RICS predicts November rate rise

In its economic brief, RICS said the UK economy is growing solidly, driven in most part by consumer spending in the past year. Despite fears over debt levels and utility costs, consumer spending should continue to grow, albeit at a slower pace than in the second quarter, supported by a healthy labour market. With global growth forecast to remain robust, RICS said it is likely that the Bank of England will choose to raise interest rates again before the year ends.

The U.K. economy grew 0.8% in the second quarter and 2.6% over the past year. These results confirm an acceleration from the first quarter’s 0.7% quarterly rise and 2.3% on the year outturn. The economy is now growing almost exactly at trend pace, that which is considered to be consistent with stable inflation at the government’s target rate of 2%.

Household demand, which accounts for over 62% of the economy, was the primary driver of growth during the past twelve months. Private consumption rose by 2.4% on the year, marking the strongest annual rate of expansion since the fourth quarter of 2004. Government consumption was up 2.0% year on year. However, growth has been balanced with gross fixed capital formation jumping by 6.3% over the year, as business ramped up investment in response to rapid global economic growth and buoyant demand for UK exports that have helped manufacturing recover from a difficult 2005. It was the strong economic growth picture, and above target inflation which persuaded the Bank of England (BoE) to raise interest rates in August by 0.25%, the first change in exactly a year.

Inflation looks set to cause worries for the BoE as figures for August were running 0.5% above the government’s target. Of further concern to the BoE is the recent strength of consumer perceptions of inflation, which could feed through into higher wage demands. The old inflation measure, RPIX, which the BoE used to target, is the highest since 1993 and almost 1% above its target of 2.5%. While the BoE’s August rate rise and the recent declines in the price of oil (which should lead to falls in household utility bills) should lead to an easing in consumer price expectations, the BoE may decide another rate rise is necessary to ram the message home that it is serious about keeping inflation low. Key in this regard is the strength of the underlying economy. Most importantly the consumer.

Consumers will be feeling a positive boost from the performance of the UK housing market. After a weak first half of last year, the August 2005 interest rate cut and a general economic recovery reinvigorated the market. Activity levels as measured by mortgage approvals have increased to significantly above their decade average of 102,000, to 120,000 in August. This year has seen an acceleration of house price growth with the RICS forecasting that prices will rise by 7%, after a 3% rise in 2005.

Along with the housing market recovery, mortgage equity withdrawal, the amount of equity home owners release from their property, has also recovered from a low of 3.2% of post-tax income in 2005 Q1 to 5.8% in the first quarter of this year. As the housing market is expected to remain strong throughout the remainder of the year, consumer spending will gain support from significant amount of mortgage equity withdrawal. If consumer spending were to hold up and the other parts of the economy stay strong, then RICs predicts that the BoE will raise interest rates again.

Occupier demand in the commercial property market expanded moderately in the summer months, supporting rental growth. Rent rises have generally been in line with consumer price inflation since early 2005 with both trending moderately higher. However, strengthening in rental growth has almost entirely reflected the marked recovery in the health of the office sector, with rent rises in July reaching 3.3%, almost double the rate seen in March and falls in the first half of 2005.

This contrasts with other sectors, where rental growth has been broadly stable or even slowing down. The August interest rate rise has so far had little impact on the economy or retailers. Moreover, the recovery in high street spending this year is starting to feed into higher retailer confidence in August, with for example employment intensions not as negative as they were only 12 months earlier. The business and financial services sector also remains robust with job vacancies standing at high levels, which augurs well for office demand in the next 3-6 months.

Investment activity in the commercial property market eased back a fraction in the second quarter as a lack of available product has reduced sales activity. Actual demand remains robust, however, as property yields dropped further. According to CB Richard Ellis, property yields in the second quarter dropped to 5.1% for prime premises, the lowest recorded in 35 years though the pace of decline has smallest in over a year. In the case of retail property yields were static in Q2 and has led to a slowdown in growth of capital values. Institutional investors and financial corporations were the biggest net investors in the second quarter as volatility in the equity market reaffirmed the position of property as a portfolio diversifier.

The latest figures from RICS showed that house price growth accelerated for the fifth consecutive month in August, hitting the fastest pace since May 2004. This fits in with the latest Bank of England data on mortgage approvals, which shows strengthening demand for mortgages. Price rises are being driven by a combination of new buyers entering into the market and a standstill in new property supply. Buyer enquiries rose for the fifteenth consecutive month in August, up at the fastest pace since September 2003. Completed property sales for the past 12 months have also risen firmly as stronger buyer interest fed through to final transactions.

New instructions to sell property showed little change in August as the holiday season has come to an end. Above trend economic growth, driven mainly by consumer spending, combined with a strengthening employment and wage picture is supporting buyer confidence. Buyer enquiries are also being supported by rising first-time buyer (FTB) accessibility, with an upturn in loan-to-value ratios enabling more to enter the market as the required deposit diminishes compared to income levels. Loans to FTBs rose by 20% in the first seven months of the year compared to the same period a year ago, although FTB accessibility still remains low by historic standards.

In spite of this recent improvement in FTB accessibility, the combination of August’s quarter point interest rate rise and annual house price inflation (6% by the official government measure) far outpacing average earnings growth (4.4% as measured by the three month moving average), will further diminish FTB housing affordability., as the initial debt servicing cost of a mortgage rises.

August’s quarter point interest rate rise has yet to impact on prices and buying activity. The prospect of further monetary tightening has dampened surveyors confidence a touch in the short term, although the mood still remains upbeat. Expectations for price rises over the next three months are close to this year’s high point, and surveyors are anticipating a strong Autumn selling season. Further increases in the base rate will cool the housing market.