The last couple of weeks have seen alarm building in the mortgage market, with gathering consequences for the housing market. The latest Rics survey of surveyors' views of the market, released on Wednesday, will give us an up-to-date snapshot. How dire could things get?
It is vital to put current developments in context. Many people will blame the Government’s botched mini-budget for today’s mortgage market travails. It is true that the announcement of large net tax cuts made the likely future level of Bank Rate higher.
Also, the loss of confidence caused by how the mini-Budget was presented resulted in longer-term rates being higher than they needed to be.
But the fundamental truth is that higher interest rates were on the way in any case. You only have to look at what other countries, led by the US, have been doing.
And, at the bottom of it all, is a surge of inflation which has to be overcome and a tight labour market which needs somehow to be loosened up.
The rise in interest rates has shocked so many people because they have got used to an ultra-low level which is without precedent in the whole of our history.
Before the recent cycle of rate rises began in December last year, Bank Rate was 0.1pc. Until recently variable rate mortgages were available at 1.5pc and two-year fixed rate mortgages were at 1.1pc. These mortgage rates were also without precedent.
You didn’t need to be John Maynard Keynes to realise that this was an aberration and the medium-term risk was all one way.
Similarly, house prices have been rising relentlessly now for many years. Since 2012, they have risen by 66pc, well in advance of the overall increase in consumer prices.
In real terms, house prices have increased by over 30pc. This dramatic growth has been reflected in a record level of the ratio of average house prices to average earnings. It currently stands at 7.8, above the previous peak of 7.5, registered in 2007. The long-term average is 5.1.
It is true that so-called affordability – that is to say, the percentage of a typical mortgagee’s income taken up by mortgage payments – has until recently been pretty much average by historical standards.
But that is because interest rates have been so absurdly low. Once rates return to some sort of normality, affordability will be strained.
So what lies ahead for the market? Of course, no one can be sure what will happen, but Bank Rate will probably rise considerably from the current 2.25pc. I suspect it may reach something like 5pc next year. At this level, mortgage rates would probably stand at about 6pc, or possibly a bit higher.
Some people appear to be of the view that house prices never fall. They apparently believe that prices are driven ever higher by a continual imbalance between demand and supply, caused by the upward pressure of population on a housing stock that increases only slowly since housing construction is at very low levels.
They misunderstand the nature of “demand”. It is not some immutable thing which emerges directly from the number of people in the country. Rather, demand expresses willingness and ability to buy at the prevailing prices. “Willingness” is empty without “ability”. And ability is all about incomes and finance.
When interest rates rise, the ability of people to afford what they would otherwise like to buy is impaired.
Almost all short-term movements in the price of property are due to changes in demand, rather than supply, and those changes in demand are often caused by changes in interest rates. Unemployment is the other big driver.
Actually, interest rates and unemployment often move together as the shift towards higher interest rates tends to slow the economy and increase unemployment. That is exactly what is in store for next year.
Anyone who thinks that house prices can’t fall needs to look at the history of the market. Average house prices fell by about 20pc between 1989 and 1992 and again by only slightly less than this in 2007-9.
Actually, the picture is starker than that because in earlier housing downturns the market was able to adjust a good deal via higher inflation rather than outright falls in prices. In real terms, average house prices fell by about 30pc in 1973-1977 and by more than this in 1989-92.
What is likely to happen this time round?
I suspect that if I am right about interest rates, average house prices will probably fall by between 10pc and 15pc. That would probably translate into a fall in real terms of between 20pc and 25pc, making this the third largest fall in the last 50 years.
This may sound apocalyptic but in fact things aren’t as bad as they sound. After a relentless rise in prices on the scale that we have experienced, such a correction is not extraordinary. Nor is it all bad.
For new borrowers, lower prices will improve affordability. Moreover, once banks pass the majority of interest rate rises through to their depositors, many savers who have been extremely hard done by because of the nugatory interest rates that they have received on their savings, will at long last get more.
There is, though, a danger of something much worse. What the economy needs is for house prices to drift down gently. It is in no one’s interest that they should crash.
That would be a nightmare, not only for those caught up in it, but for the monetary authorities. For this would run the risk of causing severe financial instability.
This is why, although interest rates have to go up a fair bit, starting with a largish rise at next month’s meeting of the MPC, the overall approach needs to be “softly, softly”. This combination is going to be a difficult act for the Bank of England to pull off.
Roger Bootle is chairman of Capital Economics
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