The discussion is usually couched in terms of the house price to earnings ratio but – as explained in an earlier post – the rental yield on housing is a superior measure of valuation.

The chart below shows historical National Accounts data on the rental yield together with a current estimate based on prices having fallen 11% from their peak late last year (as suggested by the Halifax index).

The current estimated yield of 3.4% compares with a long-term average of 3.6% – a reasonable estimate of “fair value”. Assuming no change in rents, prices would need to fall a further 6% to bring the yield up to the average. The RICS survey of letting agents released today indicates that rents are still rising so a smaller decline would be possible.

Now suppose the market undershoots to the same extent that it overshot in 2007. The yield got down to 2.9% last year – 70 basis points below the average. A rise to 70 b.p. above the average would take it to 4.3%. This would involve a further 21% fall in prices from current levels, assuming unchanged rents.

The bottom line? A further 10-20% fall in prices would bring them to an attractive level for a long-term owner or investor.

There were glimmers of hope in business and consumer surveys last week. The first of the regional manufacturing surveys released for August – from the New York Fed – reported a significant recovery in expectations for future activity – see first chart. If confirmed by this week’s Philadelphia Fed survey, this could presage an improvement in the national ISM survey over coming months.

Meanwhile, the early August national consumer survey conducted by the University of Michigan showed a further recovery in household perceptions of the housing market: the percentage balance of respondents judging the present to be a good time to buy a home rose to a three-year high – see second chart. However, an increase in mortgage rates following the financial crisis at Fannie Mae / Freddie Mac may delay any impact on activity.

Why does inflation keep overshooting MPC and consensus expectations?

Inflationary pressures often strengthen in the early stages of economic slowdowns, for at least four reasons. First, output is typically above its trend or potential level when the slowdown begins; a fall beneath trend is needed to stem inflation momentum. Secondly, productivity tends to slow along with output, as employers are initially reluctant to cut workforces, implying faster growth in unit labour costs. Thirdly, monetary expansion often remains strong well into an economic downswing; ample liquidity accommodates price increases and may boost inflation expectations. Fourthly, a slowing economy may be associated with a fall in the exchange rate, putting upward pressure on import prices.

All these factors have been at work recently but exchange rate weakness has played a particularly important role in pushing up core inflation and magnifying the domestic impact of rising global food and energy prices.

It is too late for the MPC to influence coming high inflation outcomes, which reflect past policy mistakes. Monetary growth has slowed to a level consistent with inflation returning to target over the medium term, while the effective exchange has stabilised since April. Barring a monetary reacceleration or renewed sterling weakness, the MPC should hold to a stable course despite the obvious damage to its credibility from the current overshoot.

How has the global economy performed so far this year?

Better than might have been expected given the credit crisis and soaring commodity prices. Globally, annual industrial output growth has fallen from 5% last year to 3% in mid-2008 (first chart). So far at least, weakness in the G7 economies has been offset by continued strength in emerging markets. Output growth in the seven largest emerging economies – the E7 – was still running at 9% in mid-2008.

What is your forecast?

I expect global industrial output growth to slow further to 1-2% over coming months as G7 numbers move into negative territory and emerging economies moderate. However, this would still represent a relatively moderate downswing by historical standards – much less severe than 2001, for example. And I think growth will start to recover in late 2008 and into early 2009.

What factors will support global activity?

The US economy is probably past its low point. Last year our probability indicator suggested an evens chance of a recession (second chart). Now it’s saying the risks have receded. The change mainly reflects the Fed’s aggressive policy easing in late 2007 and early 2008. The impact of this policy change should be feeding in by late this year.

What will drive any US recovery?

The stocks cycle – initially at least. Companies have cut stocks to very low levels (third chart), which has been a major drag on the economy. I doubt they will fall further. Even if they simply stabilise, there will be a significant positive impact on growth.

How will that affect other economies?

As US firms stop cutting stocks, import demand will rise, helping to support foreign activity. There is a significant positive correlation between global industrial output growth and the US stocks cycle (fourth chart).

Could high oil prices lead to a harder economic landing?

My forecast assumes they stabilise below the recent peak. The supply / demand balance seems to be shifting as the decline in OECD consumption accelerates. Weaker OECD demand should accommodate rising emerging world consumption, barring any supply shock.

What about emerging economies?

The indicators suggest only a modest slowdown. One reason is that external finances remain strong. Emerging countries continue to pile up foreign exchange reserves. This tends to be associated with loose domestic monetary conditions, which in turn support domestic demand (fifth chart). My forecast assumes E7 industrial output growth eases from 9% to 6-7% by early 2009.

What is the main risk to your forecast?

European weakness. Europe seems to be about a year behind the US in the cycle and is turning down even as the US finds it feet. Recession risk is rising – not just in the UK but in Euroland too. Unlike the US, there is no policy stimulus in the pipeline. Globally, the risk is that a recession in Europe outweighs improvement in the US and emerging market resilience.

Using the raw yield to assess valuation is problematic because rents fluctuate significantly with the economic cycle. A high yield may not indicate that property is cheap if rents have been boosted above a sustainable level by a buoyant economy. Conversely, it may be right to invest when yields are low if rents are below trend and likely to benefit from future strong economic growth.

Based on their long-term relationship with GDP, I estimate rents are about 5% above trend currently – see first chart. There were much greater deviations in the early 1970s and late 1980s, when rents overshot by 30-40%. This implies a normalised or cyclically-adjusted yield of 5.9%.

Any judgement about valuation should also take account of returns on competing assets. The rental yield is often compared with yields on conventional gilts but this is invalid because bond interest is fixed while rents rise with inflation over the long run. In other words, the rental yield should be compared with real not nominal interest rates.

The second chart below updates my comparison of the normalised rental yield with real yields on long-term index-linked gilts. The gap between the two has surged from 3.1% in last year’s second quarter to 5.1% currently – the highest since 1994 and well above a long-term average of 3.6%.

Tight credit conditions and a weakening economy should lead to a further fall in demand for property space and rents are likely to undershoot their trend level over coming quarters. Current valuations already discount much gloom, however.

The swing reflects a combination of: very weak business and consumer surveys; slower M3 growth; a fall in short-term bond yields; and the less hawkish policy statement issued after last month’s meeting. These factors have offset a further slight deterioration in inflation indicators.

The model is consistent with a peak in official rates but it will take several more months of data to confirm this scenario.

During the first half of 2007, Rock accounted for £10 billion of the £54 billion increase in UK net residential mortgage lending. During the first half of this year, UK lending slumped to £30 billion, while Rock borrowers repaid £13 billion. In other words, Rock’s U-turn accounts for £23 billion of the £24 billion fall in UK-wide lending between the first halves of 2007 and 2008.

Rock’s rapid shrinkage has exacerbated the wider mortgage market squeeze, with negative macroeconomic implications. (See Northern Rock: should Sandler slow down?)

Barring a change in policy, Rock’s loan (to be switched to the Treasury from the Bank of England) should continue to fall rapidly during the second half, ending the year well below £10 billion. Mortgage repayments should remain high: documentation on loans within the Granite pool suggests the number of fixed-rate agreements expiring during the second half will be similar to the first six months. Retail deposit inflows should slow but Rock may repay less non-official wholesale borrowing than in the first half.

With the Treasury planning to swap £3 billion of the Bank of England debt for equity, the loan portion of the outstanding balance could be down to £5 billion by year-end.

The transfer of the Rock loan from the Bank of England to the Treasury will have an initial negative impact on the money supply, to the extent that additional gilts issued to finance the transfer are purchased by the UK non-bank private sector, with payment made from existing bank or building society deposits. A £17.5 billion reduction in such deposits would cut broad money M4 by 1.0%.