Higher inflation has the potential to severely hurt the performance of the UK housing market. Although inflation currently stands at just 0.9%, it is forecast to reach almost 3% by 2018. While this is not high by historical standards, it could mean that an interest rate of 0.25% is no longer viable, which may lead the Bank of England to raise interest rates. In turn, this would make mortgages more expensive, which could cause a drop-off in demand for property.
Of course, higher inflation has itself been caused by weak sterling. Following the EU referendum, sterling has become one of the worst performing currencies across the developed world. This makes imports more expensive, and while retailers have done an excellent job thus far of absorbing those higher costs, eventually they are likely to run out of efficiencies they can make At that point, higher prices will become a reality for consumers, thereby increasing the rate of inflation.
Confidence remains high
In addition to higher levels of inflation, the UK economy is also performing much better than was forecast just after the referendum. Of course, Brexit hasn't actually happened yet, but the confidence of consumers and businesses has remained relatively high. This could mean that the Bank of England is less easily able to justify interest rates being at historic lows, especially if inflation moves higher and there is pressure to cool off rapid price rises.
In such a situation, mortgage demand is likely to fall. Although many existing homeowners may have locked in a low rate for the next couple of years, higher mortgage rates will affect housing affordability for first time buyers. They have historically been the driving force behind the housing market and if they are suddenly only able to borrow 80% or 90% of what they can borrow at present due to higher debt servicing costs, it could mean that property prices fall.
The end of a winning streak
Furthermore, the UK property market is hardly cheap at the present time. Although supply is limited, the reality is that houses are almost as expensive relative to incomes as they were just prior to the credit crunch. Therefore, a correction may be required, just as was the case during the credit crunch, in order to bring houses down to a more realistic and justifiable value range. And with stamp duty rises on second homes, a lack of mortgage interest relief for higher earners over the next few years and a potential squeeze on the UK jobs market, a correction may be prolonged.
Already in London house prices have started to fall. It would be unsurprising if this gradually spread throughout the rest of the UK as the full effects of Brexit are felt. Added to the potential for higher inflation and higher interest rates is greater levels of uncertainty from Brexit. When combined with a lack of affordability, this could mean that house prices finally end their winning streak in 2017.
Peter Stephens has no position in any shares mentioned. The Motley Fool UK has no position in any shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.