Data on new orders suggest that output is likely to fall sharply in the first quarter of 2009 as well as in Q4 of last year; further declines in output, if not at the same pace, are likely beyond then. The widening margin of spare capacity will act as a significant drag on costs and prices. Coupled with the deflationary impact of falling commodity prices and the cut in VAT, CPI inflation will continue falling over the year and may go well below the target rate of 2% despite the impact of sterling’s depreciation on import prices. With its inclusion of mortgage interest and other housing costs, the change in the RPI is expected to turn negative. The downturn itself has set powerful contractionary forces to work. Over-indebted households and companies will be pulling back on spending to try and pay down those debts. Although the recent falls in commodity prices will help to mitigate some of the downward pressure on household income, rising unemployment is not only constraining the spending of those losing or not finding jobs but is likely to boost precautionary saving across the household sector. And falling property prices are reducing activity in the housing market and the construction sector. With credit hard to come by, companies will find it difficult to fund new investment projects and few companies would be likely to invest large sums of money even if they could raise the funds. Commercial property prices are still falling rapidly.
Conventional mortgage rates have dropped from around 6 percent in early 2004 to around 5 percent recently. Other factors could also be raising housing’s fundamental value. For example, recent changes in tax laws may be having an effect. In 1998, tax rates on capital gains were lowered and the exemption from capital gains taxation for housing was raised to $ Both of these changes would reduce the potential tax bite from selling one home and buying another. Another development, which may be making housing more like an investment vehicle, is that it’s now easier and cheaper to get at the equity—either through refinancing, which has become a less costly process, or through an equity line of credit. Both of these innovations in mortgage markets make the funds invested in houses more liquid. So there are good reasons to think that fundamental factors have played a role in the unusually high price-to-rent ratio. But the bottom line here is fuzzy. It’s very hard to say how big a role these factors have played, so we don’t know how much remains unexplained. Frankly, even the best available estimates are imprecise, and they don’t definitively answer the question: Is there a bubble, and if there is, how large is it? Given this uncertainty, my focus as a monetary policymaker is on trying to understand what kind of risks a drop in house prices would pose for the economy. One of the classic ways to do this is to ask “What if…?”—in other words, to pose a purely hypothetical question.