Britain's housing market is an unexploded economic bomb

UK house prices saw their biggest fall in 18 months in April. But property is still nowhere near affordable, says John Stepek. And that's bad news for the rest of the economy.

UK house pricessaw their biggest fall in 18 months in April, reckons the Halifax.

Yesterday's report from the lender suggested that house prices fell by 3.7% in the three months to April, compared to the year earlier. And month-on-month, prices were down by 1.4%. The average house price by this measure at least is now £160,395.

Halifax economist Martin Ellis preferred to describe this as "some downward movement in prices", which shows just how averse property pundits are to using the word "falls". But there's no doubt that this is a pretty hefty decline.

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However, it's nowhere near enough to make houses affordable yet and that's bad news for the rest of the economy.

Are house prices set for a long slow decline?

Not every property survey is quite as gloomy as the Halifax's most recent one. Surveyors and estate agents are more optimistic than anyone had expected. According to the Royal Institution of Chartered Surveyors (Rics), the majority are still seeing house prices fall. But the reading for April came in at -21, rather than the -23 expected. And that's the most upbeat they've been since July 2010.

Perhaps this isn't too surprising. You'd expect there to be a bit of a 'spring bounce' in the market. But other aspects of the report suggest that the market is about to run into more quicksand.

The number of buyers on estate agents' books has stopped falling. But the number of homes on the market is rapidly rising. The percentage of agents seeing a rise in sellers came in at 18, compared to just four in March. As usual, when you have supply rising faster than demand, that suggests prices should fall.

And house prices remain unaffordable on historic measures. As Allister Heath in City AM points out, the average house now costs around 4.4 times the average income, still well above the "post-1983 average of 4.0 times". After the early 1990s crash, "prices fell to 3.1 times earnings".

So it's hard to believe that house prices are set to rise any time soon. It's just a question of how much further they'll fall. A recent report from the National Institute of Economic and Social Research (NIESR) suggested that real - ie inflation-adjusted - prices will slide by 10.5% by 2015.

NIESR expects inflation to do most of the dirty work. For example, this year it expects nominal house prices to be flat, but for CPI inflation to come in at 4.5%. It doesn't sound disastrous, but if it happens, "it will be the longest period of falling house prices that we have seen", says NIESR.

Or will we face a short sharp plunge?

The idea that inflation will bring house prices back to affordability is probably comforting for property bulls. Sure, it's not painless, but it's less painful than an almighty crash. But to me, there's a problem with this notion. And you can sum it up by comparing the British housing market to the US one.

US house prices are still falling. In fact, they're in the midst of a double-dip right now. And that could continue for some time.

What was the difference between Britain and the US? It comes down to the way mortgages are affected by central bank policy in each country. In the US, borrowing costs for homeowners are linked to long-term rates, rather than short-term ones. So the Federal Reserve, despite its very best efforts, could only do so much for homeowners.

Even when the Federal funds rate was slashed to 0.5%, the monthly bill for most homeowners didn't drop as much. So in effect, there was no real bail-out for homeowners. And that's been painful.

In Britain of course, when the Bank of England slashed rates to 0.5%, many homeowners saw their home loan payments plunge. That put a floor under the housing market, and prevented a surge on repossessions. However, it now leaves us in a difficult position. Here's why.

High house prices will be a drag on the UK economy

The US may not raise interest rates for quite some time. But when the time comes for rates to rise, the one thing the Fed won't have to worry about is causing a surge in 'foreclosures' and a fresh collapse in prices. Because property in the US is now cheap on many measures.

Sure, there's a tremendous backlog and over-supply of repossessed homes to get through, so prices may keep falling for a while. But in effect, the worst of the shock is over. I suspect that anyone who had the money and the inclination to buy now would probably turn a profit at some point in the future. And when a recovery eventually comes, US consumers will benefit from cheap housing.

Britain has yet to go through this 'clearing' process. We're going to have this millstone of over-priced housing dangling around the neck of our economy for a long time. The Bank of England can't raise interest rates for fear of crippling the consumer and therefore the banking sector, by sparking another slide in house prices.

This is a serious handicap. For inflation to bring house prices back in line with earnings quickly, then wages have to start rising more rapidly than they are now. But if that happens, then the Bank will have no choice but to raise rates. And that in turn will hit house prices. On the other hand, if wages remain stagnant and the cost of living keeps rising, that'll just put more pressure on consumers and homeowners. That's not a recipe for strong house prices either.

In short, British house prices are still unaffordable. And the economy would have to tread a remarkably steady path between inflation and stagnation over the next four years for prices to come back into line simply through gentle erosion. I don't think we can expect that degree of stability I'd be surprised if we don't get a second leg of the house price crash well before then. In the meantime, you can keep an eye on what's going on with house prices using our housing market indicators.

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John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.