Understanding Housing Market Volatility

Joseph Fairchild, Jun Ma and Shu Wu

Journal of Money, Credit and Banking, 2015, vol. 47, issue 7, 1309-1337

Abstract: The Campbell–Shiller present value formula implies a factor structure for the price–rent ratio of housing market. Using a dynamic factor model, we decompose the price–rent ratios of 23 major housing markets into a national factor and independent local factors, and we link these factors to the economic fundamentals of the housing markets. We find that a large fraction of housing market volatility is local and that the national factor has become more important than local factors in driving housing market volatility since 1999, consistent with the findings in Del Negro and Otrok (2007). The local volatilities mostly are due to time variations of idiosyncratic housing market risk premia, not local growth. At the aggregate level, the growth and interest rate factors jointly account for less than half of the total variation in the price–rent ratio. The rest is due to the aggregate housing market risk premium and a pricing error. We find evidence that the pricing error is related to money illusion, especially at the onset of the recent housing market bubble. The rapid rise in housing prices prior to the 2008 financial crisis was accompanied by both a large increase in the pricing error and a large decrease in the housing market risk premium.

Date: 2015
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Persistent link: https://EconPapers.repec.org/RePEc:wly:jmoncb:v:47:y:2015:i:7:p:1309-1337

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