A post in May suggested that house prices were bottoming, on the basis that the national rental yield had returned to its long-run average while low interest rates would limit distressed selling, so housing was unlikely to become significantly undervalued.

Valuation is often assessed using the house price to income ratio, which remains far above its long-run average. This was the basis of a Fitch Ratings forecast this week that prices will fall by 20% from current levels. As argued in the earlier post, however, the "equilibrium" level of the ratio has trended up over time, partly reflecting the pressure of an expanding population on constrained supply.

An alternative approach is to use rents rather than income as the basis for comparison. Rents already embody supply / demand fundamentals. People need to live somewhere – the choice is between buying your own home or renting, not whether or not to spend income on housing.

An economy-wide rental yield can be calculated from national accounts data by dividing the sum of actual rental payments and imputed rents of owner-occupiers by the value of the housing stock. The yield has fluctuated around a stable level, averaging 3.6% between 1965 and 2007 – see chart. This seems low but the measure includes subsidised social housing and takes account of vacant properties.

The earlier post estimated that the yield had risen to 3.8% by April 2009, suggesting small undervaluation. This assumed that the value of the housing stock had fallen by 21% from the end of 2007, in line with the Halifax index. Subsequent official figures, however, showed a smaller decline during 2008 while prices have recovered significantly since the spring, with the Halifax measure up by 6% from its April low by September.

Incorporating these changes and recent data on rents, the national yield is estimated to be 3.4% currently, suggesting house price overvaluation of about 5% based on the 3.6% long-term yield average – far below the 24% claimed by Fitch. This deviation can be eliminated without a fall in prices since rents are rising – by 7% in the year to the second quarter.

Rather than renewed weakness, further price gains appear more likely near term – improved mortgage availability and rising consumer confidence may lift demand, while low interest servicing costs, government financial support and negative equity will continue to limit supply. The risk of a mini-bubble would increase if the Bank of England were to inject more liquidity into the economy by extending its gilt-buying operation next month.

The 1976 sterling crisis was triggered by a blow-out in the fiscal deficit and excessively loose domestic monetary conditions, caused partly by government borrowing from the banking system. Sound familiar?

Fiscal concerns reflected a rise in public sector net borrowing to 7.0% of GDP in 1975-76 – far below the 12.4% officially projected for the current financial year.

The IMF rescue in late 1976 involved a currency stabilisation programme based on limits on "domestic credit expansion" (DCE). This is defined as bank lending to the private sector plus the portion of the fiscal deficit not financed by selling debt to domestic non-bank investors. The focus on DCE was appropriate because much of the liquidity created by credit buoyancy was flowing overseas, so money supply statistics did not fully reflect the scale of monetary laxity.

This perspective is relevant currently because of evidence that liquidity created by the Bank of England's quantitative easing (QE) programme has been flowing abroad, putting downward pressure on sterling. The table presents recent data on the relationship between DCE and money supply growth. The right-hand column covers the period from April to August, during which the Bank bought £120 billion of gilts.

The contractionary effect of liquidity outflows on broad money is captured by the "external and foreign currency counterparts". The impact amounted to £49 billion over the five months – significantly larger than the £24 billion increase in broad money over the same period.

It is possible that outflows would have occurred in the absence of QE. The external counterparts, however, had a positive monetary impact in the prior 12 months to March 2009. The timing of the swing into negative territory, and the consistent contractionary influence in each of the five months covered, suggests a linkage with QE.

This analysis supports the argument in a previous post that the Bank's gilt-buying is creating excess liquidity, which is being reflected in buoyant asset prices and sterling weakness but is not apparent from the broad money supply data. If the Bank expands QE further, the currency decline could accelerate.

The chart shows sterling's trade-weighted index together with the contribution of public sector DCE to annual broad money growth – a negative correlation is apparent. This contribution is now 10 percentage points, the highest since – 1976. 

Industrial and manufacturing output figures for August were shocking, showing falls of 2.5% and 1.9% respectively from July to new lows for the recession. If the figures are to be believed, UK manufacturers are bucking the trend of global recovery, despite the supposed big boost from the plunge in the pound. The US, Japan and Spain have reported industrial output gains of 0.8%, 1.8% and 1.1% respectively in August (Germany and France publish later this week).

There are reasons for doubting the figures, including the discrepancy with manufacturing purchasing managers' survey results and the uniformity of declines across industries, suggesting a problem with seasonal or working-day adjustments. The numbers, however, will feed directly into the first estimate of third-quarter GDP released on 23 October – this may now show little if any growth (although later upward revisions are probable).

Hopes of the UK economy "rebalancing" towards a manufacturing-led recovery in response to a lower exchange rate look even more tenuous. An economic revival remains dependent on the much larger services sector, with financial services playing a key role. Fortunately, recent business surveys suggest that service industries are performing much better than manufacturing – see yesterday's post – although this has yet to receive confirmation by official services output data.

The recent slide in sterling began on the day the Bank of England announced a £50 billion expansion of its quantitative easing programme. The timing is unlikely to be coincidental. The Bank’s gilt-buying may be creating excess liquidity in the economy, helping to explain surging asset prices as well as the fall in the pound.

The suggestion that monetary conditions are over-expansionary is controversial since broad money supply trends remain sluggish, with the Bank’s favoured measure growing at an annualised rate of only 4% so far in 2009. The impact, however, of supply trends on markets and the wider economy depends on the velocity of circulation of money. Having plunged in 2008 and early 2009, velocity may now be recovering.

Velocity is inversely related to the demand to hold money. A flight from markets as the financial crisis snowballed from late 2007 led to a big increase in money demand but this move is reversing as confidence returns and investors become disenchanted with record-low deposit rates. Despite weak supply growth, therefore, households, firms and institutions may be holding more money than they desire. Their efforts to remove the excess involve an increase in investment in markets and spending in the economy.

The current monetary backdrop echoes conditions between late 2005 and mid 2007 but excess liquidity was then the result of buoyant money supply expansion rather than weak demand. Excess money magnified the credit bubble while causing strong economic growth and, later, a significant inflation overshoot.

This inflationary process, however, was short-circuited when the bubble burst in late 2007. With banks curtailing credit expansion, the money supply slowed sharply while money demand boomed as investors fled risk assets. Excess liquidity in early 2007 was replaced a year later by a deficiency of supply relative to demand. This shortage exacerbated market and economic weakness as households and firms sought to boost cash levels by liquidating investments and cutting spending.

Official support for the banking system and the Bank’s gilt-buying have succeeded in stabilising money supply growth this year while money demand has eased, initially in response to interest rate cuts and more recently as confidence and risk appetite have revived. Several recent developments support the view that excess liquidity is now present.

First, households and companies have been shifting funds out of savings accounts into currency and accounts used for transactions purposes – a typical precursor of increased financial investment or spending. A narrow money measure comprising notes and interest-free current accounts has surged at an annualised rate of 46% so far in 2009.

Another sign of reduced money demand is the strong pick-up in mutual fund inflows, with retail sales of unit trusts and OEICs on course to surpass the 2000 record this year. Institutions have also been putting cash to work, with purchases of securities back up to 2007 levels in the spring quarter.

The deployment of funds by investors has allowed non-financial companies to issue bonds and shares in record amounts, using the proceeds partly to pay down more expensive bank debt. Their liquidity ratio – UK bank deposits divided by loans – has recovered to pre-recession levels, supporting hopes of a revival in business spending.

Higher-than-anticipated cash levels may partly explain markedly more optimistic consumer and business surveys. Consumer confidence has risen by much more in the UK than other major economies, supporting a linkage with the Bank’s unusually aggressive easing.

Finally, while asset prices are influenced by other factors, the strength and breadth of gains are consistent with monetary laxity. In addition to the fall in the pound, recent outperformance of gilts and UK property suggests looser conditions than in other economies.

What are the policy implications? If excess liquidity is present the economy is likely to recover faster than the Bank expects while inflation may continue to overshoot its forecasts, partly owing to renewed sterling weakness. This argues strongly against further easing and suggests that some withdrawal of monetary stimulus may be needed early in 2010 to keep the Bank’s projection for inflation in two years’ time in line with the 2% target.

Calls for a further extension of gilt-buying in November based on weak broad money trends are misguided. It would be unfortunate if officials, having ignored the monetary dimension while the bubble inflated, now place overreliance on broad money numbers when a range of other evidence indicates loose policy. A further monetary boost would risk creating another boom-bust in asset prices and the economy. With sterling already on the ropes, it could also precipitate a full-scale currency crisis.

Purchasing managers' surveys for September were encouraging, with further gains in services output and new business offsetting slippage in the corresponding manufacturing indices. A weighted average of services new business and manufacturing new orders is only slightly below its long-term average, supporting hopes of GDP growth of 2% annualised or more during the second half – see first chart. (The rise in the PMI indicator had been foreshadowed by recent better corporate earnings news – see previous post.)

The suggestion that the recovery is being led by services rather than manufacturing – in contrast to widespread expectations of "rebalancing" to be induced by a plunging exchange rate – is supported by the CBI's quarterly surveys of financial services, business and consumer services and manufacturing. The balance of manufacturing firms expressing greater optimism has recovered to the middle of its historical range but the corresponding balances in the two services surveys are at multi-year highs – second chart.