The housing market is likely to be "highly sensitive" to any significant interest rate changes, according to a new research paper from the Central Bank.

It also warns that further strong house price rises would "almost certainly" result in overvaluation in the market.

The paper, by Mr Kieran McQuinn, says that given the low level of interest rates since the introduction of the euro, house prices - though at "historically dizzy heights" - are not out of kilter with the ability of borrowers to sustain repayments.

This conclusion is in line with other recent research. However, Mr McQuinn warns that this does not mean that the market is "impervious to a serious correction in the future," which would be highly disruptive to the economy.

House prices are very responsive to movements in disposable income, according to Mr McQuinn's paper A Model of the Irish Housing Sector.* Any slowdown in the rate of income growth - which would happen if overall economic growth slowed sharply - "would have a depressing effect on house price growth or even the levels of prices themselves".

Low interest rates have allowed purchasers to pay ever higher house prices, according to the paper. "However, any persistent upward movements in interest rates would greatly affect this affordability, placing resultant pressure on prices."

The paper makes no prediction of the likely interest rate trend, however analysts expect the ECB to start to increase borrowing costs either later this year or early in 2005. With interest rates at the low point of the cycle, "further strong increases in house prices (double digit) would almost certainly result in overvaluation in the property market".

Initial examination of the housing market would suggest that prices have diverged worryingly from their appropriate long-term value, according to the paper. However, allowing for the lower interest rate environment since we joined the euro, analysis "suggests that long-run values are not out of kilter with the ability of the general public to sustain mortgage repayments".

House prices at the end of 2002 were "in line with their long-run equilibrium values," according to the analysis, and affordability indicators suggest that most borrowers can meet repayments comfortably.

House price increases are likely to slow in the years ahead, the paper says. However, a key factor will be how the construction sector reacts, with a risk that the market could be depressed if house building does not slow in line with easing demand.

*Full text available at www.centralbank.ie