Economics/Cliff Taylor: Rates may be rising in the US and UK, but the sluggish euro zone is happy to maintain the status quo

It didn't take long. Just a couple of hours after the US Federal Reserve Board increased interest rates, the text message arrived. "But what 2 do about the mortgage?" it said. A friend with a hefty mortgage wanted to know whether to stay variable or opt for a fixed interest rate now that the cycle was turning upwards.

Not all mortgage-holders will be quite so attuned to the movement of international markets. However, in the months ahead, US and UK rates will continue to head higher and speculation will build on when Europe will follow (the first half of next year is the common view among analysts for the timing of the first European Central Bank increase). But will this drumbeat of higher interest rates be enough to give housebuyers serious pause for thought? Will the Central Bank warnings earlier this week alert the market to the risk of higher repayments and thus slow borrowing and hold back property prices?

Not likely, or not over the next couple of months anyway. We are left with property prices among the highest in Europe, but still clipping ahead at 12 per cent plus per annum, and mortgage borrowing continuing to rise at an annual rate of 27 per cent plus. Property prices cannot continue to rise at this rate indefinitely and the rate at which lending is rising is clearly unsustainable, but the question remains: what is going to stop it all?

Traditional theory would suggest that a "shock" would be required to cause a property crash. The typical culprits would be rising unemployment or high interest rates. Mortgage interest rates rose by four percentage points in the UK in 1988-89 and rose as high as 18.5 per cent by early 1990. Even though this was a time of generally higher rates, it is hardly surprising that increases of this magnitude triggered a major crash in property prices and an infamous period of "negative equity", when outstanding mortgages were higher than the value of the property.

In the UK, the property market led the way to a generalised economic downturn. However, in Boston in the late 1980s, problems in the wider economy triggered the property market collapse. The Massachusetts economy had stormed ahead in the early to mid-1980s, driven by the success of parts of the tech sector, particularly Digital Equipment's mincomputers (remember them?) and by a rise in federal defence spending, which benefited many of the regions big employers. Unemployment fell as low as 2.3 per cent at one stage and house prices doubled between 1983 and 1987. But a move in the tech market away from mini computers towards the PC and a post-Reagan cutback in defence spending sent the economy into reverse and shot unemployment to almost 10 per cent by early 1988.

Suddenly, the property market was massively over-supplied, confidence was hit, financial institutions were in trouble and prices collapsed.

Have either of the London or Boston crashes got lessons for Ireland? Both do show that when the property market does turn, it can do so very quickly. House prices in London, for example, rose by 22 per cent in 1988, but by early 1989 they were starting to slip quarter on quarter and by 1990 the annual drop accelerated to almost 6 per cent.

The change , of course, reflected a reverse in confidence. Buyers had purchased on the basis that property values could only go one way, leading to prices overshooting any kind of reasonable level. As higher rates (in the case of the UK) or a big rise in unemployment (in the case of Boston) undermined this confidence, prices quickly fell as the expectations of buyers sharply reversed.

However, both these markets had an obvious catalysts for a collapse. Here, there is no clear pin on the horizon to burst the bubble.

Take interest rates. ECB rates are now in a trough, but increases should be gradual. Most analysts believe that the first increase from the existing level of 2 per cent will not come until the first quarter of 2005 at the earliest. Even then, increases should be gradual. A fairly average forecast would be for rates to increase by around 0.5 to 0.75 of a percentage point next year and perhaps by a further 1 - 1.25 points in 2006. This could bring base rates to 4 per cent and lead to a two-point rise for mortgage borrowers. Not pleasant for those with large loans but hardly enough to precipitate a crash.

Nor does there appear much danger that interest rates will rise more dramatically. If anything, in fact, the latest economic evidence indicates that the big euro-zone economies are still very sluggish and it is not beyond the bounds of possibility that rates will not rise until well into next year. Much will depend on the ECB's view on inflationary expectations, but growth trends in most euro-zone economies at the moment do not look anywhere near vigorous enough to fuel inflation, though higher oil prices could have an impact.

Whatever way you stack it up, three-year mortgage rates now on offer of 4 per cent or higher don't look like a particularly attractive bet (text messager take note). There is no sign, either, of a generalised economic downturn triggering a rise in unemployment. In fact, growth estimates are being revised up and the jobs market looks healthy.

Which brings us back to fundamentals. Housing demand is shooting up, with 69,000 completions last year set to be well exceeded in 2004. Meanwhile, the buy-to-let market looks vulnerable, with rents falling and vacancy terms appearing to increase. Could we see some big complexes with a host of apartments for sale and prices dropping?

Parts of the market look vulnerable, but where is the shock that will trigger a downturn? Nowhere in sight. This market has to slow somehow and maybe it can be a softish landing. But the longer the price and borrowing boom continues, the greater the vulnerability over the next few years.