The news from the UK housing market is looking increasingly gloomy. Measures of housing activity are down. Prices have started to fall again and it looks like they are going to nosedive. Sorry to be the harbinger of bad news.

The coalition government's austerity package of cuts and tax rises has decimated consumer confidence. It hasn't helped that ministers have talked the economy down, which has scared people. It's no time to buy a house if you think you might lose your job. Wage growth is anaemic across all sectors. Presumably, if large numbers of workers are fired in a town, that would be bad for local house prices. And credit availability is down. Over-exuberance in lending has been replaced by under-exuberance. None of this looks good for house prices.

According to the property website Rightmove, asking prices this week recorded their biggest monthly fall in three years. New sellers cut their prices by 3.2% in November. Nine out of 10 regions in England and Wales experienced falling prices. The Royal Institution of Chartered Surveyors housing market measure for November fell to an 18-month low. A recent survey by the Home Builders Federation found that the number of deposits on new homes and of site visits have dropped sharply.

The Nationwide House Price Index fell in October to the lowest level in eight months, and is 11% below the peak reached in 2007. The Halifax index shows prices are down 17% from 2007.

The house price to earnings ratio, which is the best measure of affordability, using the Halifax data, stands at 4.5, down from a high of 5.8 in July 2007. As wages rise in an area, this tends to push up house prices; banker's bonuses in the City push up prices in surrounding areas. The average of this series was 3.6 from 1983-2002, before the surge in prices. So for house prices to return to their long-term average, they have approximately 20% to fall.

In most recessions homeowners struggle because interest rates rise and this is devastating for those on variable rate/tracker mortgages, whose payments rise. This time interest rates have remained low, but when rates rise that would change fast in the recovery – and then prices would inevitably fall.

Cutting housing benefits, as the coalition government is proposing, could potentially lower rental prices, which in turn could also lower house prices. If house prices were to fall by another 20% that would leave about 4m households in negative equity – and an average of £100,000 a person would not seem a crazy estimate of the average per capita loss. In the US, homeowners are not responsible for such losses and can resort to what is called jingle mail. They put the keys to the house in an envelope and post them to the bank. The federal government has had to step in to rescue the banks with all these bum loans.

In the UK there is no jingle mail, and the mortgage holder is responsible for any loss if they default. To minimise disruption in the short-term, many banks would probably renegotiate loans to interest payments only. But that is not a permanent fix. Homeowners with negative equity would find it difficult to move, so the mobility of the UK's labour force would fall and unemployment would rise. This would give opportunities to workers from the EU accession countries, who are highly mobile.

One possibility would be for the Bank of England to step in and buy mortgage-backed securities to the tune of £400bn (4m loans of £100,000). This is the basis for the idea from Danny Gabay of Fathom Consulting that the government set up a bank to purchase the mortgages of these "zombie households".

But there is a better way – five or six years of 5% inflation does the job nicely. That way we get to inflate our debt away and we don't have to go through all this austerity nonsense. In the long run, interest rates need to rise back to some normal level – say 4% – so that when the next shock comes the Bank of England can cut rates. For now, interest rates have to stay at 1% or lower until at least 2015, which hopefully will create some inflation. And more quantitative easing would help, as that adds more stimulus to the economy – which is positive for house prices.

Today's data release of 3.2% for the consumer price index overstates inflation: if VAT increases are stripped out, the rate is 1.4% and it still excludes house prices, which would lower inflation further. Eventually, rates can rise, but not for ages. Inflation good, unemployment bad. Inflation looks like the homeowner's saviour. All the other alternatives look worse.

