(Following article is written by Graeme O'Meara, economic consultant at Indecon, Dublin, Ireland. The article is based on a paper published by O'Meara in Ireland's Economic and Social Review. Central Bank News occasionally publishes articles by guest contributors if they are of interest to our readers.)
By Graeme O'Meara
A new research paper published in the Economic and Social Review re-opens the debate over the causes of housing booms and the role of central banks.
Much of the recent interest in housing bubbles has emanated from the booms and busts observed in the housing markets of a number of OECD countries. When housing bubbles burst, they tend to plunge an economy into recession through declines in consumption and investment. It has been argued retrospectively that periods of low interest rates create an environment conducive to the buildup of imbalances in the housing sector.
Interest rates influence house prices by making credit cheap and increasing the demand for houses through a number of channels. First, lower interest rates reduce the opportunity cost of buying a house compared with investing in other assets. Second, a type of financial accelerator effect creates a feedback loop between house prices and interest rates as the net worth of borrowers changes in response to changes in the value of their assets. A number of studies including Iacoviello (2005) and Calza et al. (2009) have shown that a reduction in interest rates increases the value of houses by increasing the present value of future user costs, enhancing borrowers’ current debt capacity and demand for housing. Third, interest rates can affect house prices through the risk taking channel, where lower rates of interest encourage financial institutions to lever up in order to achieve a target rate of return – a search for yield effect (Rajan, 2005 and Borio and Zhu, 2008).
Many economists, including John Taylor, have argued that in the years preceding the housing bust in the US, the Federal Reserve’s monetary policy stance was too loose, as examined relative to a Taylor rule. It has been reported that the Fed’s deviation from a Taylor type rule contributed to the run up in house prices.
As many other central banks pursued a policy similar to the Fed’s over the years 2000-2006, this paper extends the analysis to a number of other OECD economies.
In looking at house prices, the paper assumes that similar to any other financial asset, house prices have an equilibrium or ‘fundamental’ value. This estimated economically based on demand side and supply side drivers in the housing market. We look also at the behaviour of the price to rent ratio relative to its fundamental value. The analysis shows that for many countries observed house prices veered significantly away from their fundamental value.
We estimate a series of equations which explain housing bubbles as deviations from
the Taylor rule. The data covers the period 1981Q1 to 2013Q4.
We report a statistically significant relationship between Taylor rule deviations and the
deviation of house prices from their fundamental value. The impact is higher when the model is estimated over the period 2000-2013, compared with the estimates over the full sample and over the period 1981-1999. The countries for which deviations from the Taylor rule are consistently significant in explaining housing bubbles are the US, Australia, Norway and the UK.
Whilst the impact of Taylor rule deviations on housing bubbles is more pronounced over the last decade, in line with Dokko et al. (2011) we find a quantitatively small impact of monetary policy on housing bubbles, and this is in tandem with a considerable body of literature which attributes a greater role to excessive credit provision in driving the rapid increase in house prices. While interest rates affect lending and borrowing behaviour through the channels mentioned above, it is likely that the historical relationship between interest rates and house prices became less stable over the last decade in light of exuberant behavior observed in the global financial system. Thus the paper concludes that a monetary policy stance more closely aligned with a Taylor type rule could reduce some of the imbalance in the housing market, but would not be all effective on its own without being complemented with the use other instruments by which a central bank could restrain house prices.
The paper is available at this link: http://www.esr.ie/article/view/454