Q&A Seven Questions about House Price Cycles

• Author: Prakash Loungani

Question 1: What are the broad features of house price cycles?

Between 1970 and the mid-1990s, on average across OECD countries, the median upturn in house prices lasted four years and the median real increase in prices over the course of the upturn was 33 percent (see figures). The median downturn also lasted four years, during which time prices fell 20 percent. These figures are based on work by Igan and Loungani (forthcoming), but estimates by the IMF (2003), Girouard and others (2006), Claessens, Kose, and Terrones (2008), and Andre (2010) are in the ballpark. These studies also find considerable variation across countries and across time in the duration of upturns and downturns; the figures show the 25th and 75th percentile bands for the duration and amplitude of housing cycles.

Question 2: Are we near the trough of the present housing cycle?

The present housing cycle started in the mid-1990s and early-2000s for most countries. The median upturn in this most recent cycle lasted over twice as long as those in the past (41 quarters compared to 16 quarters) and was more pronounced, with prices rising nearly three times as much as in the past cycles. The median ongoing downturn is approaching the halfway mark in terms of duration and amplitude of price declines, which suggests that further corrections could be in the offing. And with prices having risen much more sharply than in earlier upturns, the declines in prices might also eclipse those observed that were in the past.

Question 3: What anchors house prices in the long run?

Economic theory asserts that house prices, rents, and incomes should move in tandem over the long run. House prices and rents should be cointegrated because buying and renting are alternate ways of meeting the need for shelter (Poterba, 1984). Likewise, in the long run, house prices cannot get too far out of line with people's ability to afford houses, that is, with their incomes. For most countries, these long-run relationships do have some drawing power, though the rate of mean reversion is often so sluggish that the relationships do not pass formal tests of stationar-ity (Girouard and others, 2006). For instance, the ratio of house prices to rents in the United States has reverted to its long-run average four times between 1970 and the early 2000s. Between 2000 and 2006, the ratio of house prices to rents rose dramatically above the long-run average and has been moving back toward it since then. The United Kingdom has a similar story for the ratio of house prices to incomes. For a few countries, the long-run relationships are a very weak anchor. In Australia and Canada, there has been a trend increase in the price-to-rent ratio since the mid-1980s.

However, even in cases where long-run relationships do act as an anchor, in the short run house prices drift away from them, often quite strongly and for long periods of time (Klyuev, 2008). As the IMF (2004) demonstrates, demand momentum leads to increases in house prices, often in excess of what can be explained on the basis of the demand-side forces. For instance, over the period from 1992 to 2006, Ireland's annual real income growth was twice the rate of the preceding two decades, but annual growth in that country's house prices was 10 times the...