House prices begin to cool

UK house prices rose by just 0.3% in January, the lowest monthly rise for eight months, according to the Nationwide Building Society.

Commenting on the figures Fionnuala Earley, Nationwide's Chief Economist, said: “2007 started off with a bang as the Bank of England raised interest rates for the third time in six months. Only time will tell how much the surprise decision will affect sentiment in the housing market, but even before January’s rate rise there were already some very early signs of cooling. House prices increased by just 0.3% in January, the smallest monthly rise since May last year, which pulled the annual rate of house price growth back into single digits. Prices increased at an annual rate of 9.3% in January, down from 10.5% last month. The price of a typical house now stands at £173,225.

Early signs of cooling emerged even before January’s rate rise

”The slowdown in the rate of house price growth adds to the growing list of cooling indicators. Estate agents reported some easing of demand in December and January. The number of newly agreed sales is rising more slowly and the length of time properties are on the market seems to be getting longer. More importantly, new buyer enquiries recorded their first fall in 19 months. While the correlation with mortgage approvals is not perfect, it suggests that the 129,000 house purchase approvals recorded in November may have been the peak. It is likely that we will now begin to see a weakening in demand as a result of stretched affordability and rising interest rates.

“Of course, prices are determined by supply as well as demand. For now, supply, as measured by new instructions for sale of properties with estate agents, is actually falling more quickly than demand and this puts upward pressure on house prices. As a result, estate agents are still reporting firm house price gains and an expectation of more to come. However, eventually the slower demand will ease the rate of house price growth to more sustainable levels.

Impact of recent rate rises beginning to feed through
“Interest rates affect house prices, but it is important to not overstate their impact. A number of other supporting factors remain in place. Labour market developments, such as strong employment growth, low unemployment and steady growth of earnings, have now supported the housing market for a number of years and will continue to do so this year. In addition, the level of house-building is still too low relative to even the Government’s conservative estimates of the expected growth in household numbers. This adds to the upward pressure on prices.

“Of course, higher rates will reduce new demand to some extent. First-time buyers will now find it more difficult to enter the market as mortgage payments take up a greater proportion of income. During 2006 aspiring first-time time buyers on average incomes have seen initial mortgage payments as a percentage of take-home pay rise from 40% to 44%. This makes it more likely that at least some of this group will choose to rent. For investors, low rental yields were already a problem and higher interest rates will have raised investors’ reliance on capital gains to achieve good returns. At the same time, higher interest rates and signs of market cooling are likely to moderate their expectations of future capital gains and thereby reduce demand. The main risk is that sentiment and expectations change abruptly in response to the rate rises leading to a severe loss of confidence. However, the more likely outcome is that the market will remain fairly stable but slow a bit more quickly than we initially expected. This would bring our expectation of house price growth in 2007 into the lower end of our 5% to 8% forecast.

Further rate rises cannot be ruled out…
“The MPC surprised markets twice, first by raising interest rates and then by revealing two weeks later that it was by the closest of margins. For some dissenters it was simply a timing issue rather than disagreement about the need to hike. But where do we go from here? There are three contending scenarios. In the first, pay growth accelerates in response to high RPI inflation. For the MPC this is the single biggest risk to its inflation target and it is likely to be prepared to hike rates sharply to bring things back into line. This would undoubtedly affect the housing market. For example, three additional rate rises on a £100,000 tracker mortgage would push monthly repayments up by around £45. On top of the three rises already the total increase would be more than £90 per month.

“In the second scenario, the MPC push rates up once more by 0.25% by May, largely in response to above trend growth in the important private sector of the economy and fears that firms will increasingly pass on higher costs. Strong economic growth, less discounting on the high street along with strong retail activity in December reduce the likelihood of another round of price cuts. For these reasons inflation may exceed 2% at the crucial two year horizon and would prompt the further rate rise. This would have much less of an effect on affordability but would still affect sentiment and expectations about future house price growth.

…but are not yet certain
“The third scenario, and the most likely by a tiny margin, will see rates remaining at 5.25%. Earlier rate rises have still to fully feed through into the economy as squeezed disposable income contributes to weaker consumer spending. In the labour market threats of outsourcing and the impact of immigration should keep a lid on pay growth. Mervyn King may still have to write a letter to the Chancellor in the next month or so, but inflation should fall sharply from April onwards. Add in the remaining slack in the labour market and the three rate rises so far may have just done enough to keep inflation on target. It is an extremely close call between rates remaining unchanged and rising once more, but higher rates will undoubtedly add to the first signs of cooling in the housing market that we have already seen.”