Source: Deloitte’s Monday Briefing 13/04/15

Consumer spending has long been a motor of UK economic activity. Growth in consumer spending easily outpaced activity in the rest of the economy in the decades before the financial crisis. From 51% of GDP in 1977, consumer spending rose to account for 67% of GDP by 2009.

The long consumer boom was associated with declining levels of savings, rising indebtedness, buoyant house prices – and widespread concern about the unbalanced nature of activity.

During the financial crisis consumers shunned debt and saved more. Real wages saw the longest and sharpest fall since Victorian times. The consumer sector lagged behind the rest of the economy.

Today things are looking up for consumers.

Real incomes are recovering, helped by an upward drift in earnings and sharply lower food and energy prices. Inflation dropped from 1.3% in October to a record low of 0.0% in February. Coupled with good job growth, rising incomes have helped consumer spending to outpace activity in the wider economy in the last year. Consumers are more optimistic about their own finances, and more willing to make big purchases, than at any time since the financial crisis struck in 2008. Last month car sales reached a March peak, up 6.0% on a year earlier. This year consumer spending is likely to grow at the fastest rate in ten years.

When UK consumers start spending the housing market generally joins in. Yet this time housing activity has flagged as spending has accelerated. In February sales of residential property were 8% lower than a year earlier.

A tightening of mortgage regulation by the Bank of England seems to have played a big role in dampening housing activity.

In 2013 the Bank removed mortgages from the Funding for Lending Scheme which was originally designed to boost lending to consumers and to companies. Last April the Mortgage Market Review came into effect, putting additional checks on mortgage lending and, for some buyers, limiting the availability of mortgages. And, in June, the Bank of England’s Financial Policy Committee issued new rules restricting the availability of high loan-to-value mortgages and requiring lenders to “stress test” borrowers’ ability to repay loans if mortgage rates rise.

These changes have squeezed mortgage supply, a process that has been reinforced by deteriorating housing affordability.

According to the Nationwide building society, the ratio of house prices to first time buyers’ incomes rose from a low of 4.1 in 2009 to 5.0 at the end of last year, not far off the peak of 5.4 seen in 2007. In London the house-price-to-income ratio stands at an all-time high of nine.

Pricier housing and tighter rules for mortgage borrowing have deterred would-be borrowers. The Bank of England credit conditions survey shows that over the last three quarters consumer demand for mortgages fell more quickly than during the crash in 2008.

This has created an unusual two-tier consumer economy.

On the one hand rising spending power and lower unemployment have driven a recovery in consumer spending. Meanwhile housing activity has been crimped by tighter mortgage regulation and concerns about housing affordability. The fact that in the last year unsecured consumer credit has expanded by 8.0% while mortgage borrowing rose by just 1.8% highlights the divide.

The Bank of England is probably pretty happy with this outcome. Last summer the housing market was heading into boom territory. A cooling housing market represents a success for financial regulation and removes one of the main reasons for early interest rate rises. With the consumer accounting for two thirds of GDP the Bank needs consumers to spend to grow the economy. After a long squeeze on households a recovery in consumer spending is probably seen by the Bank as being preferable to another debt-driven housing boom.

So where does the housing market go from here? It is hard to see the Bank of England easing mortgage regulation in a hurry. Meanwhile the General Election has created new uncertainties and the possibility of tax rises for those on higher incomes and those with the most expensive houses.

Housing activity should get a boost from a recovery in real incomes and from lower fixed rate mortgage deals. Interest rates on two year mortgages have fallen to an all-time low of just under 2.0% according to the Bank of England. However, the standard variable rate, which applies to those at the end of special or fixed mortgage deals, has crept up and, on average, stands at around 4.5%. Around half of all mortgages are SVR. The obvious solution is to switch to a lower, fixed-rate mortgage deal. But for some, at least, tougher regulations make that difficult or impossible.

Over the last year house prices have risen by 8.1% according to the Nationwide building society. Our guess is that house price inflation will soften somewhat further, rising by around 6% in 2015 as a whole.