What Causes House Price Fluctuations?

Summary of working paper 9262
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A number of studies have documented that the prices of houses exhibit both "momentum" (that is, a tendency to move together in the short run) and "reversion" (cycle around a trend). From these studies, and from the observed behavior of housing prices in regional markets, it is clear that the extent of momentum or reversion varies with location, for example between coastal and inland cities. This is important because it is only possible for large housing price bubbles to occur in locations with a lot of momentum and little cyclical return to trend values.

In Determinants of Real House Prices (NBER Working Paper No. 9262), authors Dennis Capozza, Patric Hendershott, Charlotte Mack, and Christopher Mayer use data for 62 U.S. metropolitan areas from 1979 to 1995 with economic and demographic variables for each of the metro areas to explore two explanations for momentum and cyclical behavior: information-based explanations and supply-based theories. They find that both information dissemination and supply factors influence the dynamics of house prices.

Their results show that variation in the cyclical behavior of real house prices across metropolitan areas is attributable to more than just variation in local economies. Real house prices react differently to economic shocks depending on such factors as the growth rates of the underlying population and real income in the area, the size of the area, and construction costs. Some areas may react faster or more strongly to a given economic shock than other areas. In particular, any given positive economic shock will be easier for an area to absorb if the housing stock can be increased quickly and at low cost.

The authors find that high real income growth in an area has about three times as large an effect on momentum as on cyclical house prices. They also show that high real construction costs will raise momentum but lower cyclical returns toward trend. That combination of large momentum and low cyclical response leads to real house prices continuing to rise beyond their equilibrium values even after the economic growth has slowed, causing as much as 25 percent overshooting and an eventual reversal in real prices. This result is consistent with the extreme behavior of house prices in markets such as Los Angeles and Boston in the 1980s, where large increases in real incomes were coupled with high real construction costs over this period.

Based on these results, this paper suggests that the volatility of real house prices would be reduced where lower real construction costs dampen house price cycles and where developments in information technology, which will provide better information to buyers and sellers, allow them to negotiate more efficient agreements.