Maintaining our optimism

Ramesh Sharma

February 4, 2006

We concur with a number of economists who suggest an element of overvaluation in UK house prices based on the relationship between house prices, average incomes and affordability. However, this has existed for some considerable time and reflects the shortage of housing supply in a number of areas. It has been magnified by increased demand for owner-occupied housing as a result of the growing preference for owner-occupation. It will take many years for supply and demand to be brought into balance, given the continuing rise in the working population.

UK economic growth

There is a close relationship between the housing market and the wider economy. This year we predict the UK economic growth rate will steadily increase to an average of 2.3 per cent. The increase in personal disposable income is likely to be below 2 per cent, due to the probability that the Chancellor is expected to marginally increase the overall level of personal taxation.

The Chancellor’s scope for increasing taxation is very limited given the importance of the consumer sector as a driver of economic recovery. There are no significant inflationary pressures in the economy. Despite the sharp rise in oil and gas prices, UK industrial output inflation remains below 3 per cent. This reflects the ability of UK industry to maintain strict control of other costs.

Strong retail competition is limiting the potential for price increases on the high street. The current UK rate of underlying inflation (CPI) is on target at 2 per cent. We do not expect CPI to vary far from central target in 2006. Underlying average earnings has moved marginally lower to 3.9 per cent per annum while there has been a minor increase in the unemployment rate to 5 per cent. These factors have been balanced from a housing market viewpoint by the increase in the number of people in employment. We do not expect to see a significant deterioration in the labour market in 2006, although the possibility of a more significant rise in the unemployment rate remains the principal risk to our house price forecast.

Interest rates

Interest rate stability is likely to be a feature of 2006. Currently, the forward money market view is the UK Base Rate will remain at 4.5 per cent throughout 2006. Our current view is that a 0.25 per cent Base Rate reduction may well be necessary in the middle of the year.

The Bank of England (BoE) makes interest rate decisions on a one to two year economic view. While we predict the UK economy will return to trend growth (2.5 per cent to 2.7 per cent) in 2007, it will be important for the BoE to maintain the momentum of recovery. Longer-term interest rates (swap rates) are determined by a combination of domestic and international forces. Our view on period rates remains unchanged. Period rates are currently trading in a relatively narrow range whose central point is just above 4.5 per cent. There has been a modest upturn in swap rates during the past few days in response to movements in international fixed interest markets. This reflects the expectation that the US Federal Reserve Board will increase the benchmark federal funds rate to 4.5 per cent this week, and to 4.75 per cent within the next three months. When the swap market focus returns to UK domestic factors, period rates are forecast to ease by around 0.1 per cent to 0.2 per cent.

Mortgage lending remains resilient. Net mortgage lending in 2005 amounted to £90 billion, while gross lending totalled £285 billion. This year Bristol & West predicts net lending will be around £100 billion, with gross lending around £300 billion. The most recent data is compatible with our optimistic view.

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