What goes down, must come up

Most people measure their wealth by the value of their home, which is why headlines about rising interest rates and falling house prices are so emotive. Little wonder, then, if Middle England choked on its collective Cornflakes this morning as newspapers reported the prospect of interest rates doubling to 8.5%.

We have been enjoying some of the lowest interest rates for 40 years over the past few years, even with the recent 0.25% rise to a base rate of 4.25% taken into account. A rise to 8.5% would be well below the shockingly high 15% rates of the 1980s, but would still be a real burden to homeowners used to cheap debt.

On closer reading, however, the comments by the Council of Mortgage Lenders, which represents banks and building societies offering home loans, are not quite so pessimistic. The CML's members account for 98% of the UK's residential mortgage lending. What CML director general Michael Coogan was actually saying was that interest rates would have to double in order to halve house price growth from its current level of 20%.

Speaking on the Today programme this morning, Mr Coogan said that such rate rises were "neither likely nor desirable" - and he is probably right. Such a huge and rapid increase would be likely to destabilise the economy in general, wallop manufacturers who are trying to export or invest in new services, force up the value of the pound and send shares and the stock market into a tailspin. For all these reasons, the Bank of England's monetary policy committee (MPC), which sets rates, would be extremely reluctant to impose such a sudden and unexpected increase.

Nevertheless, there is little doubt that interest rates are on the rise, and the CML suggests that they could rise as high as 5.25% by the end of this year. This is well above some predictions made at the beginning of 2004, which forecast rates in the region of 4.5% by December. However, there is evidence to support the CML's thinking. The MPC revealed that it had discussed the prospect of a 0.5% rise this month, but had decided to keep the increase to a more modest 0.25%. This gives the committee scope to increase rates again next month by a further 0.25% should they think it necessary.

While it may come as some comfort to think that rates could settle just over 5% by Christmas, homeowners should not be too complacent. If rates were to rise by a full percentage point - from 4.25% to 5.25%, anyone on a standard variable rate mortgage would see their monthly payments increase sharply. Most people, however, have bought two- or three-year fixed-rate mortgages, and so will be protected from these increases until the end of the fixed term. They may not feel the pain until early next year, when they come to remortgage and find that the cost of rescheduling their debt has increased significantly.

Anyone in the business of lending money to homeowners or selling houses is reluctant to talk of a housing market crash, for fear of precipitating one. If everyone expects the value of homes to fall, the market starts to dry up and it becomes a self-fulfilling prophecy. Hence the carefully worded comments from major estate agencies and lenders who are trying to talk the market down gently.

Almost everyone agrees that the current house price rises we are seeing - 20% house price inflation is predicted for this year - are unsustainable. What no one knows is whether the market will drift gently downwards, or suddenly collapse. Some in the City are predicting a 30% fall in prices; others suggest that prices will stabilise, and then possibly stagnate for a few years.

In the south-east, which previously saw the greatest increases, there is evidence of a slowdown. According to Land Registry figures, prices have risen by a third in London since 2001, but by about two-thirds in most parts of England and Wales. Latest figures from Nationwide and the Halifax suggest house price inflation is running at almost 20%, although data collected by the Office of the Deputy Prime Minister point to a much lower rate of growth of just under 8%.

We are certainly unlikely to continue to see the housing market powering away at the rapid rates we have become used to over the past three years. There is also the unknown element of the buy-to-let investor. Tens of thousands of amateur landlords have entered the market over the past five years, and no one knows how they will react if they see the value of their investment properties falling, and rents dipping or stagnating. Anyone thinking of ditching their pension and buying to let should bear in mind that in the short to medium term houses will no longer be the route to a fast buck.

The history of capitalism is full of tales of boom and bust. Its previous track record suggests that the housing market is likely to be no different. Asset bubbles, be they shares, gold or houses, tend to revert to their mean trend. In other words, don't expect the party to carry on for much longer.