Bank of England Must Beware Bubble Hysteria

Let me take you to the West Midlands, if not the land of our fathers then certainly the land of my father, the place I grew up. It has been through tough times but things are looking up.

Unemployment is falling and employment rising. Manufacturing is bouncing back. None of the West Midlands’ football teams got relegated this year – breaking the pattern of recent seasons – and one, Wolves, was promoted.

Why the West Midlands? Because Sir Jon Cunliffe, the Bank of England’s deputy governor for financial stability, chose to focus on it in his important recent speech on the housing market.

House prices in the West Midlands, he noted, fell 15% between 2007 and 2009, while transactions – sales and purchases – halved from 10,000 to 5,000 a month. After that, transactions recovered a little but prices were flat until spring last year.

Since then, as he also noted, prices in the region have risen just under 10%, while transactions averaged 7,000 a month. Prices are 7% below their 2007 peaks. He did not say it but in real terms – adjusted for consumer price inflation – prices are down a quarter.

Cunliffe’s choice of the West Midlands was for two reasons. One was to show the Bank is not overinfluenced by the bright lights of Mayfair, Kensington and Chelsea. It looks beyond the capital.

The other was to show that house-price inflation and rising transactions are not confined to London. The West Midlands, for house prices, is in line with the national average. It used to be the bellwether region of the British economy. Now, in at least one respect, it is again.

What does it, and the country as a whole, tell us about the housing market? We have seen an outbreak of housing hysteria, which I fear is far from over.

The Bank is thought to be readying itself for action on what Cunliffe described as the brightest warning light on the Bank’s dashboard. The Bank’s quarterly inflation report press conference, on Wednesday, will be dominated by housing questions.

Three ex chancellors, Lords Lamont and Lawson and Alistair Darling, have expressed concern about George Osborne’s Help to Buy mortgage guarantee scheme.

The Paris-based Organisation for Economic Co-operation and Development (OECD) has called for “timely prudential measures to address the risks of excessive house price inflation”, which it says should accompany monetary policy tightening, in other words higher interest rates. The clamour is growing.

We will learn more about the Bank’s interest rate intentions this week. On Thursday it left Bank rate unchanged at 0.5% for the 62nd successive month. How long can this go on?

For a while yet, I would think, unless it has had a radical change of heart. The message coming from the Bank in recent weeks was that its first port of call to dampen irrational housing exuberance would be the tools at the disposal of the financial policy committee (FPC).

Only if the FPC’s actions fail will the monetary policy committee (MPC) be called into action. That should mean the first hike in rates is some months away; I still think next year rather than this.

What are those tools? The Bank’s FPC, if it fears housing boom could turn to bust, has the power to direct banks to ensure they have the capital to weather the storm.

It could, as Cunliffe pointed out, make recommendations which directly affect lenders’ underwriting standards, as well as loan to value (LTV), loan to income(LTI) and debt-service to income ratios. It could cool the market by making mortgages tougher to obtain.

If it chooses to do so, and its deputy governor acknowledges it will be a “challenging judgment”, it may be curtains for the second phase of Osborne’s Help to Buy scheme; mortgage guarantees. It would look like a topsy-turvy world in which the Bank was at the same time reining back mortgage availability while implicitly endorsing a government scheme to increase such availability.

Should the Bank act? My favourite housing valuation measure, prices relative to their long run “real” trend has prices undervalued by almost 10%. That big fall in the West Midlands, and nationally, has not yet been fully recovered.

The only house price-earnings ratio worth considering is for first-time buyers (almost all existing homeowners have equity). This, according to the Nationwide, stands nationally at 4.7, 13% down on its pre-crisis peak. Only in London and the south-east is it up.

As for Help to Buy, there is a lot of misunderstanding. The first phase, equity loans to help buyers of new homes, will be with us until 2020. Since April last year, when it was launched, 19,394 Help to Buy 1 mortgages have been advanced, overwhelmingly (87.5%) for first time buyers, and overwhelmingly outside London and the south-east. NHBC, which monitors the new homes market, says 7% more were built in the first quarter compared with a year earlier.

Help to Buy 2, launched in October, was responsible for just 2,572 guaranteed mortgages in its first three months, again overwhelmingly to first-time buyers, and with an average house prices of £148,048. Scrapping it, or even reducing the limit from £600,000 to £400,000, might have a psychological effect but its practical impact would be close to zero.

The other possibility, which should not be ignored, is that the market is already self-correcting. The latest Halifax house price index showed a fall of 0.2% last month and has shown no tendency to accelerate in the past year. Mortgage approvals, a key driver, have fallen for two months in a row.

In the stratosphere of the top end of the London market, Grosvenor Estates has sold £240m of property in the belief the peak is nigh, while some agents report that the combination of sky-high prices and a strengthening pound has cooled the market.

These signs are far from uniform. The latest LSL-Acadata house price index, using Land Registry data, shows a 7.3% annual rise and price strength spreading around the country. The latest RICS (Royal Institution of Chartered Surveyors) survey was also strong.

But the Bank has to take things carefully. It has taken time to get housing going and to generate an upturn in housebuilding. Nipping it in the bud too soon, despite justifiable concerns about house prices in some areas, could backfire.

Professor Paul Cheshire, in a spirited piece for the London School of Economics’ Centrepiece magazine estimates that between 1994 and 2012, between 1.6m and 2.3m fewer houses were built than were needed. More land in Surrey is devoted to golf courses than housing he points out, and more have been built in recent years in Doncaster and Barnsley than Oxford and Cambridge. Planning reform is desperately needed but it is also important to nurture the current upturn in activity and building, not slam the brakes on.

This piece is cross-posted from EconomicsUK with permission.