When the Cure Fuels the Symptoms

When central banks raise interest rates to cool down the economy, the goal is to ease price pressures. But in the housing market, the outcome can be the opposite. “In many cities, higher rates have priced potential buyers out of the market, forcing them to remain renters. This increased demand has pushed rents up, making life harder for both new and existing tenants,” explains Alessia De Stefani, Economist in the Macro-Financial Division of the IMF’s Research Department. This paradox highlights just how complex the relationship is between monetary policy and real estate dynamics.

In your paper “Missing Home-Buyers and Rent Inflation”, you show how higher interest rates can push people out of the housing market and drive up rents. Can you explain how this dynamic works?

When interest rates rise, like in recent years, the monthly cost of a home loan goes up. For many people, especially renters buying a home for the first time, this increase in mortgage costs made it impossible to obtain a home loan. As these would-be buyers could not buy, they stayed in the rental market instead, increasing competition and shrinking the pool of available apartments and houses for rent, driving up rent prices. In cities where a lot of first-time buyers were priced out, rent increases have been especially sharp. In brief, higher interest rates push some people out of buying homes, so they compete for rentals instead. This extra pressure on the rental market drives rents up, making life harder for both new and existing renters.

Raising interest rates is supposed to cool demand and bring inflation down. But in the rental market, the opposite seems to happen. What risks does this pose for central banks?

A key implication of this analysis — though I want to stress that these are personal opinions based on my ongoing research, and in no way reflect the opinions of the IMF — is that tightening monetary policy may inadvertently increase headline inflation, at least in the short run. This is because rents and owner-equivalent rents account for a large share of the overall CPI basket in the US, as well as in many other advanced economies. Hence rising rent prices can have large consequences for headline inflation. It is important to stress that in the long run, these effects should dissipate, as rental supply should adjust to the increase in rental demand. In last couple of years, a fairly large increase has been seen in rental unit development and conversions across US cities, just as rental prices surged. 

In countries where most mortgages are fixed-rate, the transmission of monetary policy is weaker. How does the structure of mortgage markets shape the impact of rate hikes on inflation?

There is a large body of evidence showing that the structure of domestic mortgage and housing markets matters for the speed and strength of monetary policy transmission. This literature shows how, for example, higher homeownership rates and household indebtedness make households more sensitive to changes in interest rates, thus helping the transmission of monetary policy. The composition of the domestic mortgage markets matters, too. A large prevalence of fixed rate mortgages shields consumers from interest rate hikes, because homeowners with FRMs do not “feel the pinch” of rising interest rates in their monthly mortgage payments. In recent work, my colleagues and I show that this is a key factor determining the strength of monetary policy transmission to household consumption, both across countries and over time. 

Inflation is not just unequal across income groups, it also varies across regions. What do we know about how inflation, especially in housing, differs between urban and rural areas?

Generally, house prices in urban areas tend to be more volatile and responsive to changes in credit conditions than in rural areas. One mechanism underlying this difference is cities’ more inelastic housing supply: it is harder to build in urban areas than in rural ones, due to regulation, land‐use restrictions and geographic constraints. This means that when mortgage rates decline and housing demand increases, for example, housing supply in these areas may not be able to catch up quickly enough, pushing up house prices more. Regions which appreciated the most during a boom are also more vulnerable to sharper corrections, once the tide turns. Housing supply restrictions can also generate sharper rent price increases in urban areas during a tightening cycle, as discussed above. Another mechanism at play is the greater reliance of homebuyers on mortgages in cities, in part because housing is generally less affordable than in rural areas. This makes home purchasing activity (and house prices) more sensitive to fluctuations in interest rates and the business cycle more generally. 

How do buyers and investors in the housing market form their inflation expectations — and can these expectations themselves fuel price dynamics?

By now, there is a large body of empirical and theoretical evidence showing that people form house price expectations by extrapolating from recent and personal experiences, compared to other sources of information. This means, for example, that when people observe house prices increasing for a long period of time, they tend to become very optimistic about future price growth and to discount the possibility that the housing market could ever turn. This dynamic can indeed sometimes contribute to speculative dynamics and fuel house price growth, particularly when the share of housing investors (who buy in expectation of higher future returns) increases. This mechanism can in some circumstances feed boom-bust patterns in housing markets, because areas where prices increase excessively beyond fundamental values tend also to experience the sharpest corrections, ex-post.