Housing and the Business Cycle: Evidence from the UK Housing Price and Quantity

Abstract

This paper investigates the importance of housing price and quantity variables in the UK business cycle since the mid 1950s. We start with a baseline Markov-switching common factor model for the UK economy into which we incorporate a house price variable (nationwide house price index) and a quantity variable (new housing starts) into the baseline model. Then, we evaluate the importance of the two housing market variables in the fluctuations of the overall economic activities. When house variables are allowed to directly affect the evolution of key macro indicators, the results are similar to those for the US in the previous studies: although the year-onyear housing quantity changes have significant on the UK business cycle beyond the three macro indicators, the usual yearon-year house price changes do not. However, asymmetric decreases in house price significantly affect the UK business cycle more than the asymmetric decreases in house quantity. When house variables are accommodated to influence the probabilities of transitions between expansions and contractions, we find strong evidence that changes in both house price and quantity variables significantly affect the switching of the UK economy between the two phases, although house quantity variables predict the upcoming business cycle phases better than house price. Moreover, for both house price and quantity variables, most useful information is contained in their asymmetric decreases.Keywords: Housing, Price, Quantity, UK, Business cycle, Markov-switchingJEL Classification: E21, E44, D41I. IntroductionThe extended period of sharp and continued house price increases, coupled with the booming investment in residential construction since the mid 90s has engendered a plethora of studies on the link between the housing market and the macroeconomy. As summarized in the satisfactory survey by Muellbauer and Murphy (2008), housing markets and the rest of the economy interact in multiple ways. However, if we concentrate on the of housing price on macroeconomic activities, we seem to have reached a wide consensus on the theoretical front. The effects channel emphasizes price appreciation, which causes subsequent increases in the wealth of homeowners, a direct extension of the permanent income hypothesis. More recent research, such as those by Aoki et aL (2004) and Iacoviello (2005), suggest that innovations in housing finance allow homeowners to use their homes as collateral to loosen their borrowing constraints.Unlike the general agreements revolving around the presence of the house price-macroeconomy relation in the theoretical front, the empirical evidence on the role of house prices over the business cycle remains mixed. For example, Davis and Heathcote (2005) find a contemporaneous correlation between the nationwide house prices in the US and output as high as 65% over the 1971-2001 period. However, Kan et aL (2004) find that the contemporaneous correlation between house prices and output growth is merely 15% or smaller on average in about 50 major US cities. Recently, Learner (2007) challenged the traditional view on the role of house prices, arguing that housing markets are grossly understudied by macroeconomists interested only in understanding business cycles. He reported several stylized facts about the behavior of the US housing market over the business cycle, claiming that i) housing investment leads the business cycle, and a fall in residential investment is a reliable harbinger of a recession, and ii) volumes, rather than prices, in the housing sector are what matter for business cycles. Supporting the second stylized fact, he pointed out that eight out of ten US postwar recessions have been preceded by substantial problems in quantity variables such as housing investment and consumer durables. Alvarez et aL (2009) (for the Eurozone) and Alvarez and Cabrero (2010) (for Spain) provided similar evidence highlighting the leading nature of housing market cycles with respect to business cycles, which reflects the cyclical features of a variety of housing market indicators such as hous- ing starts, housing permits, and the amount of residential investment. …