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).