Market commentary

A subdued market, as expected

Another month passes and news filtering out from the housing and mortgage markets continues to paint a down beat picture. The house price indices reveal further declines and the number of housing transactions is currently running around 40% down on last year. Lending, at £25.5 billion in May, was about 20% lower than a year ago, and most of the activity will have been in remortgaging.

This is broadly as expected. Once the extent of the credit crunch became clear, the lack of available finance was sure to feed through into the housing market more generally. And the coming few months will most likely see more weak numbers, and the possibility of further deterioration. We expect it to be some months yet before conditions start to improve.

Chart 1: Prices and transactions declining

Source: Bank of England, HBOS

Notes: Three month change on previous three month of seasonally adjusted series 

But it is not as gloomy as some headline writers might have one believe. While conditions are more difficult, and we anticipate a modest increase in the number falling behind on their mortgage payments, the vast majority of borrowers are in a strong position. Employment levels are still high, although they are likely to decline modestly in the coming months.

While falling house prices have meant that some households face negative equity, it is reassuring that the number in this position looks to be small, and the extent to which these borrowers find themselves in negative equity is modest. This is not a return to the early 1990s. Fewer people have bought at the top of the market this time round, and earlier price rises have given the vast majority of mortgage holders a sizeable equity cushion in their homes. In addition, there is no reason to expect most people in this position to do anything other than continue to pay their mortgages in full every month.

No room for Bank to move

There is unlikely to be any immediate assistance from lower official interest rates. The Bank of England finds itself stuck between the proverbial rock and hard place. The story of rising inflation (through higher food and commodity prices) and slowing growth is one seen across the globe, and one over which the Bank has no direct control. Several of the world's central banks are having to walk the tightrope of supporting weaker economic growth while not letting inflation feed through into the wider economy and compromise stability over the longer term. Inflation has reached 3.7% in the euro area and 4.2% in the US, higher than the authorities will be comfortable with. At their recent summit, the G8 finance ministers agreed on the global nature of the recent rise in inflation and "to take appropriate actions, individually and collectively, in order to secure stability and growth in our economies and globally".

The inevitable consequence was that this week Bank Governor Mervyn King had to write to the Chancellor to explain why inflation had breached the 3% ceiling of its target range. CPI inflation rose to 3.3% in May, only the second time it has topped 3% since the Bank of England was granted independence in 1997.

Chart 2: Inflation exceeds the target range

Source: National Statistics 

The Governor is likely to have to put pen to paper several more times in the coming months before inflation drops back below 3%. The Bank's own projections show inflation not dropping back into the target range until early next year. At the same time, economic growth has slowed to below trend and most commentators are expecting only fairly modest growth next year as well.

Partly as a consequence, there has been a recent sharp increase in public expectations of inflation. The Bank concluded that some of the rise can be attributed to people forming expectations of future inflation rates based on recent developments, ie a rise in inflation leads people to believe inflation will be higher in future. But this did not account for all of the jump. The Bank also believes that individual experience of inflation (particularly rises in frequently purchased goods such as food and fuel) and increased media coverage of rising prices had an impact. 

These heightened concerns have had a direct impact on the expected path for interest rates. The Bank will not want the current rise in inflation to become embedded. Sentiment has turned quite sharply from a month ago and the markets no longer expect any further rate reductions this year. Looking further ahead, the next move is now expected to be a rate increase. As a consequence, swap rates, which reflect the cost of raising funds over specific time periods, have risen and there has been an increase in the price of fixed rate mortgages.

Chart 3: Interest rate expectations rise

Source: Bank of England

Notes: The market expectation curves relate to commercial bank liabilities. The market expectation ranges are derived from short sterling option and futures contracts traded on LIFFE. 

On a positive note, there is no sign yet of pay demands leading to faster wage growth in response to the rising cost of living. It seems unlikely that we will see a return to the days of rising inflation leading to higher pay demands being acceded to and a vicious circle emerging as price growth accelerates in response. While rising, most of the underlying measures of inflation show a much more modest increase than the headline figures. To date, it is a phenomenon concentrated in food and energy prices.

Awaiting an improvement in the credit markets

While concerns over inflation are likely to keep official rates higher than they might otherwise have been, the gap between costs faced by lenders and bank rate also remains a significant challenge. While the Bank has cut its official rate by 0.75% since last Summer, market lending rates are still at similar levels. Until confidence returns to the credit markets and money market rates converge nearer to bank rate, the dislocation between official rates and lending rates will remain, as will the lack of funding made available for mortgage lending. We are still waiting to see whether the Special Liquidity Scheme will overcome this. 

So the difficult market conditions look set to continue for some months yet. But providing the authorities' attempts to free up the credit markets are successful, we still anticipate an improvement later this year.

Economics team

1. Paul Samter
2. Bob Pannell