Explaining House Price Dynamics: Isolating the Role of Nonfundamentals

This paper examines the role of nonfundamentals‐based sentiment in house price dynamics, including the well‐documented volatility and persistence of house prices during booms and busts. To measure and isolate sentiment's effect, we employ survey‐based indicators that proxy for the sentiment of three major agents in housing markets: home buyers (demand side), home builders (supply side), and lenders (credit suppliers). After orthogonalizing each sentiment measure against a broad set of fundamental variables, we find strong and consistent evidence that the changing sentiment of all three sets of market participants predicts house price appreciation in subsequent quarters, above and beyond the impact of changes in lagged price changes, fundamentals, and market liquidity. More specifically, a one‐standard‐deviation shock to market sentiment is associated with a 32–57 basis point increase in real house price appreciation over the next two quarters. These price effects are large relative to the average real price appreciation of 71 basis points per quarter observed over the full sample period. Moreover, housing market sentiment and its effect on real house prices is highly persistent. The results also reveal that the dynamic relation between sentiment and house prices can create feedback effects that contribute to the persistence typically observed in house price movements during boom and bust cycles.     

The monetary policy dilemma: Will interest rates have to rise?

UK interest rates are now at their lowest level for more than two decades, and the government is hoping that interest rates can be kept at a low and sustainable level comparable to the 1960s. Indeed, some commentators are calling for still lower interest rates to offset the risk that the £12bn tax increases and cuts in government spending that will come into effect in the next financial year will lead to stagnant consumer spending and a stalled recovery. Against this must be weighed the risk that the recent very good run of inflation figures will prove temporary. Both headline and underlying inflation will be pushed up by indirect tax increases and there is the possibility that wages will follow too, as employees seek to maintain their living standards in a tightening labour market. That risk would point to a much more cautious monetary policy stance and the possibility that the government may need to raise rates from their present level if it is to achieve its inflation objective. The Chancellor faces a clear dilemma. In this Viewpoint, we assess the evidence available to guide him in his decisions and draw out the implications for the future path of interest rates.