New inflation yardstick may signal lower rates

SHOULD we be worried about house prices? Money markets believe last month's interest rate cut to 3.5% will be the Bank of England's last. They see rates climbing next year, reaching 4.5% by summer and heading for 5% by the end of 2004.

This would threaten an already finely-balanced housing market. Prices are higher in relation to incomes than at any time in the past. The last two times they approached these levels, in 1973 and 1989, they promptly collapsed.

London prices, which tend to lead the nationwide market, have fallen some 10% from their peak 18 months ago. Prices for luxury homes have slumped. The latest survey from Rightmove shows average asking prices have stalled.

First-time buyers have all but vanished. If this continues the effects will be felt all the way up the chain - you can't trade up if no one will buy your starter home.

The boom has been fuelled by an explosion in debt, over which Bank of England Governor Mervyn King raised the alarm last week. The average household owes nearly as much on its mortgage as it earns in a year - before tax.

Debt to income is 93%, a third higher than at the 1980s peak. While many households have no mortgage, plenty of others owe four or even five times their incomes.

This leaves the economy hyper-sensitive to any rise in interest rates. Bank of England data shows the country's mortgages total £716bn. Some £500bn has been borrowed on variable rates. Raising interest rates 1.5% would suck an extra £450m out of household budgets every month.

The Centre for Economics and Business Research says the slowdown in mortgage equity withdrawal is already depressing consumer spending.

This constitutes the bear case, but it is not the whole story. While prices overall have hardly moved in recent months, buyers are returning to doorsteps after a near strike dating back to last autumn.

Estate agents' unsold inventory is slowly clearing. Rightmove reports more buyers than sellers. Investment banking in the City, the driver of the capital's economy, is starting to recover.

Optimism about house prices is growing in the Square Mile. Shares in housebuilders, which have languished in the bargain bin for two years because of fears about a slump, have soared although many remain cheap.

Fewer people are talking of a crash. House price forecasts have been marked up at spread betting firm IG Index. The CEBR says housing equity has risen even faster than housing debt. And the market's fundamentals remain in place. Supply growth is heavily constrained. Demand is not.

While house prices are high, in real terms mortgage payments are not. And there are reasons to believe the money markets are exaggerating the likely rise in rates.

Gordon Brown is moving the Bank of England's inflation target from RPIX, currently 2.9%, to the European-style measure HCIP, which is 1.3%.

The change, which provoked a rare public complaint last week from Mervyn King, may come in November or be delayed until March. The Bank's core forecast already saw inflation falling to just 2.25% next year. Under HCIP it may face pressure to cut interest rates even further.

With a General Election perhaps two years away, the last thing Brown wants is any risk of a housing crash. Hence the change, say cynics.