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House prices as bonds

It’s often said that cheap money has driven up asset prices. What’s not so appreciated is that this raises a big puzzle about the housing market.

Few economists doubt that low rates have inflated house prices. In fact, say Bank of England economists, “the rise in real house prices since 2000 can be explained almost entirely by lower interest rates.” My chart shows their point. It shows that as index-linked gilt yields have fallen since the 1990s so the ratio of house prices to the earnings of first-time buyers has risen. There’s a simple reason for this. As interest rates fall we discount future cash flows less heavily: these cash flows might be rent, or the rent we save by owning our own home. And if future cash flows become more valuable so too will the asset that generates them. Lower interest rates therefore mean higher asset prices. Simple. 

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