UK house prices are 6% overvalued, based on a comparison of the national rental yield with its historical average.

The national rental yield is derived 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 – see first chart. The yield averaged 3.6% between 1965 and 2007. (The low value partly reflects the inclusion of subsidised social housing and vacant properties.)

The house price boom pushed the rental yield below 2.8% in the third quarter of 2007, suggesting that prices were overvalued by 30%, based on the 3.6% long-run average. Current prices are 5% lower, according to the index published by the Department of Communities and Local Government, while national accounts rents have risen by 18%. The resulting 3.4% yield implies overvaluation of 6%.

Housing market bears compare house prices with earnings rather than rents. The ratio of the value of the housing stock to household disposable income is 59% above its long-run average – second chart. This average, however, is a misleading guide to "fair value" because the ratio has trended 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.

The national rental yield, by contrast, has fluctuated around a stable long-run level. Rents already incorporate fundamental influences on housing demand and supply. People need to live somewhere – the choice is between buying your own home or renting, not between spending money on housing or retaining income for other purposes.

The current 6% overvaluation does not imply that house prices will fall, for two reasons. First, the deviation can be corrected by rising rents – up by 7% in the year to the first quarter. Secondly, a below-average rental yield may be sustainable as long as nominal and real interest rates remain low, limiting forced selling.

(This is a follow-up to a note in May 2009, which suggested that house prices were bottoming because the rental yield had returned to its long-run average.)

Business activity of smaller manufacturing firms is not being constrained by insufficient credit, according to the July CBI SME trends survey. The accompanying press release states that: "Just 4% of firms cite credit or finance constraints as likely to limit export orders, compared with 12% in the previous quarter. This is now in line with the long-run average. Furthermore, 5% of firms say credit or finance are factors likely to act as a brake on output, also in line with the historic mean."

The SME survey covers firms with fewer than 500 employees. The CBI's survey of larger manufacturers in July, released a fortnight ago, also reported a normalisation of numbers citing credit availability as a constraint on output and exports – see chart.

By contrast, the last Bank of England agents' survey stated that, while bank credit availability had improved, "conditions remained significantly tighter than those prevailing prior to the financial crisis." Possible reasons for the discrepancy are 1) the CBI surveys are more up-to-date, 2) the Bank's survey includes non-manufacturers, which may be experiencing greater problems and 3) the CBI improvement may reflect stronger internal cash-flow generation that has reduced the demand for external finance – credit is probably still difficult to obtain for those firms that need it most.

A post in May last year suggested that the annual rate of change of GDP would turn positive in early 2010 while the Treasury's forecast of 1.25% growth for the year as whole was achievable. This was based on a forecasting model that estimates the annual GDP change three quarters in advance using a range of monetary and financial inputs, including inflation-adjusted broad and narrow money supply growth, companies' liquidity ratio, three-month LIBOR, the yield spread between corporate and government bonds, share prices and the effective exchange rate. The consensus at the time was gloomier, with many economists and journalists embracing the "creditist" view that no meaningful economic recovery was possible without a revival in bank lending to the private sector. The Bank of England was also downbeat: in its May 2009 Inflation Report, the Bank's mean forecast for the annual GDP change in the first quarter of 2010 based on unchanged policies was -1.5%. (This was the infamous Report that also projected a fall in annual consumer price inflation to below 1% while estimating only a 7% probability that inflation would be above 3% in the second quarter of 2010 – the outturn was 3.4%.)

Recent official figures largely validate the predictions of the "monetarist" model. Excluding volatile oil and gas extraction, whole-economy output rose by an annual 0.2% in the first quarter of 2010 and by 2.0% in the second quarter. Assuming that quarterly expansion slows to 0.5% during the second half of the year (and ignoring possible upward revisions to earlier estimates), GDP will increase by 1.6% for 2010 as a whole – comfortably above the Treasury's derided 1.25% forecast. The Office for Budget Responsibility (OBR) displayed little originality in the economic projections underlying its post Budget fiscal analysis – its forecasts of GDP growth of 1.2% and 2.3% respectively in 2010 and 2011 were suspiciously close to consensus numbers of 1.2% and 2.2% reported in the Treasury's June survey of forecasters. Stronger 2010 expansion supports the view that the OBR was too pessimistic in projecting public sector net borrowing of £149 billion in 2010-11, a conclusion also consistent with recent monthly outturns, suggesting a full-year undershoot of at least £10 billion.

Will the recovery be sustained into 2011? While the model is not forecasting a boom, it suggests annual GDP growth of 2%-2.5% in the first half of next year, with the probability of a second recession – in the sense of an annual GDP contraction – rated at less than 10%. Prospects for later in 2011 depend on whether the recent acceleration in broad money supply growth is sustained – if so, full-year GDP expansion should exceed the current 2.1% consensus expectation reported in the Treasury's July survey. The model's other inputs are mostly favourable: narrow money is growing solidly, corporate liquidity is strong outside the beleaguered real estate sector, credit spreads have normalised, the trade-weighted exchange rate is at a competitive level and short-term interest rates, of course, remain at a record low. To the obvious Keynesian criticism that the model omits a direct measure of fiscal policy, the responses are that, first, fiscal effects are captured indirectly via forward-looking market variables (i.e. share prices and credit spreads) and, secondly, the model is able to explain historical growth adequately without including such a measure – see charts.