Monetary Policy, Capital Inflows and the Housing Boom

39 Pages Posted: 5 Dec 2010  

Filipa Sa

King's College London; IZA Institute of Labor Economics

Tomasz Wieladek

Bank of England

Date Written: December 2, 2010

Abstract

A range of hypotheses have been put forward to explain the boom in house prices that occurred in the United States from the mid-1990s to 2007. This paper considers the relative importance of two of these hypotheses. First, global imbalances increased liquidity in the US financial system, driving down long-term real interest rates. Second, the Federal Reserve kept interest rates low in the first half of the 2000s. Both factors reduced the cost of borrowing and may have encouraged the boom in house prices. This paper develops an empirical framework to separate the relative contributions of these two factors to the US housing market. The results suggest that capital inflows to the United States played a bigger role in generating the increase in house prices than monetary policy loosening. Using VAR methods, we find that compared to monetary policy, the effect of a capital inflows shock on US house prices and residential investment is about twice as large and substantially more persistent. Results from variance decompositions suggest that, at a forecast horizon of 20 quarters, capital flows shocks explain 15% of the variation in real house prices, while monetary policy shocks explain only 5%. In a simple counterfactual exercise, we find that if the ratio of the current account deficit to GDP had remained constant since the end of 1998, real house prices by the end of 2007 would have been 13% lower. Similar exercises with constant policy rates and the path of policy rates implied by the Taylor rule deliver smaller effects.

Keywords: house prices, capital inflows, monetary policy

JEL Classification: E5, F3

Suggested Citation

Sa, Filipa and Wieladek, Tomasz, Monetary Policy, Capital Inflows and the Housing Boom (December 2, 2010). Bank of England Working Paper No. 405. Available at SSRN: https://ssrn.com/abstract=1719045 or http://dx.doi.org/10.2139/ssrn.1719045

Filipa G. Sa

King's College London ( email )

150 Stamford Street
London, SE1 9NN
United Kingdom

IZA Institute of Labor Economics

Schaumburg-Lippe-Str. 7 / 9
Bonn, D-53072
Germany

Tomasz Wieladek (Contact Author)

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

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