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Time to give house prices a shock Samuel Brittan: Financial Times: 21/05/04 The latest Bank of England Inflation Report was noteworthy for its clear hints of further interest rate increases. It suggested a high probability of inflation climbing from just over 1 per cent to nearly 2½ per cent over the next two years on the basis of the new consumer price index, and thus above the chancellor's 2 per cent target. But if you strip away the scholasticism the reason why interest rates both will and should rise is alarm over the UK housing boom. Indeed, the biggest worry among Bank sympathisers is that history will record that it saw something like the South Sea Bubble of the 18th century emerging and did too little and too late to stop it exploding. The May minutes of the Monetary Policy Committee contain the ritual denial that the Bank was targeting "house price inflation or any other asset". But this was offset by the airing by some members of the case for a half-point increase in interest rates "to help moderate the continuing rapid increase of consumer indebtedness". As Lombard Street Research has remarked, the cumulative effect of the May interest rate increase, the new Inflation Report and the MPC minutes was to raise market expectations for short-term rates at the end of the year by some 0.36 percentage points. But expectations will not work on their own without suitable action. There are all too many indications that the gradual approach to monetary tightening has failed to dampen the euphoria. The Bank cites monthly increases in house prices so far this year of around 2 per cent, which if continued would imply a scarcely credible 27 per cent annual increase. The Inflation Report puts the ratio of house prices to earnings at well over 5.5, some 50 per cent higher than the average of the past two decades and higher even than the peak of the late 1980s. The equilibrium ratio may indeed have risen: low inflation has reduced the initial burden of debt servicing; lower long-term real interest rates have reduced the perceived real cost of owner occupation; and the supply of new accommodation has not kept up with household formation. Yet there are worrying straws in the wind, including reports that the return on rental housing has tended to fall below the cost of borrowing: a sign of a bubble mentality in which people are investing mainly in the hope of passing on their property to someone else at a higher price. House price increases might slow down and gradually level off. This would hit consumption by reducing the growth of perceived personal wealth, which would be no bad thing. For on almost all indications British output is rising well above any sustainable trend; labour markets are still tightening and growth is way ahead of the eurozone. The real worry is that rather than a housing slowdown the UK could be heading for a housing crash. Let us look at the risks. Suppose the recent extremely gradual tightening of policy continues and there is an eventual crash in house prices. There would clearly be a shock to the financial system. The Treasury and the Bank are understandably reluctant to save housebuyers from their own folly, but the blow to financial stability - for instance from the impact on the balance sheets of the lending institutions - would undoubtedly be a public concern. Suppose instead that there is some pre-emptive tightening of financial policy which turns out to be unnecessary and which slows down the economy. There could hardly be a better time for such a check; but at worst it would be easy to reverse policy; and a little egg on the faces of key Bank or Treasury officials would be a small price to pay for a precautionary stance. It is surely better to take action on the basis of fears that turn out to be exaggerated than to take no action on fears that turn out to be justified. The disadvantage of relying entirely on higher interest rates for a shock effect is that they could push sterling higher and further unbalance the economy. The reaction of too many people is to say: impose controls on lending. But this flies in the face of the evidence that such controls mainly cause economic distortions. We are left then with fiscal policy to give consumer expectations a shock. As the Treasury reminded us in its euro study, there exists a power called "the regulator" to vary VAT and other indirect taxes by up to one quarter in either direction. This has not been used for about 30 years; and the Treasury's proposal for reviving it had the fatal flaw of being tied to highly dubious estimates of the so-called capacity gap. But that is not an argument against its discretionary use at present. One cannot provide for all contingencies. If a Middle East crisis raised the price of oil from its present highly bearable $40 per barrel to the $60, $80 or $100 region, all bets are off. But that is no reason for ignoring the housing threat staring us in the face.
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