George Osborne is to give the Bank of England sweeping new powers to control the size of mortgages, as the Bank governor warns that interest rates are likely to rise before Christmas.

Amid fears that rapidly rising house prices risk becoming a bubble that would threaten Britain's economic recovery, the mortgage control measures will give Threadneedle Street the ability to impose direct curbs on the property market for the first time since the deregulation of the 1980s abolished queues for home loans.

The moves by the Treasury to limit the amount of money people can borrow are an attempt to avoid damaging the entire economy with an increase in interest rates – something the governor of the Bank, Mark Carney, warned on Thursday could happen before the end of the year.

Carney said: "There's already great speculation about the exact timing of the first rate hike and this decision is becoming more balanced. It could happen sooner than markets currently expect."

The City expects the first increase in official borrowing costs since 2007 to take place early next year.

The new powers, which Osborne intends to push through parliament before next year's election, were rejected as too draconian two years ago when the Treasury was deciding on the weapons needed by the Bank to prevent surges in asset prices causing financial crises.

But the rapid recovery in the property market – especially in London, where price increases have averaged 18% over the last year – has forced a rethink, with Osborne convinced that the Bank should have a full range of alternatives to higher interest rates as a way of cooling down the housing market.

Speaking at Mansion House in the City, the chancellor said: "I want to make sure that the Bank of England has all the weapons it needs to guard against risks in the housing market. I want to protect those who own homes, protect those who aspire to own a home, and protect the millions who suffer when boom turns to bust. So today, I am giving the Bank new powers over mortgages, including over the size of mortgage loans as a share of family incomes or the value of the house."

He also announced a fresh attempt to reform the planning system in order to increase the number of homes built on brownfield sites. Osborne believes Britain's property booms are caused by the fall in supply of new homes from 400,000 a year in the 1960s to little more than 100,000 a year. In the short term, however, he feels the Bank must have the tools to control credit in the way it did in the three decades after the second world war.

Until now, the Bank's new financial policy committee has merely had the power to recommend actions to banks and building societies, but it will now be able to directly limit the size of a mortgage in relation to the value of a home or the size of a potential homebuyer's income.

Neither the Treasury nor the Bank think there is an imminent risk of a property bubble but both are concerned about the potential for the property market – which has been through three boom-bust cycles since the early 1970s – to cause havoc once again with an economy that has only just returned to the levels of national output seen before the recession began in 2008.

Osborne said: "Does the housing market pose an immediate threat to financial stability today? No, it doesn't. Could it in the future? Yes, it could, especially if we don't learn the lessons of the past. So we act now to insure ourselves against future problems before they can materialise."

The chancellor said that it would be up to the Bank to decide on the precise caps on loan-to-income and loan-to-value ratios should they be needed. Treasury sources said Vince Cable, the business secretary, was not speaking for the government when he said mortgages should be capped at not more than 3.5 times an applicant's income.

Osborne said: "It's important that decisions to use these powerful tools are made independently of politics by the Bank of England. We saw from the last crisis the dangerous temptations for politicians to leave the punch bowl where it is and keep the party going on too long.

"Just in case there is any doubt I say today, very clearly: the Bank of England should not hesitate to use these new powers if they think it necessary to protect financial stability."

Carney welcomed the Bank's new powers. He said economic currents were flowing swiftly, with growth running at 4% a year and jobs being added at a record pace. "But there are rapids ahead, with old imbalances persisting and new ones emerging. The economy is still over-levered. The housing market is showing the potential to overheat. And the current account deficit is now at a record level."

Ed Balls, the shadow chancellor, said the government was still not addressing the fact that it was a shortage of homes that was driving up prices.

"George Osborne is still failing to tackle the root cause of the housing crisis which is that we are not building enough homes to match rising demand. Under this government housebuilding has reached the lowest peacetime levels since the 1920s," he said.

"The danger of the chancellor's failure to act on housing supply is that we see a premature rise in interest rates to rein in the housing market, which ends up hitting millions of families and businesses."

The moves announced by the chancellor will apply to the Help to Buy scheme, a decision that may result in the maximum size of a subsidised mortgage being cut from the current £600,000. Although the Bank may get criticism for denying people a foot on the property ladder, Osborne said he had no qualms about his decision.

"If the Bank of England thinks some borrowers are being offered excessive amounts of debt, they can limit the proportion of high loan-to-income mortgages each bank can lend, or even ban all new lending above a specific loan-to-income ratio. And if they really think a dangerous housing bubble is developing, they will be able to impose similar caps on loan-to-value ratios – as they do in places like Hong Kong."

Campbell Robb, chief executive of housing charity Shelter, said: "We welcome the chancellor's plans to curb risky mortgages and use brownfield land to its full potential to build more homes. Measures to rein in easy lending must go hand in hand with bold house building plans to help stabilise house prices and make rents and mortgages more affordable. But it's crucial that genuinely affordable homes are put at the heart of these plans."