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House price falls have pushed the national rental yield up to its long-run average, suggesting housing is now fairly valued by historical standards. However, if the yield were to overshoot the average by the same extent as it undershot during the boom – a not unreasonable assumption – house prices would fall by a further 16% from current levels.

The national rental yield is derived from national accounts data by dividing the sum of actual rents paid by households and imputed rents of owner-occupiers by the value of the housing stock. It averaged 3.59% between 1965 and 2007. The national yield is lower than alternative measures because it includes subsidised social housing, takes account of vacant properties and is calculated using end-period prices.

The most recent official figures are for 2007, when the yield stood at 2.84%. House prices fell by 18% in the year to December 2008, according to the Halifax index. Applying this decline to the value of the housing stock at end-2007, and taking into account rental growth of 5% in 2008, the rental yield is estimated to have risen to 3.63% by the end of last year – see first chart.

The end-2007 yield was 0.75 percentage points below the long-run average. If the yield were to overshoot by the same amount during the current downturn, rising to 4.34%, house prices would fall by a further 16% from their December 2008 level, assuming constant rents. The implied decline would obviously be larger to the extent that rents fall, as suggested by the last Royal Institute of Chartered Surveyors residential lettings survey – second chart.

A further fall of 16% would imply a peak-to-trough decline in inflation-adjusted house prices similar to the early 1990s housing downturn – see here.

The Council of Mortgage Lenders (CML) today reported a rise in the number of mortgages more than three months in arrears from 167,000 in September to 219,000 in December. As a proportion of the 11.7 million outstanding mortgages, this represents an increase from 1.42% to 1.87%.

In its December forecast, the CML projected a further rapid rise in over three months arrears cases during 2009, to 500,000 or 4.4% of outstanding mortgages by year-end. The Bank of England, in its October Financial Stability Report, has also suggested that the arrears proportion would reach 4.4% in a “severe” economic scenario.

The recent and projected large rise mainly reflects the impact of the recession on homeowner incomes. Other factors include: a lack of refinancing options for those facing payment difficulties, especially given house price falls; government efforts to reduce repossessions, implying that more borrowers remain in arrears; and the arithmetic impact of lower interest rates on the calculated number of missed payments.*

How does current and prospective arrears performance compare with the housing downturn of the early 1990s? The CML series on over three months arrears begins in 1995 but earlier figures exist for cases more than six months overdue. The statistical relationship between the two series can be used to “backcast” the three months plus arrears proportion for earlier years – see first chart.

Three points are notable. First, arrears performance was worse at the comparable stage of the last recession. GDP had fallen for two quarters by the end of 2008, when 1.87% of mortgages were three months or more in arrears. In December 1990, also after two quarters of GDP contraction, the estimated proportion – based on the backcast – was 3.2%.

Secondly, the over three months arrears proportion is estimated to have reached 6.3% in the early 1990s, well above the 4.4% level projected by the CML and Bank of England (although the CML may expect a further increase in 2010).

Thirdly, arrears peaked in December 1992, five quarters after the trough in GDP and around the same time as unemployment. Even assuming an economic recovery from late 2009, this suggests that the arrears proportion will remain on an upward trend until late 2010, or even beyond.

The key reason for expecting arrears performance to be less bad than in the early 1990s is a much lower level of income gearing. Household interest payments as a proportion of disposable income peaked at 11.9% in the third quarter of 1990 but reached only 7.9% at the top of the recent interest rate cycle and should fall to 4% or lower as a result of rate cuts – second chart.

*To explain this effect, consider a borrower whose monthly payment obligation falls from £800 to £200 because of lower interest rates. An unchanged arrears amount of £800 rises from the equivalent of one month’s payment to four, resulting in the mortgage being included in the three months plus total.

UK labour demand is weakening rapidly, as evidenced by data released yesterday showing a 26% slump in the stock of job vacancies between March and December 2008.

The recent pace of decline is faster than during the recession of the early 1990s but less rapid than over 1974-76 and 1979-81 – see chart. In other words, while confirming a serious employment recession, vacancies have yet to indicate a downturn on the scale of the mid 1970s or early 1980s.

In the three prior recessions, the stock of vacancies reached a trough 18-24 months after peaking having fallen between 52% and 69%. This suggests a further decline of 35-58% from the December level, with a bottom between September 2009 and March 2010.

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COMMENT:
AUTHOR: Emily Bagley
EMAIL:
IP: 195.50.81.249
URL:
DATE: 02/17/2009 04:38:41 PM

Please could you let me know where you got this data from regarding the slump in the number of vacancies?

Many thanks.

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COMMENT:
AUTHOR: Simon Ward
DATE: 02/18/2009 04:31:54 PM

The latest information is published in the labour market statistics first release. I obtained historical data via Thomson Datastream. The figures for the last three recessions relate to vacancies at job centres. This series was discontinued in 2001 and replaced by a survey of employers.

The MPC voted 8-1 for the cut of half a percentage point in Bank rate earlier this month, with David Blanchflower again dissenting in favour of a full-point move.

The fact that only Blanchflower wanted a larger reduction, despite Inflation Report forecasts showing annual CPI inflation well below target over the medium term, is significant. Most MPC members appear to accept that a further cut in Bank rate would provide little additional stimulus and might even have an adverse economic impact by reducing banks’ earnings and lending capacity. (This argument was made in an earlier post.)

Quantitative action rather than Bank rate cuts must therefore bear the burden of further monetary easing. The surprise here is that the Committee has already instructed the Governor to seek Treasury authority to conduct purchases of gilts and other securities financed by creating new bank reserves. Assuming approval is granted, a decision to begin unsterilized buying is likely to be taken at the next meeting on 5 March.

My MPC-ometer, like the consensus, predicted the half-point February decline. The model is not able to incorporate the diminishing effectiveness of reductions as Bank rate approaches zero so may overestimate the MPC’s inclination to cut further. It currently suggests a quarter-point fall at the March meeting; as always, consumer and business surveys released around the end of the month will be an important influence on the final forecast.

Contrary to the consensus interpretation, recent inflation news has been distinctly poor, with the cut in VAT and lower fuel prices masking a deteriorating underlying trend due to surging non-energy import costs.

The superficial view is that prices are slowing fast, with annual headline consumer price inflation down to 3.0% in January from a peak of 5.2% last September. However, using the CPI at constant tax rates, which adjusts for the reduction in VAT, the decline has been much smaller, from 5.0% to 4.1%. Moreover, this fall is fully explained by a drop in energy price inflation.

Underlying inflation is often measured by the CPI excluding unprocessed food and energy. The annual increase in this index declined from 2.8% to 1.9% between September and January but would have risen – to an estimated 3.0% – without the VAT reduction.

The culprit is the officially-sanctioned plunge in the exchange rate and a resulting large rise in non-energy import costs (import prices of manufactured goods climbed 14% in the year to December). Today’s Office for National Statistics release notes upward contributions to annual CPI inflation from a range of categories dependent on foreign suppliers, including games and toys, furniture, household and personal appliances and package holidays.

The recession will restrain domestically-generated inflation but higher import costs may continue to have an offsetting impact, barring a significant exchange rate rally. Energy effects will ensure a further fall in the headline CPI increase over coming months but the decline may disappoint MPC and consensus expectations and inflation will rebound in early 2010 as VAT and energy benefits reverse.

The plunge in the exchange rate has worsened the credit crunch by damaging banks’ capital ratios.

In its October Financial Stability Report, the Bank of England estimated that the tier 1 ratios of Barclays, Lloyds TSB and HBOS would stand at over 11%, 12.1% and 12.0% respectively after last autumn’s capital-raising. However, Barclays recently reported a ratio of only 9.7% at the end of 2008 while Lloyds HBOS has indicated a group outturn “in excess of 9%”. These levels are well above the Financial Services Authority’s minimum of 6-7% but imply a much smaller cushion than previously thought.

The declines appear to be due less to losses than strong growth in risk-weighted assets – the denominator of the tier 1 ratio. This growth in turn reflects both higher risk weightings – caused by the unhelpful pro-cyclicality of Basel Accord rules – and the decline in the exchange rate, which has boosted the sterling value of foreign-currency assets. (The sensitivity of capital ratios to currency movements reflects a mismatch between capital – held mostly in sterling – and assets, which contain a large foreign element.)

Current UK exchange rate policy is reminiscent of Japan in the late 1990s. With US approval, the Japanese authorities engineered a large fall in the yen in an effort to reflate the economy via net exports. However, this worsened a credit crunch by forcing capital-constrained banks to cut back domestic lending to compensate for a higher yen value of their foreign assets. The policy even failed to stimulate trade – the yen’s depreciation helped to topple other Asian currencies and resulting deep recessions damaged Japanese exports.

The charts below update an earlier analysis comparing GDP performance in the current recession with the last three – 1974-75, 1979-81 and 1990-91. As before, the GDP measure adjusts for the impact of strikes, while the lower chart also includes Bank of England and Treasury forecasts, contained in the February Inflation Report and November Pre-Budget Report respectively.

GDP in the fourth quarter of 2008 was 2.1% below the peak level reached in the second quarter, according to current Office for National Statistics (ONS) estimates. This compares with a peak-to-trough fall in strike-adjusted GDP of 2.5% in 1990-91, 2.8% in 1974-75 and 6.2% in 1979-81.

As explained here, however, monthly ONS numbers for services and industrial output imply that GDP in December was 1.0% below the fourth-quarter average. In other words, even assuming no further fall in early 2009, first-quarter GDP will be 3.1% below the peak level of the second quarter of 2008. So the current downturn is already deeper than the 1974-75 and 1990-91 recessions.

The Bank of England central forecast, based on a constant 1% Bank rate, entails GDP bottoming in the second / third quarters at a level 3.8-3.9% below the peak, implying a further decline of 0.8% from the estimated December reading. It then embarks on a strong recovery, rising at an annualised rate of about 3.5% over the following six quarters.

Strike-adjusted GDP fell by 6.2% in the 1979-81 recession. This dismal performance, however, was partly a reaction to a 5.3% surge in GDP in the year preceding the peak. With no comparable boom leading up to the current downturn, the Bank of England’s forecast that the current recession will be less severe is defensible, though depends on an improvement in money and credit conditions.

The Treasury forecast looked optimistic even when it was published in November – see here – and has been rendered obsolete by the fourth-quarter GDP estimate. The April Budget will probably be based on a profile similar to the Bank’s latest forecast.

Monetary news has improved recently: nominal money expansion may be stabilising, real growth is reviving as inflation falls and the MPC is finally embracing necessary quantitative action. This supports the Bank of England’s forecast that the economy will trough by the third quarter, though GDP could decline by more than it projects in the interim. However, monetary growth would need to rise substantially to justify the Bank’s projection of a strong recovery from late 2009, particularly with fiscal policy set to tighten next year. On current information, an economic revival is more likely to follow the pattern of the early 1980s and early 1990s, when GDP growth averaged only 1-2% annualised in the six quarters following the recession trough.

An earlier post drew attention to a statistical tendency for the exchange rate to weaken when Bank of England Governor Mervyn King gives a speech or appears at an Inflation Report press conference. In 12 such instances between August 2007 and November 2008, the average daily fall in the sterling effective index was 0.5%.

Mr. King gave a dinner speech on 20 January and presented at yesterday’s press conference. The sterling index dropped by 1.6% on 21 January and 1.5% yesterday. Intriguingly, it also fell on the preceding days – by 2.7% on 20 January and 1.3% on Tuesday. Are markets beginning to anticipate the “King effect”?

Today’s Inflation Report signals that the MPC sees little mileage in further cuts in Bank rate and will soon start buying gilts as well as corporate securities with the explicit aim of boosting the supply of broad money. This shift is significant and welcome but the new policy needs to be implemented swiftly to affect macroeconomic outcomes this year.

The central growth and inflation projections in the Report stretch plausibility, with GDP forecast to recover rapidly from the third quarter and annual CPI inflation below target as far as the eye can see, despite sterling’s plunge and next year’s VAT hike. There is a suspicion that the MPC is downplaying inflation risks to justify its new policy of printing money.

Further points:

• The Report argues that additional cuts in Bank rate might provide little stimulus, either because banks fail to pass them on to borrowers or their own interest margins are squeezed, damaging earnings and lending capacity. The MPC is therefore close to embarking on quantitative action beyond the current Asset Purchase Facility (APF) remit. Specifically, the APF will be expanded in scope and scale and financed by creating bank reserves.

• The Bank of England’s adjusted M4 measure – excluding financial intermediaries – rose by just 3.8% in the year to December. To bring the annual growth rate up to, say, 8%, adjusted M4 would need to expand by about £70 billion. The Bank’s asset purchases are unlikely to have a one-for-one impact on M4 so the buying programme may need to exceed £100 billion to have the required impact on monetary trends.

• While it is difficult to infer precise figures from the chart, the central growth projection based on unchanged interest rates is consistent with GDP declining by about 1.25% and 0.5% respectively in the first and second quarters before stabilising in the third. It then embarks on a strong recovery, rising by more than 0.75% per quarter over the following year. This is not impossible but looks unlikely barring an early substantial pick-up in money growth.

• The central inflation forecast shows the annual CPI increase falling to a trough of about 0.75% in the fourth quarter, recovering to 1.25% in the first quarter of 2010 as the recent VAT cut is reversed but slumping back below 1% later in 2010 and in 2011. The 2010 numbers look suspiciously low given the VAT change and likely lagged effects of the large fall in the exchange rate (manufactured import prices rose 14% in the year to December).

• The Report assumes the December VAT cut lowered the CPI by about 0.75 percentage points. This implies that annual inflation will rise by 0.75 percentage points when the reduction drops out of the annual comparison in December 2009 and by a further 0.75 points when the 17.5% rate is restored in January 2010. Yet the Report forecasts an increase of just half a point between the fourth quarter of 2009 and the first quarter of 2010. Put differently, tax-adjusted inflation would have to fall to 0-0.5% for the 2010 projections to be met.