House prices 'may fall 10% next year'

House prices could drop dramatically if Britain's economic growth fails to improve, a forecasting group warned yesterday.

It could lead to an explosion of negative equity - last suffered in the early 1990s - in which homeowners owe mortgage lenders more than their properties are worth.

A deflationary spiral in the economy could see home values fall by nearly ten per cent next year and by 15 per cent in both 2005 and 2006, according to the Ernst & Young ITEM Club.

It said such falls would be extreme though the probability was very low owing to flexibility in Britain's economy and the option of further interest rate cuts.

But it added: 'It is not difficult to see signs of possible deflation.'

While ministers say the country's sustainable growth rate is about 2.75 per cent, the average rate of growth in the past two years has been just 1.8 per cent.

It was particularly weak in the first half of this year, falling to an annual rate of just 0.8 per cent - the weakest since 1992.

However, there are signs the worst of the recent growth dip is over.

Figures from manufacturing and service industries have improved since the spring.

With low interest rates and the pound at a more competitive level, Ernst said there should be a gradual pick-up in the second half of the year.

But economic confidence was still vulnerable. 'Growth could remain stuck at its current sub-par rate for some time yet,' the report added.