Do the maths - house prices are not as high as we think

One of the condundrums puzzling a lot of people in the market until recently was why, since December 2005, seven successive rate hikes have barely dented the momentum of growth in borrowing. Still running at well over 20 per cent, the rate of mortgage credit expansion has slowed a little, but not by as much as one would expect.

Why not? With inflation at 5 per cent, interest rate hikes have all the force of a speed bump in the face of a tank; that is, little or none at all. As John McCartney, head of research at Lisney, pointed out this week, high inflation rates can change the rules of the interest rate and house price growth game in a very fundamental way.

Ireland's jump in inflation has all but wiped out the impact that European Central Bank interest rates were supposed to have. In 2005 ECB base rates were 2 per cent while inflation was 2.5 per cent. Now ECB base rates are 3.75 per cent and inflation - according to last week's figures - is now running at 5 per cent. This means that in real terms, that is, subtracting the rate of inflation from the rate of interest, interest rates have actually gone down from -0.5 per cent to -1.25 per cent.

It happened before in the late 1990s and early part of this decade, when a wave of inflation hit the Irish economy, sending real rates into negative territory.

To understand the significance of real interest rates, consider the following: imagine you could buy a holiday home for €100,000 today, and let's say this can be funded by borrowing at a rate of 2 per cent.

Or you could save the money and buy with hard cash next year. We ignore the cost of the principal (€100,000) because this is paid either way and concentrate instead on the relative advantages of the two means of purchase.

In terms of the borrowing option, the cost is €2,000 in interest paid next year. But then again, is it? If inflation is 2.5 per cent (and if holiday homes rise in price at the same rate as general inflation), you will end up paying €102,500 for the holiday home if you wait until next year. On top of the cost of waiting a year (in terms of a year not being able to enjoy the property), the cost of waiting exceeds the cost of borrowing.

Even if the ECB ups the interest rate to 3.75 per cent, if inflation gathers pace to 5 per cent the advantage of borrowing and buying now has risen even further. This - in the Irish case - is more or less what has happened.

If borrowing growth is slowing down (and it is, a bit) this has less to do with interest rates and more to do with the fact that much of the market is geared to the hilt, with little more capacity to take on borrowing).

As the interest rate cycle turns down from the middle of next year, domestic inflation should start slowing as well. In fact, inflation should moderate to around 2 per cent next year before rates start coming down, a development that should restore real rates to positive territory.

Inflation is also a benchmark against which to judge house prices. Money is only as good as the goods and services it can buy. Certainly, house prices in Ireland are higher in real terms than in most other EU countries. In nominal (actual price) terms, however, much of our 'higher' house prices reflect the fact that prices generally are higher.

A real house price index - one that adjusted house price growth rates down by the rate of inflation - would show that, in the terms that really matter, house prices haven't grown by as much as we think. That phenomenon has a further blessing: for aspirant younger buyers whose wage rises are linked to inflation, it gives them more of a chance to buy the properties they want.

• Marc Coleman is Economics Editor of The Irish Times