What is less clear, however, is whether rising rates will undermine the housing market by increasing the cost of borrowing. At first glance, they should. The higher the rate, the higher the monthly payment and the less potential buyers can afford. Housing prices fall accordingly.
There is a seductive appeal to this argument. In the case of the relationship between interest rates and house prices, however, the old warning about medieval maps holds true: here come the dragons. Unraveling the many variables at play in this dynamic should make us think about the future direction of the housing market.
The literature on the relationship between interest rates and house prices is abundant, complicated and contradictory. There is a general consensus that cutting rates near zero can help fuel a housing bubble, but the precise mechanisms and when this happens is still not fully understood. It’s also not entirely clear what happens when the Fed – or for that matter, other central banks – raises rates.
Take, for example, the rise of the financial crisis in 2008, when real estate prices exploded before crashing. Many accounts of this calamity find a version of original sin in the Fed’s decision to cut rates following the tech bubble crash in 2000 and the September 11 terrorist attacks, from a high of about 6.6% in 2000 to a low of 2% by 2003. Mortgage rates followed, and everyone piled into the housing market – or so the theory goes.
Except, as Robert Shiller pointed out, that doesn’t quite describe what happened. As he later observed, “the boom in the housing market lasted three times as long as the period of low interest rates”. In fact, it arguably started as early as 1997 and, as Shiller notes, “the housing boom accelerated when the Fed raised interest rates in 1999” (emphasis added).
This is inconsistent with common sense, let alone economic models that predict that changes in the Fed’s overnight rate (or mortgage rates) will automatically translate into a predictable change in house prices. A typical model, for example, predicts that a 1% drop in real interest rates should cause home prices to spike in some US cities by 19% to 33%.
Patterns like this – and much of the current interest rate hesitation – reflect the belief that housing lends itself to conventional asset pricing theory. In other words, housing is assumed to be like any other liquid asset, where fluctuations in borrowing costs translate into immediate price changes.
But housing is not like another asset; it is burdened with huge transaction costs. This means that prices can be quite slow to react to changes in interest rates – if they react at all. They are ‘sticky’, although some economists prefer the language of physics, trading rigidity for ‘inertia’.
Proof of this is a recent study by the Bank for International Settlements that looked at historical data on the relationship between house prices and nominal short-term rates. It found that a 1% drop in nominal short-term rates led to a 5% increase in house prices.
But it took three years for that to happen. “The empirical relationship between changes in interest rates and real house prices,” the authors observed with considerable understatement, “might therefore not be as straightforward as simple models imply.”
In other words, it takes time, if not a long time, for these changes to affect house prices. In an elaboration of this point, BIS researchers found that changes in real (not nominal) short-term rates can continue to reverberate for five full years.
All of this may help explain what happened before the 2008 crash. The lag in the effects of monetary policy may mean, as one study has suggested, that the housing bust was partly due to delayed effects of Fed hikes that began in 2004. As a result, the interest rate chickens did not return home until 2007.
Aside from the delayed effects, there is the problem of expectations. There is evidence that when the Fed delivers a “shock” when it raises or lowers rates, it will have an outsized impact on house prices. But if everyone expects him to gradually raise rates in some way and precisely do so – well, there might not be as much of an impact on the prices of accommodations.
OK, you might say. Forget short-term rates. What about 30-year mortgage rates? They are going up right now and that directly affects borrowings. Surely that bodes ill for house prices, doesn’t it?
This too has long been an article of faith. A typical early study that looked at historical data found that this was most definitely the case. When mortgage rates go up, house prices go down. But even here things are much more complex than it seems at first sight.
First, there is evidence that this relationship between mortgage rates and house prices was predictable in precisely the way we imagine before the 1980s. After deregulation of the mortgage market and the spread of securitization, lenders and buyers homeowners have found they can circumvent many of the obstacles that were originally posed by rising mortgage rates.
Since then, the relationship between rising long-term mortgage rates and house prices has become even more complicated, with more recent studies suggesting a tenuous link. In any case, there is very little consensus. Some studies find a link; others, like the one who subjected the phenomenon to a battery of statistical examinations, concluded that “there is virtually no short-term influence of mortgage rates on house prices.”
The problem, as a recent summary of the various cross-currents at work noted, is that rising mortgage rates often go hand in hand with rising wages, a stronger economy and inflation – all forces that, in different ways, are helping to ease the burden of rising borrowing costs.
None of this means that a spike in short-term or long-term rates is great news for house prices. It’s not. But given the time it will take for the full effects to kick in, not to mention the many confusing forces at work, it’s entirely possible that the housing market will surprise us yet again.
This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.
Stephen Mihm, professor of history at the University of Georgia, is a Bloomberg Opinion contributor.
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