IMF: 7 Questions About House Price Cycles

IMF: 7 Questions About House Price Cycles
Question 1: What are the broad features of house price cycles?
Between 1970 and the mid-1990s, on average across OECD countries, the median upturn in house prices lasted four years and the median real increase in prices over the course of the upturn was 33 percent (see figures). The median downturn also lasted four years, during which time prices fell 20 percent.
Question 2: Are we near the trough of the present housing cycle?
The present housing cycle started in the mid-1990s and early-2000s for most countries. The median upturn in this most recent cycle lasted over twice as long as those in the past (41 quarters compared to 16 quarters) and was more pronounced, with prices rising nearly three times as much as in the past cycles. The median ongoing downturn is approaching the halfway mark in terms of duration and amplitude of price declines, which suggests that further corrections could be in the offing. And with prices having risen much more sharply than in earlier upturns, the declines in prices might also eclipse those observed that were in the past.
Question 3: What anchors house prices in the long run?
Economic theory asserts that house prices, rents, and incomes should move in tandem over the long run. House prices and rents should be cointegrated because buying and renting are alternate ways of meeting the need for shelter (Poterba, 1984). Likewise, in the long run, house prices cannot get too far out of line with people’s ability to afford houses, that is, with their incomes.
Question 4: What factors amplify the response of house prices to fundamentals?
A number of explanations have been advanced: (1) supply constraints; (2) interactions between housing and other financial markets; and (3) slow recognition of changes in fundamentals.
Supply constraints. The difficulties of adjusting the supply of housing to keep pace with demand forces provides one explanation for the amplified response of house prices to fundamentals. Strong economic growth is often concentrated in particular sectors, regions or cities. Thus there are geographical constraints on increasing the supply of housing to keep pace with the increased economic activity in these areas. Due to such constraints, even fairly predictable and slow-moving demand-side changes, such as demographic changes, often end up having an amplified effect on house prices.
Interactions with other financial markets. Another reason for the amplification effect lies in the interaction between housing markets and other financial markets. Igan and others (2009) document the overlap of housing and credit cycles. An increase in house prices, whether driven by demand momentum or the effects of government policies or institutional changes, can have a collateral feedback effect: once collateral values increase, lenders are willing to lend even more to households, feeding the house price boom.
Misperceptions of fundamentals. Kahn’s (2008, 2009) work suggests that house prices can be driven by expectations of fundamentals that may turn out to be incorrect, giving the impression ex post that house prices were responding in an amplified manner to the true fundamentals. Kahn argues that the surge in home prices from the mid-1990s to 2007 was based on the belief that productivity growth would lead to continued growth in incomes.
Question 5: What role do behavioral factors play in driving house price cycles?
Case and Shiller (2003) illustrate how house prices could be driven by psychological and sociological factors, and that these factors can also amplify the response of house prices to fundamentals. They argue that expectations of house prices are often formed by incorrect social perceptions of reality—such as the perception that house prices never fall—and by excessive confidence in positive outcomes. .
Baker (2002 noted presciently that the housing boom would come to an end because it was being driven to a large degree simply by the expectation of higher prices in the future.
Question 6: Are house price cycles correlated across countries?
Housing is often considered the quintessential nontradable good, which generates a presumption that housing cycles ought not to be very correlated across countries. Nevertheless, the IMF (2004) and Girouard and others (2006) found high synchronization in housing cycles across countries. The conventional wisdom is that this does not reflect direct real estate market linkages, as in the case of equity markets, but rather the synchronization of monetary policy and financial deregulation across countries. It could also reflect general business-cycle linkages; globalization and financial innovation appear to have strengthened the degree of synchronization in macroeconomic and financial cycles, at least among OECD countries.
Question 7: Should monetary policy keep house price cycles in check?
Some authors maintain that deviations from the simple rule for how monetary policy should react to output and inflation—the so-called Taylor Rule—led over the period from 2002 to 2006 to the global housing boom and the subsequent bust. It is true that house prices are sensitive to interest rates (Iossifov, Cihák, and Shanghavi, 2008) and that policy interest rates were indeed very low in most countries in recent years. However, Kannan, Rabanal, and Scott (2009a) find that there is virtually no association between the monetary policy stance and the extent of house price increases across countries. As examples, they note that Ireland and Spain had low real short-term rates and large house price rises, whereas Australia, New Zealand, and the United Kingdom had relatively high real rates and large house price rises.