The decision by the MPC to cut interest rates to 3.75% in February took many in the City by surprise. With property prices apparently racing away, it seemed inconceivable that the Bank of England should run the risk of encouraging a renewed acceleration in house prices. The MPC faces a difficult task containing speculative pressures. We only have to look back at the dotcom bubble of the late 1990s or the housing boom of a decade earlier to see how rapid increases in asset prices invariably end with a painful correction.
There is little reason to believe that the current episode will be different. Mortgage lenders tell us the risks are limited, since interest payments as a proportion of take-home pay are lower than at the top of the last property bubble in the late 1980s. But we should not allow ourselves a false sense of security. It was the US economist Irving Fisher, credited with developing the theory of debt deflation back in 1932, who warned that the precise level of debt or asset inflation was not the crucial issue. It was the speed of gain in asset values in relation to underlying incomes that would ultimately determine whether prices could sustain such lofty values. Eventually, the principal does have to be repaid, a point becoming all too clear as endowment policies tumble in value.
With this in mind, it may seem puzzling that the MPC decided to cut interest rates. The evidence of a slowdown in house prices has after all been broadly confined to some selected areas of London. The Halifax house price index shows house prices rose by 1.7% m/m in February. And yet, the MPC's move makes sense. The property bubble had its seeds in the capital city: the current surge in prices across the country was ignited by the boom in City bonuses, which pushed up house prices in many fashionable areas. As prices rocketed, there was the inevitable centrifugal impact, as houseowners tried to cash in on their good fortune, 'moving out to the regions'. London led the last housing downturn, and so it will prove this time. In this respect, the MPC was right to cut rates, since the signs of a slide in house prices in some parts of London have been multiplying in recent months. One of the biggest mistakes made by the Bank of Japan during the early 1990s was to carry on hiking interest rates when there was already clear evidence that a downturn in the Tokyo housing market was underway.
The MPC has a difficult balancing act ensuring a soft landing. We should be heartened that Mervyn King is taking over the helm. The former LSE professor has been well versed in the dynamics of a debt trap. His paper in the European Economic Review on debt deflation written in 1994 shows a good grasp of the challenges currently facing the UK economy. But there is no guarantee the MPC will get it right. We can be assured that interest rates will come down quickly if they need to: rates could be down to 2% by the end of 2004. But there are a number of risks that lie beyond the MPC's control.
Firstly, there is Wall Street. On some measures, share prices are still overvalued despite the massive correction witnessed since Spring 2000. The S&P 500 index shows that share prices are currently trading on a valuation of 27 times earnings. That compares with an average P/E ratio of 19 stretching back to the start of 1980. Profits are simply not bouncing back in the US. Consumer spending is heading down and many companies are still saddled with excess capacity. In a true bear market, share prices usually overshoot on the downside. But we have seen no evidence of that yet. The Dow Jones could easily slip below 7,000 this year. On a three-year view, it is quite plausible that the benchmark index in the US will be down to 5,000 or lower.
That will have profound impact on the London economy. Significant numbers of jobs have been lost since high-tech share prices started to tumble. But many financial and legal companies are still geared up for much higher levels of business. The shakeout has arguably only just begun. That does not mean that unemployment has to rise sharply. Rather, many of the jobs being lost will be replaced by lower paid positions, possibly in the public sector, making today's house prices in London seem even more unaffordable. The challenge facing the MPC will be to ensure that the bear market in Wall Street does not precipitate a property slump this side of the pond.