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Last Updated: Friday, 3 October, 2003, 10:50 GMT 11:50 UK
House prices 'set to fall 20%'

By Steve Schifferes
BBC News Online economics reporter

The housing market could be in for a sharp correction
House prices are set to fall by 20% in the next 18 months, a leading economics firm predicts.

Over the past decade, the UK has enjoyed the longest sustained rise in house prices than at any time since the Second World War.

Between April and June this year, the average price of a house stood at 154,503, compared to 65,025 in the same period in 1993, an increase of 138% - and more than the increase in house prices in the booms of the 1970s or 1980s.

But forecasters at Capital Economics say the housing boom is unsustainable, and predict that there will be a house price crash with profound effects on the economy.

House prices increased in all the regions of mainland Britain during the third quarter
Martin Ellis, Halifax chief economist

The claims come despite the latest figures from Halifax, the UK's biggest mortgage lender, that house price growth remained strong at 1.5% during September, and 18.6% year-on-year.

"It will severely constrain consumer spending and weak consumer spending will mean that it will be a struggle to get growth up to the levels forecast by the Chancellor," said Capital Economics' Jonathan Loynes.

Housing bubble

Capital Economics argues that central banks in both the US and UK have fuelled the housing bubble by keeping interest rates deliberately low, and house prices are now at "dangerously high levels."

It predicts that average house prices will fall from 135,000 in 2004 to below 110,000 in 2007, before beginning a more gradual recovery.

According to Capital's Sabina Kalyan, house prices have reached a record of more than five times average earnings, well above the historic price/earnings ratio of 3.5 to 4.

Meanwhile, real levels of household debt are at record highs of 90%, she points out.

Some people argue that this does not matter, as low interest rates mean that households are paying out a smaller percentage of their income.

But Ms Kalyan dismisses this, arguing that the real ratio of housing costs to income is twice as high as usually reported, when taking into account such factors as endowment and pension repayments linked to house purchase.

Damage to economy

As a result, Capital Economics warns that just a small rise in interest rates, to around 5%, would push that ratio to an historic high.

It also points to the fall in the number of first-time buyers in the housing market, down from 50% to 30% in the last few years, as another warning sign of an impending crash.

If house prices did crash, it could have a severe impact on the economy.

According to Jonathan Loyne, mortgage equity withdrawal has been running at about 8% of household income, or 40bn per year.

If house prices fall, and people stop financing other purchases by cashing in their capital gains on housing, then consumer spending could be reduced by around 3% to 4%.

But he says that other factors, including a boost to exports from a lower pound, and increased public spending, will help compensate for weak consumer spending in the coming year.

Others argue that only a full-blown recession, with rising unemployment, would lead to sharp house price falls.

Bank of England concerns

The Bank of England is forecasting that house price inflation will slow more gradually, with prices broadly stable by the end of next year.

In fact, fears of a housing "asset bubble" were played down by the BoE's chief economist Charles Bean in a speech in Zurich.

He argues that "there are good structural reasons why the ratio of house prices to income should have risen," including lower inflation and interest rates, competition in the mortgage market, and the lack of housebuilding.

Mr Bean argued it would be difficult to raise interest rate decisions to curb house prices, as no-one knew whether such a move would influence people's decisions to take on more debt.

And any such policy would have to be balanced by the negative short-term effect it would have on economic growth.

"Calibrating an appropriate pre-emptive policy response is extraordinarily difficult," he said.

Nevertheless, most economists are forecasting that UK interest rates will rise to around 4% by the end of the year.

Capital Economics, however, suggest that fears about precipitating a housing price crash will persuade the Bank of England to leave them on hold for another year.

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