Monetary policy and US housing expansions: What we can expect for the post-COVID-19 housing recovery
The COVID-19 pandemic has prompted an immediate response from economists and policymakers in an attempt to design appropriate policies to tackle the ongoing health and economic crisis (Baldwin and Weder di Mauro 2020a, 2020b). While it is highly uncertain how the post-COVID-19 recovery will evolve, in this column we look at past US housing expansions to help us shed light on the possible trajectory of the next housing recovery.
Why is housing important?
Housing is a very different asset from any other financial asset, such as equities or bonds. The homeowner owns not only the dwelling itself but also the land on which it sits on. Housing can also be seen as a consumption good, in the sense that the owner consumes the housing services of living there. Moreover, housing is of particular interest for economists and policymakers alike.
- First, housing is the main asset for the majority of households – over 65% of US households own a home, while only around 24% own directly stocks and bonds, according to the Survey of Consumer Finances. In addition, the distribution of housing assets is less skewed towards the richest, which contrasts with financial assets – households in the bottom 80% of the income distribution hold roughly 43% of total real estate wealth in the economy, but only 11% of total stocks and bonds.1
- Second, real estate accounts for a substantial fraction of economic activity, with private residential investment accounting for 4% of GDP, and housing consumption accounting for 20% of total private consumption expenditures.2
- Third, recent research has found that the marginal propensity to consume (MPC) out of housing wealth is much larger than that out of financial wealth (Carroll et al. 2011).
The prominent role of housing in the economy has generated a lot of interest in how shocks to demand affect house prices and the real economy more generally. For instance, an expansion in monetary policy can stimulate housing demand via lower borrowing costs – households typically finance housing with mortgage debt (DeFusco and Paciorek 2017). Apart from this credit channel, monetary policy can also influence housing demand through the collateral or refinancing channel, whereby easier monetary conditions and higher house prices lead to higher home equity. This additional equity allows households to increase borrowing to finance consumption (Aladangady 2017, Beraja et al. 2019, Bhutta and Keys 2016, Iacoviello 2005).
Housebuilding in the recent recovery had been remarkably different from past episodes
House prices in the US had been increasing at a strong pace in the years before the pandemic shock struck. But despite the strong expansion in house prices, housebuilding activity had been relatively weak compared to the strong housing boom over 1996-2006 (Aastveit et al. 2020).
To place the dynamics of the housing market and economic activity into historical perspective, we compare real house prices, building permits, and real GDP across the past four housing expansions. We use the Harding-Pagan (2002) algorithm to identify turning points in real house price cycles since the mid-1970s. We identify four housing expansions: 1975 M9–1979 M7, 1982 M11–1989 M3, 1996 M12–2006 M4, and 2012 M3–2019 M12. These cycles are broadly in line with the housing literature (Glaeser et al. 2008). We scale real GDP and house prices to be 100 at the beginning of each housing expansion, so that we can easily compare the dynamics across indicators. We show building permits as a percentage of the housing stock at the beginning of each cycle. To smooth out strong fluctuations in the monthly data, we show quarterly data in Figure 1.
The pace of house price appreciation displays a broadly similar pattern across housing expansions, with the exception of the 1982-89 period (Figure 1). The recent recovery that started in early-2012, and that may have possibly ended in early-2020, is particularly similar to the one in the run-up to the Great Financial Crisis (GFC). By contrast, housebuilding activity, as illustrated by the number of building permits approved for construction, stands out in the 2012-19 expansion: the flow of permits averaged 0.9% of the initial housing stock in 2012, which compares with an average of around 1.6%-2.0% during the previous expansions. Aastveit et al. (2020) have found that the sluggish pace of housebuilding is linked to a decline in supply elasticities, which in turn is likely related to the tightening in land-use regulation over the past decades (Herkenhoff et al. 2018, Hsieh and Moretti, 2019). Declining supply elasticities imply that an increase in housing demand may be absorbed more by house prices. Finally, while the GDP dynamics have been relatively similar across the first three housing expansions, the economic performance during the most recent recovery has been subdued. In the light of these changes in the housing market, we ask whether the transmission of housing demand to the housing market has changed over time. We use monetary policy shocks as a proxy for shifts in housing demand to investigate this question.
Figure 1 Housing expansions since 1975
Sources: Bureau of Economic Analysis, Census Bureau, Federal Housing Finance Agency, and authors’ calculations.
Notes: Real GDP and real house prices are scaled to be 100 at the beginning of each housing expansion. Building permits refers to its flow as % of the housing stock at the beginning of each expansion. The horizontal axis shows quarters around the beginning of each expansion, and the vertical line at zero is the starting point.
We apply a flexible time-varying parameter (TVP) vector autoregressive (VAR) model that is largely data-driven in modelling changes in the dynamic relationship between variables (Cogley and Sargent 2001, Primiceri 2005). We estimate the TVP-VAR model over 1991 M1–2019 M6 using seven variables: (1) monthly GDP from Macroeconomic Advisers, (2) the CPI, (3) the policy rate measured by the Wu and Xia (2016) shadow rate to account for the zero lower bound, (4) building permits, (5) house prices, (6) the Gilchrist and Zakrajšek (2012) spread, and (7) bank credit. A model with these variables produces dynamic responses that are supported by standard macroeconomic theory. We use state-of-the-art high-frequency monetary policy shocks obtained from market surprises on intra-daily data on Fed future contracts following monetary policy announcements (Paul 2020).
A monetary policy shock that decreases the policy rate stimulates housing demand and therefore raises output, building permits, and house prices (Figure 2). But while the response of GDP seems to be overall constant over time, the responses of house prices and permits exhibit substantial time variation. In particular, house prices have become more responsive since the GFC, reaching levels similar to those during the pre-crisis period. In contrast, although the response of permits has recovered after the GFC, it remains well-below historical averages.
Figure 2 Responses to an expansionary monetary policy shock over time
Notes: The figure shows the cumulative median time-varying responses of real house prices, building permits, and real GDP to an expansionary monetary policy shock that decreases the policy rate by 25 bp.
We investigate this time variation further by looking at the relative responses between permits and house prices for one and three years after a monetary policy shock. These relative responses allow us to gain insights into the dynamic relationship between permits and house prices; the percentage change in permits for each percentage point change in house prices. The relationship between permits and house prices seems rather stable since the early-1990s and until the GFC. After the GFC, we find evidence of a substantial decline in the relative response of permits for a given percentage change in house prices: a drop of around 15% in the relative response after one year, and of around 20% in the relative response after three years (upper panel of Figure 3). This finding is consistent with the notion that construction has been reacting less to changes in demand, i.e. that US housing supply elasticities have declined (Aastveit et al. 2020).
We also look at the relative percentage increase in GDP for each percentage increase in house prices, akin to the concept of a sacrifice ratio (Ball 1994). We find that the transmission of monetary policy to real activity relative to house prices has weakened since around 2013. Our estimates show that an expansionary monetary policy shock in 2019 M6 raised house prices relatively more than output. The experience around the GFC stands in stark contrast. This was a period when the measures adopted by the Federal Reserve to fight the crisis seemed to have supported economic activity more relative to house prices (bottom panel of Figure 3). One possible interpretation of our results is that a shock to housing demand that is increasingly absorbed by house prices, rather than supply, may contribute less to overall economic output. This point relates to recent research arguing that the low interest rate environment in the aftermath of the GFC may have rendered monetary policy less effective for economic activity (Berger et al. 2020, Eichenbaum et al. 2018).
Figure 3 Relative impulse responses to an expansionary monetary policy shock
Notes: The figure shows the cumulative time-varying responses to an expansionary monetary policy shock of building permits and real GDP relative to real house prices. We show the responses for 12 and 36 months after the shock. The grey bars represent US recessions as defined by the NBER.
Implications for the post-COVID-19 recovery
The COVID-19 pandemic and the resulting economic contraction are likely creating challenges for the housing market. The next economic recovery may be very different from previous ones – a recovery from a recession marked by simultaneous supply, demand and uncertainty shocks (Baldwin and Weder di Mauro 2020a, 2020b). Our results suggest, however, that the next housing recovery may exhibit similar features as those of the 2012-19 housing expansion: a sluggish response of housebuilding to rising demand but a strong price reaction.
Authors’ note: The views expressed in this column should not be reported as representing the views of the Bank of England. We would like to thank Pascal Paul for kindly sharing the high-frequency monetary policy shocks with us.
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1 Data refer to 2019Q4 and come from the Federal Reserve’s Distributional Financial Accounts.
2 Data on the share of private investment refer to 2020 Q1, and on personal consumption expenditures to 2019.