Do Low Rates Make House Prices More Volatile?

Over at the FT blog, Cardiff Garcia has a nice summary of three papers that attempt to explain the run-up in house prices before 2007. It particularly approves of the work of my friend and co-author Susan Wachter and Andrew Levitan, who argue that a supply-side credit bubble produced the housing bubble.

As I read the piece, though, I couldn’t help but think that while it is unlikely that low interest rates would explain prices, they might explain volatility. When nominal interest rates are low, a small change in price expectations can lead to a large change in prices.

Consider the Gordon Growth model, where Value = dividend/(i-g), where in this case the dividend is the value of living in a house, i is the interest rate and g is the expected growth rate of the dividend. Let everything be real (i.e., not nominal) Consider two worlds: 2 percent real interest rate world and a 4 percent world. Now let expectations about growth vary from negative one percent to positive one percent. In the two percent world, the upside scenario produces three times the value of the downside scenario. In the four percent world, the upside produces 67 percent greater value than the downside. Hence small changes in expectations have a much larger impact in a low interest rate environment than a high interest rate environment. It may be hard to pick this up because expectations are so difficult to measure.

Just a thought.

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About Richard K. Green 103 Articles

Affiliation: University of Southern California

Richard K. Green, Ph.D., is the Director of the USC Lusk Center for Real Estate. He holds the Lusk Chair in Real Estate and is Professor in the School of Policy, Planning, and Development and the Marshall School of Business at the University of Southern California.

Prior to joining the USC faculty, Dr. Green spent four years as the Oliver T. Carr, Jr., Chair of Real Estate Finance at The George Washington University School of Business. He was Director of the Center for Washington Area Studies and the Center for Real Estate and Urban Studies at that institution. Dr. Green also taught real estate finance and economics courses for 12 years at the University of Wisconsin-Madison, where he was Wangard Faculty Scholar and Chair of Real Estate and Urban Land Economics. He also has been principal economist and director of financial strategy and policy analysis at Freddie Mac.

His research addresses housing markets, housing policy, tax policy, transportation, mortgage finance and urban growth. He is a member of two academic journal editorial boards, and a reviewer for several others.

His work is published in a number of journals including the American Economic Review, Journal of Economic Perspectives, Journal of Real Estate Finance and Economics, Journal of Urban Economics, Land Economics, Regional Science and Urban Economics, Real Estate Economics, Housing Policy Debate, Journal of Housing Economics, and Urban Studies.

His book with Stephen Malpezzi, A Primer on U.S. Housing Markets and Housing Policy, is used at universities throughout the country. His work has been cited or he has been quoted in the New York Times, The Wall Street Journal, The Washington Post, the Christian Science Monitor, the Los Angeles Times, Newsweek and the Economist, as well as other outlets.

Dr. Green earned his Ph.D. and M.S. in economics from the University of Wisconsin-Madison. He earned his A.B. in economics from Harvard University.

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