Gravity might pull property down to earth

The threat of inflation looms large across the economic landscape but price rises may not be universal. One major asset - residential property - may become deflationary, warns Stuart Langridge.

Recent pronouncements from central banks suggest that inflation has fallen. However, closer inspection suggests that these falls might only be very temporary, or purely statistical, at best.

With news of stock exchange prices showing increased volatility, funds closing, banks wobbling and central banks stepping into the money markets, it has been easy to miss other developments. The price of US light crude oil has recently passed $81 per barrel, helped by the recent cut in US interest rates. The news from America is of advanced shutdowns of oil platforms in preparation for an expected tropical storm in the Gulf of Mexico.

Recent droughts in China and Australia have caused wheat prices to surge and are threatening either higher prices for basic foodstuffs or large-scale shortages - depending upon which part of the world you live in. In Italy there have been protests from consumer associations that the price of pasta has increased by 30% because of the surge in grain prices.

A quick glance at the price charts shows that many other commodities are rising. Nickel, tin, lead and gold - while they may not seem to be quite as important as food and oil - have all been going up. A recent commodity-price index in The Economist shows that its ‘All items’ Euro index was up by 9.9% for the year to 4 September.

The price of that other essential cost of life - shelter - is less certain. Happily for many, price rises seem to have slowed and in some parts of Europe there have even been some price falls, but with the real cost of everyday life to citizen still rising fast and wage increases often linked to an increasingly out-of-touch inflation statistic, it is perhaps unsurprising that there may be less money available for housing.

In a period of higher inflation - which we must surely be in - it seems right to expect the prices of most assets to rise. As money becomes less valuable, the assets which can be purchased cost more.

While this theory will probably hold true for many types of real goods - such as oil and food - it may not be the case for residential house prices.

This can largely be put down to the massive price rises that have already occurred in many EU markets. There has to be a natural limit to the price of property. It might be supposed that this limit should come when people are not prepared to pay more to buy their own home, but it does not and has not happened that way.

The limit could come when first-time buyers can no longer afford an initial deposit for their first property. Yet experience shows that other sources such as credit cards, personal loans and parents can be used to find the money.

It might make sense that the limit comes when banks are no longer prepared to lend money to purchase, but since mortgage lending is such a large and profitable part of their business model, there will always be moves to help people borrow ever greater sums. Back in November 2006, Abbey, the UK’s second largest mortgage lender, announced that it was prepared to lend up to five times annual income to its best borrowers. Even in the current uncertainty facing global markets, Abbey announced the launch of a new scheme offering 125% loan to property value.

Instead, the natural limit to house prices will come when the general public can afford to pay no more in monthly mortgage repayments. Clearly, this depends not only on the housing market, but on all the other monthly expenses that make up a household’s budget. As the cost of running a car, heating a home, feeding a family, paying the interest bill on credit cards and so much more keep rising, the limit at which people can maintain a mortgage payment nears.

When this happens, it is quite possible that our most important individual asset may not continue to rise inexorably. Since economists believe that some European housing markets have overshot their equilibrium on the way up by quite a margin, it would seem reasonable to suggest that significant price falls are to come.

• Stuart Langridge holds UK qualifications in personal finance.

The threat of inflation looms large across the economic landscape but price rises may not be universal. One major asset - residential property - may become deflationary, warns Stuart Langridge.