Douglas McWilliams, chief executive of the Centre for Economics and Business Research, answers your questions on interest rates and house prices. Answers appear below.
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Q: Do you think house prices will start to increase now that the Bank Of England has lowered interest rates? Is there another way of preventing house price inflation?
Michael James O’Sullivan
Douglas McWilliams: Not immediately, unless rates are cut much faster than we are currently predicting. We are looking for prices to fall a little for the rest of this year and next year and stabilise during 2007. But different parts of the country will move at different rates.
The best way of dealing with house price inflation in the longer term would be to increase the supply - as my successor at the CBI, Kate Barker, has pointed out in her report for the Chancellor. Of course this would create resistance from an environmental point of view, but these are the pressures that governments are paid to balance.
Q: We are experiencing a period of low inflation and low interest rates. What in your view is the biggest risk to a return to high inflation and high interest rates or do you believe that our ability to manage our economy and other factors such as globalisation mean that those high levels of inflation will be consigned to history and not seen again in our lifetimes.
Douglas McWilliams: I wrote nearly 20 years ago that we could have low inflation for a generation caused by three factors - better monetary management; the pressure placed on governments to run economies in a non inflationary way by international financial markets and by the forthcoming deluge of cheap goods from the Far East. I was brought up in Malaysia and did my thesis on the first couple of electronics factories there and it was pretty obvious that low cost manufacturing was about to take off.
As of now most of these downward pressures on inflation still look strong. Perhaps the only factor that is a little different now is that we have a new player at the world financial table - China. And although the Chinese are probably on balance still a counter-inflationary influence, if they get their monetary management wrong - and for them they are entering new territory in trying to run a modern economy - they could create inflation in the rest of the world in much the same way as the US boosted world inflation in the 1960s and early 1970s.
More likely than not they will get it right but we will have to watch out. Other risks could be climate related crop failures or interruptions to supplies of key goods from terrorism. But my central bet would still be on low inflation.
Q: How do you think that the continued and dramatic rise in graduate debt will feed through into house prices in the long term?
Douglas McWilliams: This is one of the main reasons why we have cut our forecast for house prices in 2025 by about 5%. It is starting to affect house prices now as the number of first time buyers falls off and we expect house prices in 2010 to be quite close to where they are now. There will be a second impact when the generation of students who have had to pay tuition fees would otherwise have been coming into the housing market, mainly in the next decade. These people will have to hold back for longer.
But we need to be careful about exaggerating the impact of this. These people will still need somewhere to live so unless they stay at home until they have paid off their debts, they will go into the rental market. This in turn will make a market for buy-to-let investors. So they will still have some impact on house prices.
Q: Douglas McWilliams was one of only a few people who predicted the 1989/90 house price crash. Why is does he think it is different this time, especially as a recession looks likely?
Douglas McWilliams: Too kind, I think quite a lot of other economists predicted the early 90s house price crash though perhaps my comments were more public than those of others.
Four things look different this time. Unemployment and the risk of losing a job look likely to be much less of a problem. Interest rates don’t look like going anywhere near 15% which was twice the level that they had bottomed out at in 1988. The affordability of mortgages is much higher today than it was in 1989. And the balance of supply and demand in the housing market is tighter because of years of low levels of housebuilding and because of demographic changes and immigration.
Q: When do you think the housing market will be a good place for investment purposes?
Douglas McWilliams: We released our latest forecasts in our annual publication, Housing Futures 2025 last week. These predicted that house prices on average in the UK would begin again to rise faster than inflation in about 3 years time. But we only are forecasting a 5% peak to trough fall.
But none of us are good enough at forecasting house prices to get the timing of the housing cycle exactly right. And there are a range of other variables besides the pure economics - type of property, what region you are in, how good a deal you can negotiate and so on.
So if you feel brave you could get into the housing market now, but if you are merely expecting to go in line with the house price indices then our current forecasts say that you should hold off for a few years.
Q: Have we reached a new era in the housing market whereby it is no longer a necessity for annual incomes to match house prices, as the market will now be held up by the buy to let wealthy middle-upper classes and the influx of foreign workers as London and England in general becomes a core of global development?
Douglas McWilliams: It’s a bit more complex than that. First of all, we have entered a period where house prices underperform average earnings because they have moved out of reach of many first time buyers especially graduates faced with a heavy student loan burden.
Over the longer term it is essentially a matter of supply and demand. If demographics, including immigration and the tendency for young people to want to move away from home mean that demand exceeds supply (which is largely determined by planning), then prices will rise faster than earnings. If not then not. Buy to let doesn’t change things much because it doesn’t affect either supply or demand and people will only go into it if there are enough people wanting to let to make buy to let profitable. My guess is that house price inflation from the end of the decade will exceed average earnings inflation but not by a lot.
Q: Not long ago the Bank of England suggested that the link between the rate of increase in consumer borrowing and spending was not strongly linked to the rate of house price increase. What is your view?
Douglas McWilliams: I think the Bank’s statistical work slightly underplays the relationship. First of all there is mortgage equity withdrawal. Although in the first instance much of this is used to pay of other consumer borrowing in the longer term this creates finance for spending on consumer durables. Our model of new car sales, for example, shows a very strong link with house prices. Second, there is a link with housing transactions and spending on home improvements and furniture etc.
So I think there is a much stronger link than the Bank’s statisticians have uncovered.
Q: Could you let me know what your predictions are for interest rates in the UK and what advice you would give to those who have not yet purchased a property?
Douglas McWilliams: Our current forecast is for interest rates to average pretty close to where they are currently over the next 5 years.
We are forecasting that house prices will rise by less than inflation for the next few years. If we are right, someone who has not purchased a property has time to make up his or her mind and try to find something that suits, rather than being forced into the market by the fear that prices will soon climb out of reach.
Whether to buy or not, however, must depend on an individual’s circumstances.
Q: Now that house prices seem to have stabilised, what potential catalysts could send them up or down in future?
Douglas McWilliams: Lots of things. But our long term model of the housing market has economic growth, inflation, demographic changes, planning rules and long term interest rates as the most critical factors.
Assuming that the MPC manages to keep inflation reasonably stable, an improvement in UK growth performance might boost prices; a greater willingness to save in the economy might bring down interest rates for a given rate of economic growth and might also boost prices. Factors that could cause prices to fall could be demographic - a sharp fall in immigration, or an increase in the willingness of young people to live at home rather than move out; or a change in planning rules that makes it much easier to build new homes.
Q: Ignoring the hype and focusing on macroeconomics, are we not at the beginning of a long downward spiral in house prices?
Douglas McWilliams: I don’t think so. I think that house prices reflect supply and demand and particularly the restrictions on the supply of housing that comes from the planning system. Whether this is a price worth paying for the environmental protection that the planning system provides is an issue for debate. And of course, if the rules were changed, then house prices would move to a new level.
Q: It is my contention that, while many commentators suggest a fall in interest rates to perhaps 3.5% , the end of 2006 will re-invigorate the consumer and house buyer. Such a move should be seen in the context of a slowing economy, with all its potential negatives for the consumer – in particular, greater employment uncertainty. We have already seen some fairly sharp increases in unemployment claims in the last few months – to what extent do you agree this is more likely to further unsettle the housing market than it is to prop it up?
Douglas McWilliams: First, only a few commentators are looking for 3.5% by end 2006 - my guess is more like 4%.
Second, you are right that if rates do fall it will probably be because of economic weakness. But given that, I think rate cuts would be more likely to help the housing market compared with what otherwise would have happened. There are few cases that I can think of in recent years in any country where rate cuts have unsettled the housing market.
Q: Do you think that by lowering interest rates, and enticing more first time buyers into an overpriced market, the bubble in house prices will be further inflated, raising the possibility of a hard landing in the future?
Peter J Dunbar
Douglas McWilliams: No. Until the supply of housing is increased to cope with demand, I’m afraid that the high price of housing in the UK is largely not a bubble but the reflection of a supply demand imbalance.
Monetary mismanagement, dramatic events in the world economy (such as wars or terrorism), or a sudden lack of demand for sterling creating a currency collapse are more likely causes of any hard landing that might emerge.
I was looking at the possibility of locking into a fixed rate mortgage of ten years - what’s your long term view on interest rates? Does it make sense to go for a 10 year fix at 4.6% or do you think the long term average will be lower than this?
Douglas McWilliams: A 10 year fix at 4.6% looks at face value not a bad deal. No one can easily forecast rates that far out but most people would expect short term rates to be not too different from today’s post cut level, which would imply floating rate mortgages on average at a little over 5%. But for you to make up your mind you will need to check carefully all the terms and conditions. And also your own risk profile needs to be taken into account.
Q: We completed on our first house in Battersea SW London 2 weeks ago. We hope to have bought at the trough of the London slow down – do you envisage further price falls in central London?
Douglas McWilliams: Congratulations on your purchase. I think that the good thing about the present situation, where I expect that house prices are neither going to shoot up in the short term nor collapse, is that house buyers can take time to buy not just as an investment but as the property that best suits their needs. Remember, you spend an awful lot of time in your house. So if you buy a house that really suits you, even if you lose a little money on it you have at least got the satisfaction of enjoying the house. Treat the investment gains as a bonus.
Our latest forecasts show that London prices might fall a bit further but not too much. But if you manage to buy exactly at the trough of the market you are not only a good forecaster but also lucky.
Q: What is your view of taking the pressure off the monetary authorities by introducing long term fixed interest rate mortgages for say 20-30 years. Does any institution current offer this type of mortgage in the UK?
Emanuel Ogu, Commercial Manager, Swedia Networks UK Ltd
Douglas McWilliams: Funnily enough, I think that the widespread existence of variable rate mortgages makes the UK economy much easier to control. It means that the MPC only has to move interest rates by relatively small amounts to keep the economy on track because so many of us have variable rate mortgages that we adjust our spending quite quickly to relatively small movements in the interest rate. In other countries - and Spain is the biggest counter example - it is quite difficult to manage the economy with interest rate movements because the economy is insensitive to them. Ultimately this means that interest rates in such economies might have to be moved further to achieve a given result.
I understand that long term fixed long rate mortgages are sometimes available but only for relatively large mortgages (around half a million pounds or more). To find one you can either look yourself or try a specialist broker. The difficulty is that the derivatives market is pretty shallow for longer term instruments and the lending institutions normally need to back any fixed rate mortgage with derivative instruments to insure their interest rate risk. In addition, longer term fixed rate mortgages are likely to be subject to pretty onerous terms for early repayment since otherwise they would be a one way bet for the borrower.
Q: Given that oil is now trading at over $61 per barrel - a 40% rise this year - the cost of raw materials are surging at the fastest annual rate for 20 years, inflation as measured by the (arguably inefficient) CPI index is already at the 2% Bank of England target and outstanding private debt in the UK is at unprecedented and dangerous levels, shouldn’t the MPC be voting to raise interest rates?
Douglas McWilliams: Fair point. But another way of looking at it is that despite the rise in the oil price and cost of raw materials (which is largely measuring the same thing) the admittedly inefficient CPI is still only at 2.0%. There are lags in the system so inflation will probably edge up a little later on this year. But my colleagues and I think that unless the pound slides sharply it is more likely than not that inflation will be falling by early next year. And consumer demand - which is the largest element by far - has weakened considerably this year, while unemployment has been rising for 6 months now. Both will prove counter-inflationary after a lag.
So I think it would be reasonable for rates to edge down a little. But the reasons that you mention partly explain why we only expect a couple of quarter per cent cuts in the next year whereas some other commentators are looking for much bigger falls.
Q: Many politicians and estate agents have, in recent years, described mortgages in a low interest rate-low inflation environment as ‘cheap mortgages’. Wouldn’t it be more meaningful to describe them as slow mortgages ? Since, the lower interest payments are simply a reflection of a lower real rate of reduction of the debt, and are balanced by a higher real rate of repayment in the later years of the mortgage.
Douglas McWilliams: The simple answer to your question is yes. The lower rate of interest in a low inflation environment merely means that the real value of the repayments in the later years of the mortgage is relatively higher.
But I suspect that this is one of the situations where what works in practice doesn’t work in economic theory.
This is because for many new buyers, their horizons are often very much limited to the short term. Faced with high house prices, they are prepared to mortgage themselves up to the maximum monthly repayment (in cash terms) that they can afford. And lower interest rates permit larger mortgages for the same level of cash monthly repayment even though in a low inflation environment the real value of these repayments towards the end of the mortgage period will be higher than they would have been in a high inflation environment. So the lower interest rates have in effect raised housing demand even though economic theory tells us that they shouldn’t have done so.
Q: House prices in Japan, where base rates have been zero for a long time, have been going down for 14 years. Could this happen in the UK? Does it indicate that low interest rates are not powerful enough to control the housing market?
Richard McCreery, France.
Douglas McWilliams: You have raised one of the fundamental points of economic theory. Because you can always put your cash under the bed, nominal interest rates cannot go significantly below zero (they might be slightly negative as some kind of insurance charge). And this means that at a time when prices are expected to decline the real rate of interest may sometimes be stuck at too high a level (zero plus the rate of price decline) to promote economic stability. This was one of Keynes’s insights though unusually he explained it rather badly and called it the Liquidity Trap.
Now this explains fairly well what has been happening in Japan, though it now looks to be at an end. Can it happen in the UK?
I would never say never, but it looks unlikely in the short term because the chances of falling prices in general look to be low. Also the psychology in Britain (and indeed in many other Anglo Saxon economies) seems to be more tolerant of borrowing than that in Continental Europe or Asia.