Sunday, 15 June 2008

How far will UK property prices crash?

It is everyone's favourite parlour game - guess the price drop in the UK property market. What is it going to be? Will the market be down 10, 20 or 30 percent? Does a 50 percent drop seem realistic?

Over the the last week or so, I tried to formulate my own answer. As I started to think about it, I realized that the answer might reveal a lot more than the amount of negative equity that recent home buyers might face. It may also tell us something about recent monetary policy and the Bank of England's growing tolerance of inflation.

Most answers to the "price drop" question begin by looking at past experience. I will be no different. When it comes to generating unsustainable bubbles, the UK housing market is repeat offender. In many respects, today's housing bubble looks a lot like previous ones; too much credit fueling unsustainable house price inflation, followed by a painful crash.

Long term data emphasizes the repetitive nature of housing bubbles. Over the last 56 years, the UK market divides into two periods; the stable years of 1952-70, and the bubble years that started in 1971 and continues to this day. During this latter period, the UK went through four housing bubbles.

During the first period, the years of stability between 1952-1960, house prices increased, in real terms, at a steady rate. During those 18 years, property values, adjusted for RPI inflation, increased by about 28 percent, or about 2.4 percent a year. This 2.4 percent growth rate is remarkably similar to the annual real GDP growth rate.

This similarity should be no surprise; GDP growth reflects increasing labour and non labour income. Therefore, this period was marked by a close correlation between house prices and total income growth. In other words, during these two decades, house prices were largely determined by good old fashioned fundamentals.

The second period started in 1971, when the UK experienced the first of four property bubbles in 36 years. The first bubble occurred in 1971, when the Heath government liberalized banking regulation. The reform led to an explosion of credit which fueled a housing bubble. By 1973, the UK had double-digit inflation, increased rates were up, which killed off the bubble, and prices crashed.

The crash was only temporary dip. A second more muted bubble quickly followed under the Callaghan government. At the time, houses became a hedge against inflation. The government kept interest rates low and negative, which further encouraged price increases. However, the appalling policy choices caught up with Callaghan and by the end of the old Labour government, inflation was high, forcing the inevitable hike in interest rates. As usual, higher rates burst the bubble, and prices in real terms came crashing down.

The third and fourth bubbles are much more familiar; the Thatcher bubble (1985-91) and the New Labour bubble (2001-2007). There is no need to go through the causes and consequences; the facts are well known and I won't repeat them. Suffice to say, that during the early years, both bubbles enjoyed copious credit. Inflation increased, followed by higher rates and a crash.

The trend growth of house prices during the stable period (i.e. 1952-71) offers a good guide as to how far prices are likely to fall once a housing bubble bursts. I estimated the trend growth of prices during these 18 years and then forecasted house prices for the period 1971-2008. The forecast is illustrated below as the pink smooth line. (The sharp eyed reader will notice that the trend is not a straight line. It is, in fact, an exponential trend.)

During the three previous bubbles, once the party was over and the market crashed, house prices returned to my forecasted long run trend growth. Typically, prices did more than return to long run trend. In every one of the last three corrections, prices fell slightly below their long run trend.

What would it take for prices today to return to my forecasted long run house price trend? First, we need to recognize that prices can return to trend via a combination of three factors; a) a nominal price drop, b) increasing inflation (other prices catch up with house prices), or c) rising real incomes.

Let us start with an extreme case - a pure nominal price adjustment that occurs immediately. As the chart suggests, prices today are a long way from long run trend growth. As of March 2008, it would take a nominal drop of 44 percent for prices to return to long run trend.

Of course, this type of adjustment is too extreme; prices will not adjust immediately. Sellers will go through a prolonged and agonizing period of denial before expectations adjust downwards. Inflation will erode the real value of house prices and wages will gradually increase. Nevertheless, the extreme case tells us the rough order of magnitude of the required change. It tells us that our three adjustment factors; nominal prices, inflation and growth, taken together, must adjust together by around 40 percent to bring prices back to trend.

Now let us assume a more gradual adjustment, say, around six years up to December 2013. During that period, we will assume that economy will grow at its normal rate 2.4 percent. If it maintains this growth rate, the economy will be about 15 percent larger in five years. Allowing for this rate of economic growth, real house prices would need to adjust a further 27 percent.

We will consider two possible adjustment scenarios to get this 27 percent real adjustment; a) no fall in nominal prices, and an average economic growth rate 2.4 percent, with all the adjustment occurring through inflation ; b) inflation increases at 2 percent a year, again the economy grows at 2.4 percent, and nominal house prices adjusts to get us back to the long run trend.

In the first scenario, inflation does all the work. Therefore, the key question is what inflation rate gets us back to long run trend. The answer? It turns out to be 4.2 percent, which is more or less the inflation rate we have today.

In the second scenario, nominal prices do all the work in terms of adjustment, while inflation grows at 2 percent and the economy at 2.4 percent. The answer here is that prices have to fall 11.5 percent between now and 2013.

If you were sitting in the Bank of England and these two scenarios were placed before you, which would you choose? Meet the inflation target with tight monetary policy and see real house price reductions, or have a higher inflation rate, with a more relaxed monetary policy, and stabilise nominal house prices at their current level. Recent RPI data tells us what choice the MPC made.

The MPC appears to have gone for the inflation option. Since 2006, the RPI inflation rate increasd from just over 2 percent and it has been consistently above 4 percent.

The timing of this higher inflation rate is very compelling. Back in 2005, the MPC tried to stabilize housing prices by raising interest rates. For a short period, prices stopped growing, and even began to fall. However, higher rates began to reduce economic growth. The MPC didn't like the slow growth, falling house price mix, and began to cut rates again. Once the MPC went back to loose monetary policy, house price inflation took off again, and inflation crept up to 4 percent.

Sadly for the inflationist MPC, this benign inflation-led adjustment has fallen apart. It disintegrated last summer when Northern Rock went under. The vision of a UK bank beign ripped apart by a deposit run frightened other banks. They woke up and realized that lending, even mortgage lending, contains risks. They took a long hard look at their lending portfolios and saw that the UK personal sector was carrying huge amounts of debt.

All the banks came to the same conclusion, it was time to pull the plug on the housing market. Mortgage approvals tanked and prices are now in free fall. The five year adjustment scenario is out. Prices could be hitting their long run trend level within 24 months or less.

What kind of price fall would return the housing market to trend growth by December 2009? With 4 percent inflation, and 2.4 percent economic growth, it would need a nominal fall of 25 percent. So, there you have it, my answer - 25 percent.

(Thank you, Brian from Canterbury for the articles and suggestions, they were very useful).

30 comments:

Anonymous said...

Your 25 percent number is quite close to a lot of other pundits.

David said...

Interesting analysis, but I can't help feel you've only answered the question 'How far will prices fall to return the housing market to trend growth by Dec 2009?' and not the question that is your blogpost title: 'How far will UK property prices crash?'

As you clearly show in one of your diagrams each crash overshoots the trend on its way down - the last one significantly so. Just by eyeballing, it suggests the further away from the trend houses prices are when they crash, the further they tend to overshoot the trend. I agree, by your analysis, that a 25% fall by Dec 2009 is a good bet, but at that point will we be, say, only half way through the crash? Or 60%? Or a third?

I don't know. It's fun to speculate, though.

[p.s.: Good blog - I enjoy it a lot!]

Anonymous said...

Brilliant, brilliant!

The next low will be c. 53% of real house prices at the peak. It will be achieved in the south c. 2015 and 'nationwide' c. 2017-2018.

B.

Anonymous said...

Oops: correction to mine above: the next low will be a drop of c. 53% from the peak, i.e. 47% of real house prices from the peak. Sorry. Keep predicting! B.

Anonymous said...

First of all I would like to thank you for your good work.

Secondly I would like you to take in to account the 25% price fall+ the fall of the value of the British Pond against the Euro.

Anonymous said...

A very good article about repossessions in the UK:

http://www.wsws.org/articles/2008/may2008/hous-m26.shtml

Alice cook said...

Anonymous, I did post something on the euro value of UK housing a while back. The answer is that in euro terms, UK housing is already down about 20 percent.

David, the question always needs to be framed as a price drop within a certain time period. It chose two periods December 2013 and December 2009. The number then drops out from the assumptions and the time period.

However, I am saying a little more than "prices will be down by 25 percent by Dec 09". I am suggesting that the BoE were prepared to allow a little more inflation to help the adjustment along. That plan fell apart last summer.

Alice

Edward Harrison said...

Alice,

I'm in the Washington D.C. area now but I had a good friend in for the weekend from Hampshire who was telling me there were many dire predictions of -50% in property values.

On it's face it makes sense. I had a flat in London that I bought in 99 which had double in value from 1987. I later sold it and the next owner had it on the market at the height of the bubble in '05 for more than double what I had paid. The price rise was absolutely frightening. It was easily overvalued by 100%.

But, I told my friend I felt pretty much the same way that you do. No way will the BoE allow nominal prices to fall 50%. The crushing burden of debt in a fall of that magnitude will wipe out so many people that people will start walking away from their homes.

It seems unfathomable to me that any monetary authority would look at the scenarios you posed a not allow some inflation to reduce the debt burden so many now have.

Edward

Anonymous said...

Alice,

Very interesting post, but I feel you left out a crucial determinant discussing inflation: If other prices go up then that will leave LESS money left over to go into an asset bubble not more. The only way inflation could help housing is if the money supply increased even faster. But the past year at the US has shown us doing this means the extra slosh goes into any asset class BUT housing.

The hard fast nominal shock remains the only likely path.

Nick

powerman said...

Some points suggesting to me that the nominal price fall from peak to trough might be larger than 25%.

1) As mentioned, your graph clearly shows overshoot when recent bubbles collapsed.

2) We have commodity price inflation, but no sign yet of income inflation (it's the ratio of house prices to income which critically needs to shift to restablise the market). If we have commodity inflation without income inflation, the nominal house prices will have to erode further rather than less, because people will have less money available at a given salary to fund mortgage repayments. The government will have to start allowing higher public sector pay awards to try and spark this off.

3) Many western governments have another incentive to allow a higher rate of inflation, because they're facing substantial final-salary pensions from retiring baby boomers working in the public sector. Inflating these obligations down in real terms would help their balance sheets somewhat.

4) The problem they may face is that because private sector labour is now much less unionised and prone to overseas competition than it used to be. This suggests that public sector pay and private sector pay are now less coupled than they used to be. People working in the private sector will become increasingly angry about at this. Attempting to inflate away the housing problem and public pension commitements which does not result in private sector pay inflation will lead to a very unpleasant a political and economic situation. We'll just find that most of us who didn't get into the property market early enough still can't afford to get in, whilst our living expenses increase faster than our incomes.

This will of lead to a real terms reduction in 'discretionary spending' and see redundancies in a range of industries.

Alice cook said...

powerman

1) An overshoot is highly likely, but how far? I thought it better to stick to a simple story of returning to trend.

2)Not yet, but this year's wage increases are mostly over. They happen Jan-Apr. Price expectations are rising (see earlier posts). In any event, RPI inflation is already at 4 percent, which is what I assume in the post.

3) I agree.

4) I don't agree with your first point. The data shows a close correlation between public and private sector wages. Besides higher wage growth doesn't cause inflation. Inflation can only occur if there is a higher money supply. High wage growth plus tight monetary policy equals unemployment.

Thanks for the comments

Alice

aSteve said...

I liked your innovation to use an exponential trend... I think that is a valid move - and not one I've seen elsewhere.

I think your analysis of the likely fall by Dec '09 is flawed (though I don't offer a competing figure from my analysis.)

The point is, it really is different this time. In every previous bubble, the mortgages were funded domestically... which meant that the money supply went up at the same rate as house prices went up. This is not true of the most recent bubble - where mortgage debt has been substantially funded by overseas investors. With an effective end to foreign portfolio investment in UK debt, our money supply will not permit general inflation over the medium term - unless, of course, by some miracle, we encourage substantial direct investment. (This seems very unlikely as we are a relatively high tax economy relative to emerging markets.) In addition to our money supply being affected by an external shock that was not present in previous crashes, there is a double-whammy from the price of imported goods - which make up a far greater proportion of RPI than in previous crashes. Finally, we can no-longer consider ourselves a closed economy in any way... the upshot of which is that there can be less upwards pressure on the price of labour today than there has been in the past.

In the past high (RPI) inflation indicated wage inflation. Today, high inflation means a lower proportion of earnings available to service debt... or a reduction in consumption... which would prove the key to triggering a downwards spiral into economic depression.

For these reasons, I expect that the nominal price of houses will fall significantly this time.

simon said...

This bubble should have halted in 2004, (the next three years were complete madness) so I expect a steep drop.

There is too much debt and inflation is a classic cure

Due to the swift decline in prices, inflation might take too long for only a 25% fall.

(I'm only guessing of course).

I noted that the Halifax were advertising 10% savings rate. (It made me feel all nostalgic).

Anonymous said...

Great post! And very readable blog.

I think I shall nick your graph to frighten my friends with over dinner some time. My gut feeling (and thats all it is) is that the market needs to come down about a third to increase affordability. Starter homes need to be in the 70-80K region, currently where I live they are about 120K. That would tie in with your 25% reduction, and allow a bit for the inevitable overshoot. I think the drop will be fast, and in nominal terms mainly, and anyone thinking of buying should hold off until autumn 2009 or preferably spring 2010.

Anonymous said...

"Inflation can only occur if there is a higher money supply"

This is the crux of it all. If the UK puts Mugabe into No.10 then the government will hyperinflate it's way into meeting public sector wage extortion, and bring about a complete economic collapse.

They aren't THAT dumb. There are also very strong counterweights to the desire to inflate:

- Lenders do not want the value of their debtors to be inflated away. Who tend to be lenders? Banks. The rich. I.e. the people government usually pander to;
- Foreign investors won't touch the UK if they do a major inflation-default. Argentina is STILL paying the price for theirs;
- Despite rising negative equity, worst case scenario will be well less than 10% of voters. The other 90% will strongly oppose it the moment they understand it;
- Actual mortage rates will shoot up because lenders will make them all adjustable at a high rate than inflation. The amount of principle will therefore come down;

We are sitting down to a banquet of consequences. I personally believe serious ongoing CPI/wage spirals are off the table.

Nick

Edward Harrison said...

Nick,

I have to disagree about inflation and foreign investors touching the UK. Inflation is already well above the target rate. I guarantee you that the BoE would have raised rates by now had it not been for the credit crisis.

The truth is options are limited. The house price bubble has been so pronounced that it requires a massive decline in houses to get back to trend (and then there's the overshoot down).

3%-4% inflation, if manageable will erode 20% of the losses in 5-6 years. If one considers 2007 as the top that means a 25% loss in equity plus 3-4% inflation per year to 2012 gets you back to trend. I reckon any the BoE would see this as an acceptable compromise.

The question is can they do it without inflation accelerating.

Edward

Edward Harrison said...

Just to elaborate a little more. To my mind, any inflation erodes the value of assets. 0% inflation is better than 1%. However, central banks prefer low inflation to zero inflation because they fear deflation and want a margin of inflation 'cushion.'

That said 3-4% is considered excessive and unwarranted. However, I believe the BoE would accept 3-4% for a longer period in order to let (moderate) inflation do some of the work.

What I believe they fear is 4% leading to 5% leading to 6% and on and on.

Zero inflation and 50% down is bad. 10% deflation and 40% down might be worse. In an indebted society like the UK, inflation is considered desirable.

Edward

andyrich29 said...

I agreed David, you haven't considered the overshoot Alice.

This is mainly caused by Huge loss of confidence!

Markbaldy said...

I think house are worth about 50% of their cuurent values - certainly no more.
Even then, a whole swathe of properties are totally out of reach of the majority of most working people.
I think the combined affects of the following points will result in economic meltdown in the UK.
1).UK too reliant on imports so inflaton will spiral upwards.
2).As a country and personally, we are in massive amounts of debt and
just to pay the interest on those debts will stretch finances.
3).Tax hikes by this government to pay for their mismanagement of the economy will screw every last penny out of "Britains hard working families".
4).Demand for oil and other natural resources by China/India etc... will further fuel inflation.
5).Because this government has not thought ahead, we are now at the mercy of Russia for our gas supplies so they can charge whatever they want.
6).Banks will continue to charge more for money - especially when property starts dropping big time and LTV ratios go pear shaped.
7).People's focus will switch from making a quick buck from property speculation to simply surviving and paying their bills - economic growth will be negative.

Anonymous said...

Just so everyone knows, when I say inflation I always mean increase in the money supply. What most of you call inflation I call CPI/wage increases/price increases or whatever. Thought I'd best remind you I'm Austrian in economics so we don't talk at cross purposes!

Anyhow, there's talk about what the BoE will "allow" and "not allow". One of the few bubbles still floating is that the BoE has any control over this mess.

EVEN IF they start the printing presses, and EVEN IF they are prepared to let us face the consequences of it, there's still the question of CAN THE BoE SUCCESSFULLY INFLATE the UK economy.

I think no, and the reason is 1990s Japan. In a deflationary spiral like we are in, the velocity of money creeps to zero. No matter how much money is printed it never gets past the balance sheets of the depositary banks. The reason is no-one wants to lend (capital impairedness) and no-one wants to borrow (no rising asset classes, everything will be cheaper if you wait).

Right now we are seeing the CPI rise due a a complex array of causes including index speculation, hot cash, and past inflation. The moment the oil and food bubbles burst (I reckon within two months from now), we will enter deflation for real.

BoE CAN'T inflate away housing debt without resorting to Mugabe tactics. Then there's also the question of would they WANT to. We are talking like the BoE has a mandate to protect the government. They have their own thing to do, and saving houses isn't part of it.

Those emergency measures were all to save banks, not homedebtors.

Nick

Mark Wadsworth said...

Alice, I find it's better to look at house-prices-to-earnings rather than adjusting house prices for inflation, that way the trend line that joins the troughs is more or less flat. But you're the expert.

Further, I have given up guessing how far they'll fall or even when the bottom will be reached, all I can say is, the troughs last quite a few years, so timing my next purchase is not overly critical.

Prices will fall quite sharply (and I can see arguments for 20% as well as for 60%) and then stay flat for a few years, which is when I will buy again.

Mark Wadsworth said...

Edward 00.50.

Zero inflation and 50% down is bad. 10% deflation and 40% down might be worse.

That's not the choice though, is it? The choice is between
a)Zero inflation and 50% down, and
b) 10% INFLATION and 40% down.

or indeed nominal prices flat and 50% inflation, or any other two numbers that add up to 50. Your numbers add up 30.

chriswov said...

I t is my view that your pink trendline of real house price increase since 1952 has benefitted from a benign period of resource availability and production growth.
Today "resource constraints" is the buzz phrase.The pressure on commodities is enormous from a growing population and an increasing number of which are joining in on the consumption frenzy.
Over the last 56 years the continual lowering of real commodity prices(see Wik-Great Commodities Depression 1980-2000)
has enabled the spare money released to power the pink line-this process is now in reverse.

Edward Harrison said...

Nick,

You are so spot on about the BoE. I tend to agree that they are in a pickle and CAN'T inflate. I HOPE that they CAN inflate a little.

But the whole Japan predicament is exactly where I am coming from on this as well. You saw what Gillian Tett had to say in the FT on Friday? I have a blog entry on that here.

After all, my site is called "Credit Writedowns" because I believe, like you do, that deflation is the real worry because velocity goes to zero as you say. BUT, my HOPE is the BoE will recognize this and try to get around it if it's not too late.

If there's no inflation, witness Japan as the ultimate BEST CASE outcome here in the US as well as in the UK. The Japanese at least saved. We, however, do not.

Edward

Edward Harrison said...

This has been a good discussion. I think I'll write something about it and 1990s Japan.

Anonymous said...

Edward,

I'm checking out your blog, so thanks for the tip. BTW, I'm HOPING for deflation. I think it's about time savers were rewarded over borrowers, and time for the West to cut down on all of it's frivilous consumption.

Of course what I want and what I predict won't necessarily match.

Nick

Edward Harrison said...

sorry Mark, you're right. 60% down plus 10% deflation. That is definitely worse

Edward Harrison said...

Just posted a partial answer to Nick's desire for deflation.

Credit deflation and the Japanese problem

Anonymous said...

On the highs and lows:-

The 'stable years' can be thought of as a properly 'damped' system - like vehicle suspension that gives a pleasant ride or a bridge structure that doesn't shake itself apart.

The 'bubble years' can be thought of as a negatively damped system. The oscillation has widening amplitude;artificial influences on lending (from ignoral or of hiding risk)exacerbate the boom-bust oscillation so the whole looks increasingly unstable.

Is there a mathematician out there who can deduce a formula for the curve of the 'troughs'? It is virtually a straight line until the 96 bottom, which is lower than a straight line projection.

Maybe the next trough will be so low that it shows no real gain over the 96 trough, or even a drop.

We might then be into deflating property asset prices, stable currency, lowish interest rates and negligible inflation - and, I suspect, austerity, austerity, austerity as in the 50's era of gently declining real house prices.

B.

jinga007 said...

It is interesting that Alice has written an article much better and clearer than anything you read in mainstream media.

I feel Alice is a normal intelligent person and that all the people writing here are normal intelligent people.

Why is mainstream media full of nonsense? Does anybody know why that is?