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Some areas to be upbeat about

Gary Styles, strategy, risk and economics director of Hometrack, identifies the big risks to economic stability in 2008 and comes up with a prognosis for the UK that is not an entirely gloomy one

The outlook for the world economy and interest rates underwent a major shift in the last quarter of 2007, leaving us all uncertain and nervous about the short and medium-term prospects for the economy and markets.

The chancellor’s Budget has shown only a modest downgrade in economic prospects but the major forces driving the economy have shifted markedly.

Chart 1 shows the biggest issues facing the economy and the mortgage market this year. These forces are biased towards the downside but two or three of them combined could have a real impact on the medium-term outlook in the UK.

US prospects
Prospects for the US economy have shifted sharply in the last quarter as the full extent of the housing market and credit crisis has unfolded.

Economists expect outright recession will be avoided in 2008 (defined as two quarters of declining output) although it looks likely to be a close call given the combination of rising inflationary pressures and weakening domestic demand.

The Fed has been quick to cut interest rates and is concentrating on the short-term need for growth rather than focusing too much on inflationary pressures.

Credit supply shortages
The spread between interbank and official policy interest rates has narrowed considerably in most major economies. This is widely seen as a sign of increased confidence but much of this improvement merely reflects the success of coordinated central bank liquidity opera- tions. However, in recent weeks the spread between interbank rates and official rates have started to widen again .

How much of a problem is world inflation?
The governor of the Bank of England and the chancellor believe upward inflationary pressure from world food and energy prices are significant. In the February Inflation Report the Bank went to great lengths to dampen interest rate expectations based on world inflation pressures and concerns that this could translate into a higher wage cost spiral.

Although output price inflation reached 5.7% in February and input price inflation exceeded 19%, wage inflation has remained at 3.8-4.0% for some time. Wage inflation will need to be watched closely around the world as the time lag from higher goods price inflation feeds into wages and other costs.

The risk facing the world economy is that central banks accommodate any rise in world inflation and this could lead to stagflation. For example, in China inflation has reached a 12-year high of 8.7% and this will quickly affect imported costs around the world. But the impressive co-ordination shown by central banks this time makes it more likely rapidly rising oil prices and food prices will be managed without too much interest rate and exchange rate volatility.

Localised housing and mortgage weakness
Many lenders are taking comfort from the initial assessment that the overall market will experience a soft landing in house price terms in 2008. But the overall picture is likely to disguise a wide spread of outcomes for price and transaction volumes across sectors and regions.

Localised and sectoral falls in demand could result in house prices for certain types of property falling 10% or more. These localised limited falls can translate into significantly higher levels of arrears and losses for lenders. Maintaining consumer and business confidence is vital as increased price volatility is inevitable as volumes slow.

Declining lender appetite for risk
The credit crunch has resulted in lenders reducing their exposure to perceived higher risk markets in the corporate and retail sectors. We estimate that mortgage lending growth is probably 5-10% lower as a result of reduced risk appetite and score tightening.

It is easy to review the risks in 2008 and arrive at a fairly gloomy prognosis. However, there are several areas to be upbeat about. Structural and regime shifts in the market quite often speed up existing adjustment processes and put the economy on a more sustainable path.

Housing and mortgage volumes are not as weak as many reports indicate and in January both remortgage and house purchase volumes rose.

More modest consumer spending growth and less reliance on house price inflation can only be a good thing for the UK economy. A strong economy built around corporate and business investment rather than rapid household spending should be welcomed by us all.

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