Chancellor’s forecasts for housing market activity and trade balance look optimistic

The Office for Budget Responsibility (OBR) updated their macroeconomic forecast today. The outlook remains one of continued moderate output growth (marginally below 2½ per cent per annum) and is very similar to the forecast that we produced earlier this month. Figure 1 plots both forecasts together, along with a fan chart that summarizes the uncertainty around NIESR’s forecast, highlighting the lack of discernible difference between the two forecasts.

Figure 1

A sustained revival in productivity growth underpins both forecasts, with the OBR’s being the more optimistic, allowing real consumer wages to regain recent peaks within the next five years (2018-2019 in the case of the OBR and 2020 in the case of NIESR). In both cases the rising standard of living is not mirrored by improvements in housing affordability, as the house price to earnings ratio is expected to remain high by historic standards.[1]

Figure 2: House price to earnings ratio (per cent)

One of the UK’s domestic imbalances stems from the accumulated debt of the household sector. The forecasts of NIESR and the OBR show a substantial difference in the expected path of the household debt to income ratio. Figure 3 plots the historical evolution and forecast of the debt to income ratio for the G7 countries and includes both the OBR’s forecast for the UK and NIESR’s forecasts for the G7.

Figure 3: Household debt to income ratio

At present, the UK’s debt to income ratio is second to Canada. Under the OBR forecast, the UK’s ratio will by 2020 become almost equal to Canada’s, whereas under NIESR’s forecast the debt to income ratio will stay broadly constant. Around a third of the difference in the forecasts is explained by a stronger projected income path in NIESR’s forecast, but given our similar views about the projected evolution of house prices, the remaining difference most likely comes from the OBR’s expectation of a gradual resumption in housing market activity. Compared to the July OBR forecast, residential transactions are no longer predicted to return to the historical average. This is partly explained by the higher rates of stamp duty on purchases of additional properties announced today. Together with housing affordability, the view of the UK housing market as a risk to financial stability and the increasing active use of macroprudential policy to subdue the froth in the market and a tightening of monetary policy could well combine to depress housing market activity relative to what the OBR assumes.

The magnitude of the current account deficit is a further indicator of an unbalanced economy that attracts significant attention. The recent sharp deterioration in the current account is not due to the trade balance, but is rather due to a rapid switch from surplus to deficit on the primary income balance. As Lane (2015)[2] suggests, this may be due to financial engineering, such as an increase in the number of UK firms relocating their headquarters to a foreign country, leading to a sudden increase in foreign direct investment liabilities. The locations of economic activity remain unchanged, but the current account and net investment data show a deterioration. If this is the case, resolving this accounting issue would reverse the position of the primary income balance. Accordingly, NIESR assumes that this deterioration is transitory.

The OBR forecasts the deficit on the trade balance to shrink gradually, while NIESR is expecting it to widen over the next few years before starting to shrink. Both NIESR and the OBR expect the transfers component of the current account to remain fairly constant over the forecast horizon and the primary income balance to recover, with a more rapid recovery expected by NIESR. A downside risk to both of our forecasts is that the deterioration of the primary income balance turns out to be structural rather than transitory.  

Figure 4: Current account balance

 

[1] Different measures of house prices give different estimates of the price of the average dwelling. We use the ONS measure in the calculation reported in figure 2. Both the Halifax and Nationwide would report levels of the ratio (using the same average earnings metric as in figure 2) around a third lower. A high level by historical standards and a recent upward trend would still be present, though the pre-recession peak are not yet regained with these two measures.

[2] Lane, P. (2015), 'A financial perspective on the UK current account deficit', National Institute Economic Review, 231 November, pp F67-F72. Available at: http://ner.sagepub.com/content/234/1/F67.full.pdf+html

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