In a previous postI argued that high house prices, in the UK and perhaps elsewhere, could simply reflect lower expected long term interest rates. This had some people puzzled, because it appeared to ignore supply and demand. Surely it is higher demand combined with inelastic supply (supply that is insensitive to changes in prices) which is to blame for high house prices? This short post clarifies how both views can be correct at the same time. I also raise a question about housing wealth and inequality at the end.
The easiest way to think about this, at least for me, is to imagine no one owned their own home. Everyone rents, and houses are owned by landlords. Rents represent the price of ‘housing services’, which is the flow of benefits we get by having a roof over our head. If we calculate these rents in real terms, we have the relative price of housing services compared to other goods. Real rents will reflect the supply and demand for these housing services. If we all suddenly decided we wanted to rent a house in the countryside as well as our house in the city (or vice versa), and if the supply of houses did not increase, rents would rise dramatically until enough of us thought that maybe this wasn’t such a good idea after all.
Suppose real interest rates fall, but the supply of housing is fixed. There is no particular reason why lower real interest rates should change the demand for housing services relative to other goods. Then with no change in demand or supply, rents do not change in real terms. But house prices will, because they are - to use a bit of jargon - the present discounted value of future rents, where the discount rate is the real interest rate. This is a shorthand way of saying that lower interest rates mean that investments in financial assets yield lower returns than the same amount invested in housing, so investors will want to own houses rather than financial assets. This pushes up house prices until the rate of return on both types of asset are equalised.
That assumes housing supply is inelastic, which is a reasonable assumption in the short term. However suppose by some means (economic or political) these higher house prices generated an increase in the supply of houses to rent. If the demand for housing services is unchanged, greater supply will begin to push down rents. Falling rents push down the yield from owning housing assets. As a result, housing becomes less attractive as an asset, and prices begin to fall.
So if housing supply was very elastic, permanently lower real interest rates need not lead to higher house prices in the long run. Instead, they could produce much lower rents, because a lot more houses get built. Such an outcome seems unlikely in a country like the UK, but it could happen in a country like the US where there is plenty of land available to build on. This is one possible reason for the different trends in house prices in different countries that I commented on in my previous post.
So my original post was certainly not suggesting that increasing housing supply would have no impact on prices. What it was suggesting was that in evaluating whether current prices represent a bubble, we need to allow for the possibility that high prices today reflect a view that real interest rates may stay low for some time.
If interest rates do stay low for some time, and this does keep house prices high, an interesting question is why this matters. Take the case where everyone rents. Rents are unchanged, so those renting are no worse off. Landlords appear richer, but their future income in real terms has not changed. If people own their own houses, their houses have not suddenly got bigger or better. This is related to, but is not quite the same as, a question recently raised by Chris Dillow. It is different because it potentially applies to anyone who owns assets that get more valuable simply because interest rates fall, and not because the future incomes they generate increase. It is the same issue that is raised when some complain that Quantitative Easing, by - say - raising share prices, is benefiting the rich. I think this change in wealth does matter, as this evidence suggests, and I hope to explore the reasons why in a future post.
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