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The interest rate puzzle

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Summary:
Simon points to the widespread (but not universal) consensus among economists that house prices are high because (pdf) interest rates are low. For me, this raises a puzzle. On the one hand, this seems not just true, but trivially true. Housing is an asset. And the price of an asset should be equal to the present value of its future cashflows: rent if you’re a landlord or the rent saved if you’re an owner-occupier. Lower interest rates raise the discounted present value of future cashflows and so raise asset prices. Which is consistent with the fact that house price to income ratios have trended up as real interest rates have trended down. This is just common sense. But, but, but. There is one significant asset class that has not benefited from the downtrend in real interest rates –

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Simon points to the widespread (but not universal) consensus among economists that house prices are high because (pdf) interest rates are low. For me, this raises a puzzle.

On the one hand, this seems not just true, but trivially true. Housing is an asset. And the price of an asset should be equal to the present value of its future cashflows: rent if you’re a landlord or the rent saved if you’re an owner-occupier. Lower interest rates raise the discounted present value of future cashflows and so raise asset prices. Which is consistent with the fact that house price to income ratios have trended up as real interest rates have trended down.

This is just common sense. Hpilgy

But, but, but. There is one significant asset class that has not benefited from the downtrend in real interest rates – equities. The dividend yield (or earnings yield) on the All-share index is now much the same as it was in the early 90s despite the slump in real interest rates.

Hence my puzzle: why have lower real rates boosted house prices so much but not share prices?

An obvious possibility arises if we remember the old adage, “never reason from a price change.” Why have real interest rates fallen? One obvious possibility is that growth expectations have done so; low rates are the product of actual and expected secular stagnation. To the extent that this is the case, the benefits to shares of lower discount rates have been offset by a drop in expected future dividends, leaving valuations unchanged.

This, however, doesn’t get us far. For one thing, lower expected economic growth should also mean lower rents. Rental yields therefore should not have changed either.

How, then, can we explain the failure of share prices to respond as much as house prices to lower rates?

In theory, this would happen if investors fear a shift in incomes from profits to wages; in the 70s, this caused house prices to rise relative to equities. But this seems more fear than reality: for most of this century, Kaldor’s stylized fact has held for the UK: the profit share hasn’t changed much.

A more promising possibility is that the expected growth of listed companies has fallen. Today, these are older than they used to be and many might have gone ex-growth. Perhaps the best growth companies are to be found among those that aren’t on the market.

All this, though, just raises another problem: the numbers just don’t add up. Since the early 90s, we’ve seen a six percentage point drop in real interest rates. But real GDP growth cannot have fallen that much. And even if we chuck in a bit of expected redistribution away from profits and a drop in growth of quoted companies relative to unquoted ones, we must surely still be shy of six percentage points.

There’s an obvious thing which might fill this gap – risk. One reason why dividend yields haven’t fallen is that the equity risk premium has risen.

There are good reasons why it might have done so – not least being that the financial crisis reminded us that economies and markets are more volatile than we thought during the “great moderation.”

But again, we have a puzzle. Many of the risks to equities are also a risk to house prices – such as the danger of recession or expropriation of exploiters. Why should equities have been more sensitive than house prices to these low-probability/high-impact dangers?

All this leaves us with three possibilities.

One is that housing was grossly under-priced in the 90s whereas equities were not, and falling interest rates have triggered a correction of that misvaluation. 

A second is that both markets are worrying more about distribution risk – a shift from profits to wages – than I think.

A third is that simply that housing is over-priced.

There is a precedent for an entire asset class to become grossly misvalued when interest rates change. Back in 1979, Franco Modigliani and Richard Cohn argued (pdf) that equities were hugely under-priced because investors were discounting future cashflows by high nominal interest rates; they were taking on board the bad news of high inflation and not the good. The subsequent rebound in the market suggests they might have been right (pdf).

I wonder whether a slightly analogous thing might be happening to house prices. They are pricing in the good news of low interest rates but not the bad.

I don’t say this with huge confidence. But there is, surely, a puzzle here.

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