Opinion: Why lower interest rates won't lead to higher house prices

By Philip O'Connor One of the central tenets of economics is that a fall in interest rates will lead to an increase in investment, economic activity, and also the value of assets. Of course, these statements are made with the caveat: "all else being equal." But perhaps all else is not equal, as once this seemingly logical statement is tested in practice, it is often not supported by the data. In fact, economic recessions are marked by low interest rates, and boom times by high interest rates, the opposite relationship to that proposed by the dismal science. So what about the effect of falling mortgage rates on house prices? Falling interest rates have been widely reported in the press to be a good thing for house prices as the cost of owning a house declines with the mortgage rate. This leads to greater affordability and hence to "price support" for houses. But examining the data indicates a different conclusion.

Here is a graph of the variable mortgage rate against the median monthly REINZ house price in New Zealand over the time of the boom in house prices in recent years. Over this time, mortgage rates (on the right hand axis) and house prices (measured on the left hand axis) have moved in the same direction! Higher mortgage rates have lead to higher house prices. In fact, a mathematical measure of co-movement, the correlation coefficient, where +1 is perfect co-movement and -1 is perfect opposite movement, has a value of 0.79. This indicates that house prices and mortgage rates are strongly moving together. Now that interest rates have fallen dramatically, what does it say about future house prices? Those that propose falling interest rates are good for house prices, must explain why the dramatic increase in mortgage rates from 6.7% in December 2001 to 10.9% in May 2008, lead to a doubling in the median price of a New Zealand home. Their argument must be: increases in interest rates are good for house prices (a fact), and decreases in interest rates are also good for house prices (a prediction). In other words, any change in interest rates is good for house prices. So how about an alternative view of the world? The fall "off a cliff" in mortgage rates is signalling a dramatic decline in the demand for housing (and mortgages), and indirectly, in the price of the median New Zealand house. Some confirming evidence is the decrease in house sales witnessed around the time of the drop in mortgage rates, as house sales declined 50% year over year to March 2008 (according to REINZ) and is currently at around 20%. In examining the data, the only possible comfort found is that the correlation between mortgage rates and house prices over the entire period where data was available, from January 1992 to the present, is 0.11. So the long-term co-movement between mortgage rates and house prices is only slightly positive. However, the data in no way indicates the opposite relationship, that falling interest rates will lead to higher house prices, which is so commonly cited in the press these days. _______________ * Philip O'Connor is a Senior Lecturer in finance at the University of Auckland's Department of Accounting and Finance.