Working Paper: CEPR ID: DP17187
Authors: Klaus Adam; Oliver Pfuti; Timo Reinelt
Abstract: U.S. households' housing price expectations deviate systematically from rational expectations: (i) expectations are updated on average too sluggishly; (ii) following housing price changes, expectations initially underreact but subsequently overreact; (iii) households are overly optimistic (pessimistic) about capital gains when the price-to-rent ratio is high (low). We show that weak forms of capital gain extrapolation allow to simultaneously replicate the behavior of housing prices and these deviations from rational expectations as an equilibrium outcome. Embedding capital gain extrapolation into a sticky price model featuring a lower-bound constraint on nominal interest rates, we show that lower natural rates of interest increase the volatility of housing prices and thereby the volatility of the natural rate of interest. This exacerbates the relevance of the lower bound constraint and causes the optimal inflation target to increase strongly as the natural rate falls.
Keywords: monetary policy; subjective housing price expectations; natural rate of interest; housing booms; optimal inflation target; effective lower bound
JEL Codes: E31; E44; E52; E58
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Households' housing price expectations deviate systematically from rational expectations (R21) | Increased volatility in housing prices (R31) |
| Lower natural rates of interest (E43) | Increased volatility in housing prices (R31) |
| Increased volatility in housing prices (R31) | Exacerbated lower bound constraint on nominal interest rates (E43) |
| Lower natural rates of interest (E43) | Higher optimal inflation target (E31) |