By Nitesh Patel, Strategic Economist at Accord Mortgages
Only a few weeks ago the Bank of England were grappling with the considerable challenge of maintaining post-pandemic recoveries in the face of a generational surge in inflation. Now, against the backdrop of geopolitical crisis, that policy challenge has become even more acute, though looking at some of the economic data you’d be left asking what the problem was.
In February, we were heading back to a life of normality after two years of the pandemic and the economy, as measured by Gross Domestic Product (GDP), was back to where it was in February 2020 – a month before the first lockdown. The unemployment rate was close to where it was before the pandemic, whilst house prices were still rising. And the Bank of England felt confident enough to raise the Bank Rate without hurting this recovery not once, but twice.
There already were economic headwinds coming mainly from rising inflation and the measures to combat this - higher interest rates - which would lead to higher mortgage costs and the likely slowing in house price growth. The global uncertainty and volatility resulting from the invasion of Ukraine will have economic impacts around the world, including the UK.
That said the UK is not as exposed to the economic consequences of the war in Ukraine as the rest of Europe. Even so, in response to the surge in global commodity prices caused by the war, inflation is now expected to peak at a higher rate and GDP growth to get slower than previously thought.
UK inflation reached 5.5% in January, up from 5.4% in December and the highest reading since March 1992. A year ago the annual rate was 0.4%. For some households the squeeze on living standards is intensifying, and it will get even worse in April, with further energy prices and tax increases coming in. A third policy rate hike by the Bank of England this month saw the base rate increase to 0.75%.
Covid-19 has had a lasting effect on inflation levels. Significant short-term changes in prices that occurred during the lockdown period (known as base effects) resonate in the data today, long after the strictest rules have been eased. The prices of goods and services that were cut sharply during lockdown are now getting back to ‘normal’, and this change is contributing to the high overall inflation rate.
Global consumer spending, especially in the United States, has rotated away from services and towards goods. That has put additional pressure on global supply chains which had already been disrupted by Covid outbreaks, which in turn has led to sharp increases in input and transport costs, as well as backlogs and shortages in production.
The increases in the energy price caps since April 2021, with a third due in April this year, have played a big part. Higher energy prices accounted for about six-tenths of the rise in headline inflation in advanced economies last year. Other drivers were transport cost, second-hand cars, clothing and footwear.
What we are seeing is goods price inflation accelerate at twice the rate of service price, and this in the main has been caused by the pandemic as consumer tastes shift.
However, firms’ input costs are rising. Unit wage costs have grown on average by 1.2% since Q2 2020; whereas in 2019 the average was just 0.2%. Brent crude oil has increased from $66 per barrel to over $100 per barrel, whilst natural gas today is $4.50/MMBtu up from $2.83/MMBtu. The war in Ukraine is a key driver of the more recent increase.
In early February the BoE forecast inflation to peak at 7.25% in April and slow to around 4.5% by the end of the year. It is now expected to be closer to 8%, perhaps even higher, which should mean the BoE starts raising the Bank Rate, though it remains to be seen if it reaches 2% by the end of 2022 as the financial markets expect.
And if lenders passed on these increases in full on mortgage rates then mortgage payments as proportion of take-home pay would surge given that house prices have been rising for most of the past two years. And with inflation rising faster than wage growth you would expect housing demand to slow and therefore price growth too.
Housing market activity has been remarkably resilient to the withdrawal of stamp duty relief in September. Following a dip in October transactions (incl. cash buyers) bounced back to 107,000 in January, above the average of 98,000 p/m in 2019. With mortgage approvals rising above 2019 levels too, transactions look set to remain elevated for the next few months as households continue to adjust to remote working.
The supply of homes for sale has fallen dramatically in the past year –a contributing factor to rising prices. There are tentative signs that supply is turning a corner with unsold property stock per surveyor holding steady in January and the RICS sales instructions balance recording its highest reading since April 2021, albeit remaining negative. Zoopla data is also seeing recovery in the levels of new supply in several regions– though figures are still low.
In 2021 there were 405,000 FTBs, a 20-year high, compared to a pre-pandemic five-year average of 335,000 – this would have contributed to low stocks. But with new buyer enquiries strengthening, even if supply does improve price growth will remain strong in the near term.
Investment in the housing market picked up less sharply than household saving in 2020 and 2021, suggesting that prospective buyers still have cash available to fund a large deposit. During the pandemic the household sector has built up excess savings of around £180 billion.
But quoted mortgage rates ticked up across the board in January. And with market interest rates continuing to rise in February and banks’ net interest margins slim, we could see a further pickup in mortgage rates that could cause demand to ease later this year.
The house price-to-earnings ratio rose further above its 2007 peak in Q4 2021. But the impact on mortgage repayment costs as a share of income of higher house prices has so far been offset by falling mortgage rates and solid nominal wage growth. However, affordability will deteriorate this year if mortgage rates continue to rise.
The current volatility in money and bond markets makes the precise path of longer-term rates hard to predict. The increased cost of funds for lenders from Bank Rate rises since December will place upward pressure on new mortgage lending rates – potentially deterring new buyers. We are likely to see a shift to more remortgaging and product transfer activity as homeowners lock into attractive fixed rate deals before borrowing costs rise.
The buy-to-let (BTL) sector has also benefited from the Stamp Duty holiday. The number of BTL mortgages for house purchases was 111,600 in 2021 compared to 75,100 in 2019 - an increase of almost 50%.
According to Zoopla, UK rental demand is up 76% in January compared to similar periods between 2018-2021. Rental demand has gathered momentum in city centres over the last six months as the pandemic started to ease. This time last year Zoopla were reporting the ‘halo effect’ as demand in wider commuter zones rose amid a ‘search for space’ but dipped in city centres amid consecutive lockdowns. Now, demand appears to have bounced back in city centres as offices have re-opened, students have returned, and the increased ease of global travel has allowed a release of pent-up international demand.
Average UK rents rose 3.7% in Q4 2021 taking the annual rate of rental growth across the UK to +8.3%. This further rental growth was underpinned by a continued rise in rental demand, particularly in city centres, amid a chronic shortage of supply. The average rent for the UK is now at £969 pcm, a new high, and £62pcm higher than at the start of the pandemic.
The volatile and unpredictable nature of the economy continues to throw us some curveballs and in a corner of the market that relies on predictions, we could be in for a few more shocks and surprises. That said, focusing on what we do know – the data, the stats and facts suggest strong remortgage and product transfer activity, along with a rebounding BTL market are sure to keep brokers busy.
The overriding concern of central bankers in the US and here in the UK is that higher energy prices will push up inflation expectations, causing workers to bargain for higher wages and setting in train a self-perpetuating wage-price spiral. But for this to materialise inflation expectations must ratchet up and labour markets need to be tight in order for expectations to feed into higher wages. This is a bigger threat in the US and UK (where labour markets are relatively tight) than it is in the euro-zone.
At the same time raising rates too fast coupled with the squeeze on real incomes, which is itself disinflationary, could put the recovery into reverse. Accordingly, the most likely outcome is that the BoE proceed with a gradual tightening of monetary policy.