House Price Dynamics: Fundamentals and Expextations

Bank of Canada working papers are theoretical or empirical works-in-progress on subjects in economics and finance. The views expressed in this paper are those of the authors. No responsibility for them should be attributed to the Bank of Canada. ii Acknowledgements We are very grateful for comments received from seminar participants at the Bank of Canada and the Joint Central Bank Conference: Bank of Canada/Atlanta FED/Cleveland FED/Swiss National Bank. We especially thank Kevin Lansing whose guidance helped shape the content of the paper. Of course, any omissions or errors remain those of the authors. Abstract We investigate whether expectations that are not fully rational have the potential to explain the evolution of house prices and the price-to-rent ratio in the United States. First, a Lucas type asset-pricing model solved under rational expectations is used to derive a fundamental value for house prices and the price-rent ratio. Although the model can explain the sample average of the price-rent ratio, it does not generate the volatility and persistence observed in the data. Then, we consider an intrinsic bubble model and two models of extrapolative expectations developed by Lansing (2006, 2010) in applications to stock prices: one that features a constant extrapolation parameter and one in which the extrapolation coefficient depends on the dividend growth process. We show that these last two models are equally good at matching sample moments of the data. However, a counterfactual experiment shows that only the extrapolative expectation model with time-varying extrapolation coefficient is consistent with the run up in house prices observed over the 2000-2006 period and the subsequent sharp downturn. Résumé Les auteures tentent de déterminer si l'évolution des prix des maisons et du ratio de ces prix aux loyers aux États-Unis peut s'expliquer par le fait que les anticipations ne soient pas entièrement rationnelles. Elles résolvent d'abord un modèle d'évaluation des actifs à la Lucas sous l'hypothèse de rationalité des anticipations afin d'obtenir une estimation du niveau fondamental des prix des maisons et du ratio prix/loyers. Même si le modèle parvient à restituer la moyenne empirique du ratio, il ne génère pas la volatilité et la persistance observées dans les données. Les auteures considèrent ensuite un modèle de bulle intrinsèque ainsi que deux modèles dotés d'anticipations extrapolatives mis au point par Lansing (2006 et 2010) pour l'analyse des cours en bourse : dans le premier, le coefficient d'extrapolation est constant, et dans le second, il …