Discussions about how far house prices could fall often confuse two issues – the extent of current overvaluation and the possibility that a serious economic downturn will result in prices undershooting “fair value”. This post focuses on the former.

According to widely-quoted IMF research (here, p.11), UK prices rose by nearly 30% more than justified by “fundamentals” between 1997 and 2007. Some commentators – including the MPC’s David Blanchflower (here, p.5) – have used this 30% figure as a measure of current overvaluation. As David Smith of the Sunday Times pointed out in a recent column, this is incorrect because the reference is the level of prices in 1997, not “fair value” at present. Adjusting for price growth since 1997, the IMF calculations imply 15% overvaluation currently.

The IMF approach may be questioned. The definition of “fundamentals” includes affordability, income growth, interest rates, credit growth, equity prices and population trends. The relevance of credit expansion and equity prices for sustainable valuation is debatable. In addition, no allowance is made for constraints on the supply of housing – likely to have been a more significant factor in the UK than in other countries recently experiencing house price booms.

Popular comparisons of the house price to earnings ratio with its long-run average significantly overstate current overvaluation. The first chart shows one such measure – the value of the housing stock divided by household disposable income. The ratio clearly trends higher over time, reflecting factors such as improving quality, the pressure of an expanding population on constrained supply and a high income elasticity of demand for housing.

Rather than its long-run average, the log-linear trend of the ratio is probably a better guide to current “fair value”. On this basis, prices were 10% overvalued at the end of last year versus an 85% deviation relative to the average.

An alternative and superior approach is to use rents rather than earnings as the basis of comparison. Rents already embody fundamental influences on housing demand and supply. Moreover, a potential homebuyer does not face a choice between consuming housing services or retaining earnings for other purposes – the decision is rather whether buying is financially preferable to renting.

The second chart shows a measure of the rental yield on housing derived from the national accounts – actual and imputed owner-occupied rents as a percentage of the value of the housing stock. The yield stood at 3.0% at the end of 2007 against a long-run average of 3.6%, suggesting price overvaluation of 20%.

However, this figure overstates the need for prices to fall to restore value, for two reasons. First, rents are growing solidly – by 7.7% on the national accounts measure in the year to the fourth quarter. The trend seems likely to persist, with the latest RICS letting agents’ survey reporting strong tenant demand and expectations for rents – see third chart. Secondly, low real yields on competing assets – particularly government bonds – may mean the “equilibrium” rental yield is below its long-run average.

Based on the above, a house price decline of 10% by 2009 could be sufficient to restore valuations to a sustainable level. This is consistent with modelling work by academics John Muellbauer and Anthony Murphy, reported in Thursday’s Financial Times.

A larger fall is certainly possible – based on the rental yield, prices have typically undershot their sustainable level by 10-20% during serious economic downturns. However, any such decline would create another attractive entry point for longer-term investors.

A post in March gave a list of reasons for expecting stock markets to rally. (A modified version of this piece appeared on the Telegraph website and elicited a torrent of hostile comment from enraged bears.) The MSCI World index (in dollars) has since risen by 10% and the FTSE 100 by 14% (to yesterday’s close). Is optimism still warranted?

One of the reasons for expecting a rally was that equities were then discounting an enormous amount of bad news. The first chart below updates an earlier comparison of the performance of world stocks in the current cycle with historical “soft” and “hard” landings – see here. At their March lows markets were fully priced for a hard landing scenario.

Following the rally, investors appear to be assigning roughly equal weight to the soft and hard landing scenarios. I still think a hard landing will be avoided, at least in 2008, but market levels are no longer hugely misaligned with economic fundamentals.

Another bullish argument was that plentiful global liquidity would be redeployed in equity markets as investors’ fears of financial meltdown abated. The second chart updates measures of G7 liquidity and risk aversion, last discussed here.

Liquidity remains ample although the indicator may be overstating the position because money supply figures have been distorted by the credit crisis. As expected, risk aversion has fallen and should continue to move lower barring further financial accidents. So the liquidity / risk backdrop still looks supportive.

The recent rally has been led by the energy and materials sectors but this pattern may be unsustainable, since further commodity price gains would threaten global growth prospects. A continuation of the uptrend in markets may therefore require a rotation of strength into other sectors, particularly beaten-up financials.

The third chart updates the comparison of the performance of US financial stocks during the current subprime crisis with the savings and loan crisis of the late 1980s, last discussed here. If the similarity persists – a big if – financials should soon embark on a strong recovery, which could sustain the uptrend in market indices.

Summing up, there are reasons to remain constructive on equities but some caution is warranted after the recent strong rally. Continuation of the uptrend is likely to require a stabilisation or modest setback in commodity prices along with a better performance of financial stocks.

At some point this summer, Mervyn King, the Bank of England governor, faces an unenviable task. For the second time in his tenure, he will have to write an open letter to the chancellor explaining why inflation has risen more than one percentage point above the 2% target and describing what the Bank’s Monetary Policy Committee plans to do about it.

Why have the institutional arrangements designed to anchor UK inflation failed for a second time?

In an accounting sense, the increase in Consumer Prices Index inflation since mid 2007 can be largely explained by rising global prices of food and energy. The deeper question, however, is why these higher prices have not been offset by slower rises or falls in prices for other products and services, as would be expected if monetary policy had been correctly calibrated to meet the inflation target.

Regrettably for its reputation, it is clear the MPC allowed excessively loose monetary conditions to develop between 2005 and 2007. Bank rate was cut inappropriately in 2005 and maintained below its neutral level until 2007. During this period, investors’ risk appetites significantly increased. The result was a prolonged period of buoyant money and credit expansion.

In the three years to December 2007, the ratio of the broad money supply, M4, to nominal gross domestic product (GDP) rose by 22 per cent. A comparable increase has occurred only twice since 1945 – the early 1970s and late 1980s. Both episodes were characterised by rampant demand and output growth, a widening current account deficit and a subsequent large rise in inflation. These “Barber” and “Lawson” monetary booms – named after the chancellor of the day – were followed by damaging recessions. The UK has now had an “MPC boom”, again with painful consequences

The MPC discussed rapid money and credit growth at its meetings in 2006 and 2007 but played down the dangers . Members argued that the build-up in money balances was concentrated in the financial sector so would not result in a significant boost to demand for goods and services.

While economic growth has been strong, it has been lower than in the early 1970s and late 1980s, implying less pressure on supply capacity. The MPC view, however, neglected the possibility that “excess” money would flow across the foreign exchanges, leading to a sharp decline in sterling, thereby exacerbating upward pressure on import costs. The concentration of liquidity in the financial sector, accompanied by a large rise in overseas sterling deposits, increased this risk. The effective rate has fallen by 13% since July 2007 – similar to the “pound in your pocket” devaluation of 1967. In addition, monetary buoyancy may have contributed directly to rising inflationary expectations.

The upshot is that official neglect of monetary warning signals has once again been followed by an unexpectedly large rise in inflation although details of the transmission mechanism differ from earlier episodes. In effect, loose domestic monetary conditions have accommodated or even supplemented the inflationary impact of rising global costs.

How should policy now respond? Some commentators have urged the MPC to “look through” the current overshoot on the grounds that a weakening economy will return inflation to target in two years’ time. Even if this were assured, the argument neglects the MPC’s requirement to meet the target “at all times”. While policy actions have their greatest impact at longer horizons, they also affect shorter-term prospects so it is wrong to focus solely on where inflation may be two years ahead.

The recent painful tightening in credit market conditions should, in time, contribute to much slower monetary growth. The headline CPI rate, however, is set to rise significantly further and firms and employees may build a higher trend level of inflation into their price- and wage-setting behaviour.

The danger of inflationary expectations becoming dislodged from the 2% target is greater now than in April 2007 when Mervyn King wrote his last exculpatory letter. In 2007, CPI inflation returned to target four months after reaching the 3.1% threshold. Now, it is likely to remain above 2% until late 2009, barring a significant decline in commodity prices.

This means that interest rate doves who think there is scope for further monetary loosening currently are misguided if they wish the Bank to restore its anti-inflation credentials. Any future reduction must be conditional on evidence of a moderation in monetary expansion and inflation expectations. The short-term economic pain implied by such a policy is outweighed by the potential costs of failing to return inflation sustainably to the 2% target over the medium term.

An edited version of this article appears in today's Financial Times.