House prices are starting to overheat but economy has a new thermostat

It is a safe bet that when the latest figures for the monthly rise in house prices are published at the end of this week, the mortgage lenders will insist there is no danger at all of the housing market overheating - whatever the size of the increase in prices.

It is a safe bet that when the latest figures for the monthly rise in house prices are published at the end of this week, the mortgage lenders will insist there is no danger at all of the housing market overheating - whatever the size of the increase in prices.

"Buoyant, but not overheated," Nationwide said last week when it revised up its forecast for house price inflation this year from 8 per cent to 11 per cent.

For that assessment to remain true, however, many economists believe the Monetary Policy Committee might have to nudge interest rates higher still, following September's quarter point rise to 5.25 per cent. For the housing market is one of the classic early warning signals of inflationary pressure in the UK economy, and it is starting to give some cause for concern.

One indicator is simply the pace of increase in house prices. The two measures that catch the headlines regularly are the figures calculated by two big lenders, Nationwide and Halifax. Last week the former reported a 3.2 per cent rise in the national average house price during the third quarter, taking it to a level 9 per cent higher than a year earlier.

A few days earlier Halifax estimated the quarterly rise at 4.3 per cent, the biggest jump since the late 1980s, and a pick-up in the annual rate to 8.8 per cent, likewise the highest for a decade.

These two measures are based on prices in the transactions in which Nationwide and Halifax are lending money. Official figures based on all UK residential property deals, published with a longer delay, show an even more pronounced rise in prices. This index shows house prices have gained almost 45 per cent in six years.

Thanks to rapid increases in the value of houses, another late-1980s phenomenon has returned: mortgage equity withdrawal. This is defined as net lending secured on dwellings less investment in dwellings, where this includes money spent on structural repairs and purchases of newly built housing. Equity withdrawal can occur in a variety of ways - by taking out a secured loan without moving, by borrowing more than strictly needed to move house, by trading down or through inheritance.

According to estimates by Dresdner Kleinwort Benson, the City investment bank, net mortgage equity withdrawal amounted to £1bn in the first quarter of 1999 and more than £2bn in the second quarter. Preliminary data suggest it increased further in the third quarter.

Consumers spend more when they feel wealthy because of gains in asset prices, especially house prices. The household sector's ratio of wealth to income has now also returned to its late 1980s highs.

The extent of equity withdrawal so far has been enough to have boosted consumption growth by 2 per cent a year, compared with actual 4-4.5 per cent spending growth in the first half of this year, if it had all been spent, says DKB economist David Owen.

Of course, it will not have been fully spent, but the calculations do indicate the potential mortgage equity withdrawal has to tip the economy over from buoyancy to overheating.

"Equity withdrawal was one of the principal reasons why economists underestimated the strength of consumer spending in the late 1980s," Mr Owen says.

There is nothing in recent figures to suggest that the nascent housing boom will slow naturally. Lending secured on housing is a third higher than a year ago. House purchase is still very affordable, not least because of the fact that interest rates remain low compared with the recent past. Mortgage payments amount to 18 per cent of earnings on average, well below the 1989 peak of 42 per cent. Unemployment is low and still falling, while average earnings growth is accelerating and well ahead of underlying inflation.

It is true, as all the lenders argue, that the housing market is patchy. London dominates all tables of regional house price increases, with an average year-on-year rise of 20 per cent according to the Halifax figures, 15 per cent according to Nationwide.

And even within regions there can be great contrasts. Bradford has seen an average price rise of 10 per cent in two years, whereas in neighbouring Leeds the increase has been 18 per cent.

However, the same pattern has characterised the early stages of every housing boom. In 1987 some commentators dismissed talk of an impending boom by arguing that all the overheating was in London. It was true - for a while.

In its recent report Nationwide argued that homeowners had not yet forgotten the pain of the early 1990s crash in the housing market. The level of house prices remains well below the late 1980s peak, so there remains less housing equity wealth to withdraw. Tax relief has been chopped back and goes altogether in April, and stamp duty has risen.

"Conditions look a long way removed from the buoyancy experienced through much of the eighties," it concluded.

Mr Owen adds another reason for not being as concerned this time around. That is the generally more favourable inflationary backdrop, a result of structural change in the economy.

He says: "A secured loan to purchase a car from Belgium via e-commerce would not prove domestically as inflationary as one that added directly to excess demand here in the UK." DeAnne Julius, one of the MPC's prominent doves, picked up on this theme in a lecture she gave at the University of Birmingham last week.

She suggested the UK's experience in the 1970s and 1980s was going to prove a poor predictor of growth and inflation during the 1990s. "Firms and households are learning new behavioural patterns in response to the new technologies and competitive pressures facing them," she said.

So, while the housing market is displaying clear signs of being at the beginning of one of its periodic booms, one that might yet require higher interest rates, it is unlikely to prove a repeat of the last boom. On top of structural changes, we do have a firmly pre-emptive Bank of England setting loan rates. The housing market might be starting to overheat, but the economy has a new thermostat.