Thursday, January 29, 2015

Housing Tax Policy, A Series: Part 4 - Real Interest Rates are important

David Beckworth had an interesting post recently, where he pushed back on the Secular Stagnation thesis.  He included this chart:

He attempts to fully pull out both the inflation expectations and the term premium for inflation uncertainty, which has the effect of flattening the 10 year yield over time compared to the yield that only adjusts for inflation expectations.  I'm not sure I'm completely on board, though.  Any time you do a nominal time series that includes the 1970s, that big inflationary hump swamps everything else.  So, everything looks flat compared to the inflation.  But, the real interest rate line here still looks to me like it has a bit of a downward slope.  Even less than a 1% change in a measure that is at such a low level can be significant.  The cyclical noise makes it difficult to see.

He also includes this graph, comparing the 10 year real yield to the output gap.  At this time frame, I agree that there isn't much of a downward slope until 2008.  So, it may be true that there isn't a long term downtrend in real risk free rates.  But, I think there are some interesting patterns here, and I think we can start here for a check on the importance of real risk free interest rates in housing markets.

My attempt at a real risk free 10 year interest rate only goes back to 1969, and it doesn't quite match David's, but it has the same basic shape.  I can get back to 1949 with the output gap.

There appears to be a relationship between the output gap, real rates, and housing returns (these graphs reflect owner-occupant returns only).  This first graph is the comparison of annual numbers.  The output gap and interest rates are very noisy.  So, in the second graph, I compare housing returns to the centered 10 year moving average interest rate and output gap.  This makes the co-movement more clear.

The disconnect between bond yields and home returns after 2007
is due to the very high excess returns going to home owners
currently because access to mortgage credit is so shut down.
It is interesting how much more stable real returns to real estate are than 10 year treasuries (2% has been added to the real treasury yield for comparison in the graphs).  The steep drop in home yields in the 2000s was much less volatile than typical bond movements.  From a volatility point of view, homes should have lower returns compared to long term bonds, based on these numbers.  The factors that lead to this apparent return on investment are part of what I want to think about in this series of posts.

But, here, I think we can see that home prices really do react to long term real interest rates.

Note that in the past 60 years, we did have previous periods where long term rates rose and returns on houses rose with them.  Real home price/rent ratios would have fallen.

I will submit this as yet one more piece of evidence that the 2000s weren't some aberration in history regarding home prices.  This was a normal market.  The new aspect was the tight monetary policy and relatively low inflation that failed to buffer the real capital losses of home owners, which eventually became ruinously tight.  It looks to me like the rate increases in the 1950's coincided with a building boom coming out of the 1940's.  Going into the 1950's it looks like there was a housing surplus because of the swoon in population during the Great Depression and World War II.  As the parents of the baby boomers moved into single family homes, helped by New Deal home ownership initiatives, owner-occupied home building boomed, buffering the drop in Price/Rent.  And again, between 1990 and 1993, according to the Case-Shiller 10 city Index, nominal home prices fell by 8 1/2%.  From 1989 to 1996 there was a 26% drop in Price/Rent.  From March 2006- March 2007, home prices leveled off in a typical way.  A Fed doing its job in 2007 makes this a very different graph.  We have learned all the wrong lessons from this.

I did wonder if this relationship was partly an artifact of BEA imputations.  Capital consumption appears to be generally a function of real estate values.  I think this would be distortionary, because changes in real estate values that are related to interest rate fluctuations would be related to the underlying property value.  The added nominal price would not be a depreciating asset.  I think it would be more accurate to make the capital consumption adjustment proportional to rent instead of price.  In the relationship I outline above, the BEA treatment of capital consumption could cause returns on homes to fluctuate more widely because, as home prices increase, the capital consumption adjustment would also increase, leading to an inflated volatility of measured returns.  So, as a test, I replaced the capital consumption figure used by the BEA with a capital consumption estimate that is a stable 22.5% of rent.

This doesn't change the return profile significantly.  But, it does narrow the range of returns to home ownership a little bit.  In this graph, I have included the returns to equity, the returns to debt + equity, and the returns to debt + equity with the stabilized capital consumption adjustment.  In addition to seeing the small effect of the stable capital consumption this graph also shows how debt captured a much larger portion of housing returns, first from the high nominal interest rates of the 1970s and 1980s, and then because of the mortgage interest deduction after 1996.  (Remember, part of that exchange between debt and equity is a swap of cash income for deferred capital gains, so the sum of the two as the total return on the home is fairly straightforward, but the division of the return between them is complicated.)

The last graph gives more detail to the relationship of major housing tax policies and some housing market measures.  The trends in these measures seem to point to definite effects on the market as a result of these policies.  (Changes in the CRA in 1994 may also be significant, although it appears to have triggered a rise in homeownership rates, but not prices.)  But, we might have expected more generous tax policies to pull down the rate of return on home ownership, and the graphs above don't show an obvious decline in home returns over time, relative to real risk free rates.  But, a 10% increase in home prices from tax incentives would only pull net returns down by around 1/2%.  So, it wouldn't take much of a change in the measured return to homes to create a significant de facto transfer to home owners through tax policy.  I will probably revisit some version of this graph as I think through these factors.


  1. Do you know how we "observe" the term premia to deconstruct the average real rate of interest over the term period? I am aware of market measures of inflation expectations that are robust, but is the term premia just the difference between short- and long-term yields?

    1. That's a good question, Glenn. To be honest, I haven't dug into the details of that myself. I think the David Beckworth link has some links to research and models regarding that issue.

    2. I ask because it may become a sort of self-fulfilling prophesy, given that short-term rates are stuck at the zero bound. I will follow your links and see if i can learn more.

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