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Thursday, March 20, 2003

UK: Bubbling Along?

Christel de Lindt from London looks at the state of the UK housing market. His view: despite some improvement in fundamentals which justifies an increase, the market may have overshot by some 10%. He is, given everything, remarkably re-assuring on this (too re-assuring on my view). His confidence lies in the fact that previous housing bubbles were burst by sharp rate hikes. These he doesn't expect in the UK any time soon. But is he considering possible deflationary forces? If we talk about real (not nominal rates) the BoE doesn't have to change anything, if the CPI starts to move into negative territory this itself is equivalent to a rate hike. He points out, correctly on my view, that the UK has benefited from significant positive feedback dynamics in recent years. These, as evryone knows, can unwind. There is also one important factor he doesn't mention. The UK, like the US, has an important structural imbalance: its balance of trade deficit. To pay for this the UK, like the US, has to attract large quantities of foreign funds on a regular basis. This constricts enormously manoevreability on interest rates. There is another factor not considered, and that is the situation of capital values and repayment weights looking forward. In all previous UK 'bubbles' the prospect of forward looking inflation served to 'sweat off' the real weight of the repayment burden. This time we may not be so lucky. In a low inflation, or deflation, environment, with forward income little changed, the weight of the debt burden can fall heavy on UK consumption.

The UK economy has long been more dynamic than its continental peers. In the past 10 years, the UK economy has grown on average 2.6% per year versus only 1.4% in Euroland. The engine has been the UK consumer, whose spending has risen a cumulative 36.8% since 1991, more than double its Euroland peers. The side effect has been household debt (as a percentage of disposable income) rising by over 10 percentage points (pp). This has given rise to fears that after rising sharply, consumer spending is about to cave in.

Housing price rise only partly driven by fundamentals. There are fundamental reasons behind housing demand strength in the past few years, namely robust growth in real disposable income (up an average 4.9% a year 1999-2002) and lower interest rates. However, even given supportive fundamentals, house prices seem to have overshot. Fitting a simple equation where house price inflation is a function of repo rate changes, real earnings growth, and employment growth, we find that while the acceleration in house price rises is partly driven by developments in fundamental variables, these alone cannot justify the full extent of the pick-up. The equation suggests the overshoot could be in the region of 10 pp (versus roughly 5 pp at the 1988 peak).

This is why household debt picked up so sharply. Again, in light of the lower inflation, a lower interest rate environment, sustained improvement in labour market performance, and financial market liberalisation, we are sympathetic to the idea that higher debt levels might be more sustainable than 10 years ago. However, even allowing for this, the debt ratio rose well above this trend. In fact, the excess happens to be 10.8%, strikingly consistent with the 10% overshoot in house price inflation found above.

Looking back to 1956, the three episodes of sharp plunges in house price inflation were triggered by large rate hikes. House price inflation peaks have almost perfectly coincided with interest rate troughs, and a simple causality test confirms that over the period 1956-2002, the repo rate 'caused' house price inflation. Could this happen again? We do not think so. There are major differences today compared with the last boom phase (which ended in 1988).

The major distinction is that the whole economy was overheating badly in 1988, a situation very different from today: the output gap was a record +4.7% in 1988, while it stood at -0.2% last year. Business investment rose 16.8% in 1988, while it contracted 10.1% in 2002. The current account deficit averaged 4.2% in 1988, versus 1.1% in the first three quarters of 2002. Finally, inflation was about to shoot up to a peak of 10.9% in 1990 (from a trough at 2.4% in 1986). On our current forecasts, inflation should average 2.8% this year and 2.6% next year. Against this backdrop, the repo rate was hiked 7.5 pp in just 17 months. As a result, household interest payments as a percentage of disposable income shot up by 4.6 pp over the same period.
Source: Morgan Stanley Global Economic Forum

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