighties and Nineties'.

This suggests that homeowners will be far more sensitive than previously thought to the small rises in base rates, expected from next August. This will fuel above-target inflation as high as 3 per cent throughout next year, which will also be primed by high oil prices and increased in national insurance contributions.

Economists at Lehman Brothers believe Tuesday's November figure for year-on-year inflation will be as high as 2.7 per cent. That would be the highest monthly figure since March 1999.