An earlier post argued that UK house prices needed to fall by a further 6% from their July level to bring the rental yield on housing back to its long-term average, assuming stable rents. If the rental yield were to overshoot the average to the same extent that it undershot in 2007, a decline of 21% would be necessary. These could be considered best and worst case scenarios for house prices.

The two scenarios would imply peak-to-trough falls in house prices of 16% and 30% respectively.

Prices dropped by a further 1.8% in August, according to the Halifax index. The required additional declines are therefore now 4% based on the long-term average yield and 19% in the yield overshoot scenario.

The chart below compares the scenarios with the last three house price busts – 1973-77, 1980-82 and 1989-96. The comparison is in real terms – relative to the retail prices index – because general inflation carried a greater burden of valuation adjustment in the prior episodes.

The scenario paths assume that remaining house price adjustment occurs smoothly over two years while the RPI rises by 3% per annum.

In the best case scenario the peak-to-trough decline in real house prices would be much larger than in 1980-82 but less severe than in 1973-77 and 1989-96. The worst case scenario would imply greater damage even than in 1973-77.

Restricted mortgage availability and coming labour market weakness clearly suggest an outcome closer to the worst case. However, prices are now falling faster than at the comparable stage of previous busts. If the decline continues at its recent pace, nominal prices could be nearing a trough by next spring.

An improving trade account has provided major support to the US economy. Net exports contributed 1.7 percentage points to GDP growth of 2.2% in the year to the second quarter.

The consensus is sceptical of a similar positive impact from trade in the UK, despite sterling’s plunge. Independent forecasters expect net exports to contribute 0.3 percentage points to GDP growth in calendar 2008 and 0.4 pp in 2009, according to the Treasury’s monthly survey.

Recent trade figures suggest a larger boost. According to the July release issued this morning, export volumes of goods excluding oil and erratic items were 3.6% above their 2007 average in June / July versus a rise of just 0.2% in imports. Suppose total real exports and imports – including services – grow at these rates for the year as a whole. Net trade would then add 0.9 percentage points to calendar 2008 GDP expansion.

The ratio of export to import volumes in July was the highest since 2006 – see chart.

Public sector net borrowing totalled £35 billion in 2007/08, equivalent to 2.5% of GDP. The average forecast of economists surveyed by the Treasury is for a rise to £47 billion this year and £50 billion in 2009/10, or about 3 ¼% of GDP in both years. I think the consensus is underestimating the sensitivity of the public finances to the economic cycle. Borrowing could reach about 3 ½% of GDP this year and over 5% in 2009/10, implying nominal figures of £50-55 billion and over £75 billion respectively.

Conceptually, the public sector balance can be split into discretionary and non-discretionary components. The analysis below assumes the government chooses the percentages of GDP accounted for by spending on goods and services and indirect tax revenues. Other elements of the public finances – mainly benefit spending and direct tax receipts – are defined as non-discretionary, i.e. determined by the economic cycle, financial market developments and other factors. (Of course, policy decisions also affect these elements but their impact on year-to-year changes is small relative to cyclical influences.)

The first chart shows annual changes in the non-discretionary public sector balance, defined as above and expressed as a percentage of GDP, together with the fitted values of a model based on current and lagged rates of change of GDP and stock prices. (The labels on the horizontal axis refer to financial years ending in March of the year stated.) Despite its simplicity, the model is able to explain the major swings in the non-discretionary balance over the last 20 years.

Using the model to forecast requires assumptions about GDP and stock prices. GDP is projected to be unchanged between the second quarter of 2008 and the first quarter of 2009 and to grow at an annualised rate of 2% thereafter – close to the current consensus forecast. Similarly, the FT all-share index is assumed to be stable at its current level until the first quarter of next year and then to rise by 10% per annum. Based on these inputs, the model projects a year-over-year deterioration in the non-discretionary balance of 1.1% of GDP in 2008/09 and 1.7% in 2009/10.

The change in the overall public sector balance will also depend on the discretionary component. For simplicity, spending on goods and services and indirect tax revenues are assumed to remain stable as percentages of GDP in 2008/09 and 2009/10. (The former assumption, in particular, may be optimistic given a possible pick-up in public sector wage settlements.)

The second chart shows the overall balance as a percentage of GDP, including the forecasts for 2008/09 and 2009/10. Projected borrowing of 5.3% of GDP in the latter year would be the highest since 1995/96. In a full recession – not the assumption here – borrowing would probably challenge the 7.8% of GDP peak reached in 1994/95.

The measures announced by the US Treasury to support Fannie Mae / Freddie Mac and the US mortgage-backed securities market are comprehensive and should lower the cost and increase the availability of mortgage finance.

Two aspects of the plans are particularly significant. First, Fannie and Freddie will expand their portfolios of retained mortgages and mortgage-backed securities until the end of 2009 before embarking on a controlled reduction. This contrasts with the UK authorities' policy following the rescue of Northern Rock of reducing the bank’s mortgage book by £20 billion a year in 2008 and 2009. As argued previously, this has unnecessarily aggravated mortgage and housing market weakness.

Secondly, the Treasury will buy mortgage-backed securities issued by Fannie and Freddie in the open market, with no predetermined limit on the scale of purchases. Again, there is a contrast with UK policy: the Bank of England's special liquidity scheme allows mortgage-backed debt to be swapped for Treasury bills but has had little positive impact on the prices of such securities because credit risk remains with the banks.

As the chart shows, the woes of Fannie and Freddie have been reflected in a rise in the spread between conventional mortgage rates and interbank swap rates in recent months. A lowering of their funding costs should allow mortgage rates to fall significantly.