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Housing Bubbles, House Prices and Interest Rates; The Economist
Topic Started: 26 Apr 2012, 08:54 AM (1,225 Views)
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House prices and interest rates: Keeping it real

Apr 20th 2012, 15:43 by Buttonwood

ONE of the most interesting questions at the moment is why US house prices have corrected back to what looks like fair value, when prices in many European markets have not. In today's FT, Martin Wolf cites Ben Broadbent (now on the monetary policy committee) as citing low real rates as a reason for the continued strength of British prices. This bugs me for two reasons, one practical and one theoretical (which I shall leave to the end of the post for those who care).

The practical reason is, of course, that US real interest rates have fallen too. So why haven't US house prices been buoyed by the same process? Before you give the answer that the US simply built too many houses, you should recall that Spanish and Irish house prices haven't fallen back to fair value* either even though both countries are replete with empty properties.

It also struck me that measures of real rates that take official borrowing costs can be skewed (not least by QE). Homeowners can't borrow at the same rates as governments. So the key measure of real rates is the cost of mortgage finance minus the rate of wage growth. That is shown in these two charts, with the house prices index on a separate axis. As you can see, real rates have plunged in the US to their lowest levels in the last quarter-century, but it hasn't helped the housing market at all.

Posted Image

Indeed, if you take the 24 years covered by the US data and divide them into three, then the average house price gain when real rates were high was greater (at 2.25%) than when real rates were low (1.7%).

In Britain, by contrast, low real rates do seem to have made a difference. They were falling through the long boom, spiked (thanks to low wage growth) in 2009 and then fell again. In the 15 years for which we have data, the third of years in which rates were highest saw average price falls of 1.6% while the third of years where rates were lowest saw average gains of 9.6%.

But this is rather unsatisfactory; why should real rates make so much difference on one side of the Atlantic, but not on the other? There will be more on this next week but let us turn to the theoretical issue.

Low real rates drive asset prices up (say the experts) for the same reason that low yields drive bonds higher. But let us think about this in terms of the simple (ish) example of an inflation-linked bond. Take the 2.5% 2024 issue from the UK government (the numbers are here). The bond's maturity value will be par multiplied by the ratio between the RPI eight months before issue (97.7 in this case) and the same index eight months before maturity. Currently, the RPI is 232.5 so the bond's fair value is around 235% of par. But it trades at 327% of par; in other words, the real yield has fallen and the price has risen. If the RPI does not change from here, investors will suffer a capital loss. Or to put it another way, at maturity, the bond's real yield will have to rise again.

Now there may be many reasons to buy bonds on such a low yield; most notably, pension funds use them to match their liabilities and so are indifferent to price. But one can see a return to the mean is built into the structure of the bond.

But what about real assets like equities and houses? The big argument at the end of the 1990s was that equities deserved higher valuations because real rates were low. Since, in theory, the current price ought to be equal to the discounted value of all future cashflows, then, other things being equal, a fall in the discount rate ought to lead to a rise in prices. But other things aren't equal. Low real interest rates should suggest low expectations for future growth. This is true whether (as now) low rates have been engineered by central banks, or whether it is the result of supply and demand for savings. In the former case, central banks are holding rates low because they are worried about the growth rate; if they are wrong then inflation will quickly emerge (and rates will have to rise). In the second case, low rates would be the result of desired savings being higher than desired investment; there are simply not enough exciting investment projects to go round, which implies low growth.

Just as share prices are the discounted equivalent of future corporate cashflows, then house prices should be the discounted value of future rents. Now rents have rebounded a bit (yields were very low). But it surely isn't plausible that rents can rise rapidly year after year in a low growth environment because how will tenants afford them? In other words, either the Bank of England has got its monetary policy completely wrong or UK house prices are still too high**.

* Fair value assumes that, as in the US or Germany, house prices don't rise in real terms over the long run or that they rise very slowly, say 1% a year.

(**Some of you may have alternative explanations eg population density but this is already a long post and I'm going to try to deal with the issue in next week's column.)

Read more: http://www.economist.com/blogs/buttonwood/2012/04/house-prices-and-interest-rates
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More on house price fundamentals

Apr 23rd 2012, 12:54 by Buttonwood

FOLLOWING the last post, an alert reader points me to this VoxEU article on house prices and interest rates which also uses the idea that the fundamental value of houses is the discounted stream of future rents. The graphs provided by the authors suggest that house prices are still substantially overvalued on this basis in Ireland, Britain and Spain, about right in America and Switzerland and undervalued in Germany.

Rather frustratingly, the authors don't provide a link to the original paper so we can't see the methodology (and I can't find it on the Swiss National Bank website). But from a look at the graphs, it does seem as if they have allowed for the issue raised in the previous post; that one cannot adjust the discount rate, without allowing for what a low discount rate implies for future growth. Clearly, the academics have marked down their assumptions for future rental growth (as well they should, given what's happened to GDP).

Like everything else, house prices are set by supply and demand; but clearly, the supply situation in Ireland and Spain looks completely different from that of Britain. But demand is surely not an exogenous factor. I would suggest there is a three-stage process; more people will want to own their home if prices are rising and that will reinforce the boom; at some point, however, unless lending standards are not completely relaxed, people will be priced out of the market and will have to flat share/live with their parents, and the bubble will pop; at that stage, as prices fall, defaulting borrowers will send more supply into the market until eventually prices are affordable again.

What I suspect may have happened is that the US has moved more quickly to stage three, because of the greater use of foreclosure, and the wider recognition of property losses. In Britain, the number of transactions has plunged because owners have not been forced to recognise their loss; this has artificially restricted supply and propped up prices.

Read more: http://www.economist.com/blogs/buttonwood/2012/04/house-prices-and-interest-rates-0
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Housing bubbles and interest rates

Christian Hott Terhi Jokipii
29 March 2012

Visit Ireland and Spain and you will find row upon row of empty houses – the remnants of a housing boom turned bust. Were low interest rates to blame? This column looks at the effect of a deviation in interest rates from the Taylor rule and finds that keeping interest rates ‘too low’ can explain up to 50% of the overvaluation of the property market in these countries and elsewhere.

In the aftermath of the recent global financial crisis, central banks have been widely criticised for having kept interest rates too low for too long. Several authors have argued that exceptionally low interest rates spurred excessive risk-taking in the banking sector, leading to the build-up of imbalances and finally the crisis (see eg Ciccarelli et al 2011 or Altunbas et al 2010). Since property prices have been shown to play an important role during episodes of financial instability (see among others Goodhart and Hofmann 2007 and Bank for International Settlements 2004), understanding the link between monetary policy stance and the emergence of housing bubbles has become an important and topical issue for policymakers.

Some authors have called for central banks to react to movements in asset prices (Borio and Lowe 2002, Cecchetti et al 2000), while others have shown that using monetary policy to lean against asset-price fluctuations may not be a sensible strategy (Assenmacher-Wesche and Gerlach 2008).

In a recent study (Hott and Jokipii 2012), we analyse the role that monetary policy plays in the emergence of housing bubbles. More precisely, for 14 OECD countries1 we estimate the impact of short-term interest rates that are too low for too long on the emergence of housing bubbles. This article briefly presents our results and main policy conclusions.

Deviations of house prices from their fundamental level

To estimate the effect that monetary policy stance has on the emergence of housing bubbles, we need to define and identify bubble periods. To do this, we compare actual and fundamentally justified house prices.

There are various possibilities to estimate the fundamental value of houses. One way is to look at indicators like the price-to-rent or price-to-(per capita) income. These indicators have some drawbacks. First, they only consider a single factor (eg rent as an indicator for the return or income as an indicator for the affordability) and, second, the relationship between a fundamentally justified price and this single fundamental factor is not necessarily stable (eg because of changing interest rates).

We instead obtain the fundamental value by calibrating a theoretical house price model for each of the 14 OECD countries in our sample. This house price model implies that the fundamental value is given as the sum of future expected imputed rents. Imputed rents, in turn, are assumed to depend positively on GDP (as a measure of demand) and negatively on construction activities (as a measure of supply).

The calibration of the model shows that actual prices fluctuate much more than fundamentally justified. Housing bubbles (meaning positive deviations from the fundamental value) can be observed in many countries around 1990 as well as around 2007. The recent overvaluations were especially strong in the two Eurozone countries Ireland and Spain. By contrast, in Germany, Japan, and Switzerland house prices have remained below their fundamental level since the mid-1990s.

Posted ImageFigure 1.

Deviations of interest rates from their benchmark level

Determining whether monetary policy is ‘too loose’ or ‘too tight’ requires an assessment of whether observed rates deviate from some policy rule or economic model. We adopt the Taylor rule (Taylor 1993) as the benchmark rate from which to assess policy stance. For each country in our sample, we calculate interest-rate deviations by comparing observed short-term interest rates with Taylor-implied rates. We acknowledge the fact that the Taylor rule is not a rule that should necessarily be followed systematically by a central bank taking policy decisions. However, we use the Taylor-implied rates since it is a benchmark rate that can be estimated for a broad sample of countries from which to determine whether monetary policy was generally too tight or too loose.

Relative to the Taylor rule, of the 14 countries in the sample, five (Finland, Ireland, Spain, Switzerland, and the US) have interest rates that have, on average, been too low over the sample period. In Finland, interest rates remained relatively low for much of the 1980s and early 1990s. Since the introduction of the euro in 1999, rates have been consistently too low relative to those implied by the Taylor rule. In Ireland and Spain, observed rates were too low in the early 1980s and similarly to Finland, have remained consistently too low since 1999. In Switzerland and the US, rates were generally too low in the late 1980s and early 1990s and again from the late 1990s.

What is the impact of too-low interest rates on the emergence of housing bubbles?

To assess the impact that deviations of short-term rates from the Taylor-implied rate have on housing bubbles, we use the Seemingly Unrelated Regression methodology.

For most countries, we find that interest-rate deviations have a significantly negative impact on housing overvaluation. The finding provides evidence that interest rates that are too low relative to the Taylor rule are statistically linked to housing bubbles. The relationship is strongest for Ireland where interest-rate deviations explain up to 50% of housing overvaluation. Here, a 1% deviation of interest rates from Taylor-implied rates results in a 7% overvaluation. Ireland is one of the countries that experienced significant variation in the growth of both actual and fundamental house prices. Within the Eurozone the impact of interest-rate deviations on housing bubbles is greatest for Ireland, Finland, and Spain, the three Eurozone countries with the lowest mean interest rate relative to Taylor-implied rates over the sample period. These countries experienced growth of both actual and fundamental house prices that were significantly above the sample average. These findings highlight the difficulties associated with a single policy interest rate that is confronted with a heterogeneous development of house prices.

What if interest rates are too low for too long?

Our findings suggest that rates that are too lowcan lead to emergence of housing bubbles. To assess whether the duration of interest-rate deviations has an additional impact on house price overvaluation, we create additional variables that capture the number of consecutive periods that observed short-term rates are lower than those implied by the Taylor rule.

For each of the 14 countries in the sample, we show that the longer the rates deviate from the Taylor-implied rates, the higher the housing overvaluation. The durationeffectis strongest for Ireland, Spain, Finland, and the US. These are the countries for which we observe the largest average deviation of interest rates from Taylor-implied rates over the sample period. The average R-squared – a measure of the strength of the relationship – increases from around 20% to 35% when we account for the duration of the rate deviation. For Ireland, the length and the extent of the deviation from Taylor-implied rates together account for around 80% of housing overvaluation. For Finland and the Netherlands the corresponding fraction is around 50% and around 20% for Switzerland, Germany, and Norway.

What does this mean for policymakers?

Our analysis has shown that interest rates that are set too low for too long have a significant impact on the creation of housing bubbles. The strong link between deviations of short-term rates from Taylor-implied rates and housing bubbles suggest that in order to lean against house price fluctuations, it is not necessary to consider house prices directly in monetary policy decisions if policymakers set interest rates at levels close to those implied by the Taylor rule.

Our results highlight the additional complexity of maintaining an appropriate policy interest rate for a group of countries like the Eurozone that experience substantial heterogeneity in both the real estate markets as well as in the real economy. As we have seen, Taylor-implied rates as well as the development of house prices differ substantially between some Eurozone countries. Since it is not possible to react to this with a single monetary policy, country-specific measures should be taken to compensate for too low interest rates and in order to avoid a build-up of housing bubbles. This compensation could be achieved, for example, by introducing macroprudential instruments like countercyclical capital requirements for banks, limits for loan-to-income and loan-to-value ratios, or a countercyclical tax treatment of real estate holdings.

Read more: http://www.voxeu.org/index.php?q=node/7799
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