The rise in CPI inflation to a 40-year high of nine per cent in April, and likely further increase to a peak of 10 per cent in October, represents the biggest challenge the Bank of England has faced since it was given independence to set interest rates to control inflation in 1997.
Admittedly, higher interest rates will do little to ease global supply bottlenecks or reduce energy prices as the west shuns imports of Russian energy exports.
And together those factors account for about 80 per cent of the overshoot of inflation over the two per cent target. But there are also factors that could keep inflation high. A shortage of workers has already seen pay growth accelerate to seven per cent year-on-year in the latest figures.
Policymakers are worried that firms will keep raising prices to account for their rising costs and workers will demand pay increases that keep up with prices or leave for better paid jobs, putting more pressure on costs and causing inflation to stay high.
How the market could react
At Capital Economics, we think that the Bank of England will have to respond to this challenge to its credibility with the largest rise in bank rate for over 30 years. The policy rate has already been raised from 0.1 per cent to 1.00 per cent since last November, and we expect it to be hiked to 2.5 per cent by year-end and to three per cent in 2023.
Mortgage lenders have been slow to respond to the sudden change in the interest rate outlook so far. Financial market measures of interest swap rates suggest there will be a very slim, if any, net interest margin on loans written in recent weeks.
So, it was little surprise to us that mortgage rates have finally begun to rise.
After hitting a record low of 1.5 per cent last November, the average rate on new mortgages rose to 1.74 per cent in March. Based on our forecast for interest rates and assuming lenders rebuild their profit margins, we think that mortgage rates will jump to over three per cent by the end of the year and to 3.6 per cent in 2023.
House prices are particularly vulnerable to higher interest rates following their 20 per cent surge since the start of the pandemic. That increase has taken prices up to their highest level relative to earnings on record, surpassing the previous peak reached in 2007.
High prices and rising mortgage rates will lead to a sharp increase in the cost of repayments on new mortgages at the same time as households face a steep rise in living costs across the board.
That deterioration in affordability will put the brakes on home purchase demand. In fact, there are signs that even the relatively modest increase in mortgage rates thus far is having an impact.
Impact on housing market
The Royal Institution of Chartered Surveyors (RICS) survey no longer shows demand vastly outstripping supply, suggesting that the rise in house prices will slow to a crawl by the end of the year. And the number of web searches for the property websites Zoopla and Rightmove fell back to their lowest level since May 2020 in April.
All that said, we suspect that the housing market will endure a correction rather than a crash.
For one thing, because mortgage rates are likely to peak around 3.6 per cent rather than at six per cent as in 2007, the extent of overvaluation will be less severe than in the financial crisis and the previous crash in the early 1990s.
Second, limited very high loan to value (LTV) lending paired with the run up in house prices over the past two years should prevent the emergence of widespread negative equity.
And third, the tight labour market will limit forced sales and support wage growth, meaning less of a drop in house prices will be needed to make them affordable again.
All told, we are expecting a peak-to-trough fall in house prices of five per cent in 2023 and 2024, reversing about a fifth of the increase since the pandemic began.
Andrew Wishart, Senior Economist at Capital Economics