Housing Prices at the Time of QEs in California: Effect of Mortgage Rates

In this paper we look at the impact of mortgage rates on California’s housing prices during the Great Recession when the quantitative easing (QE) programs were implemented. We find that the relationship between mortgage rates and housing prices is not strong and it becomes weaker, the closer the period gets to the Great Recession. Our analysis confirms some of the existing literature on the relationship between interest rates and housing prices; that in the boom-bust housing market cycles, interest rates do not play a major role one would expect in determining the demand for housing. Our analysis shows that, even as interest rates were high in the run up to the housing market peak in 2007, housing prices kept going up; and that after the bubble burst, even as rates were kept low, housing prices did not start recovering until 2011.


Introduction
Following the global financial crisis of 2007-08, the Federal Reserve implemented "Quantitative Easing", an unconventional monetary policy, in order to lower interest rates and increase the money supply. It's not surprising that a direct impact on the housing market is the lowering of mortgage rates. An interesting questions is whether such low rates would have helped drive up the real estate market, which suffered substantial loss during the crisis. In this paper, we try to explore the relationship between mortgages rates and housing prices by looking at housing prices in California from 1998 to 2014, a period that covers a long housing boom, the Great Recession and the start of rising house prices from 2011 on in California A first look at the time series of California state level housing price ( Figure 1) and the 30 year fixed mortgage rates ( Figure 2) reveals no clear relationship between the two. During the period, mortgage rates exhibit a downward trend overall while housing price exhibit an obvious cycle with a peak and a trough. Through further econometric analysis, we find that the relationship between mortgage rates and housing prices is not strong and it becomes weaker, the closer the period gets to the Great Recession. Our analysis confirms existing literature; that in the boom-bust housing market cycles, it is the expectations of future property appreciation that play a major role, rather than interest rates, in determining demand for housing. Our findings here would be useful for those working in real estate research, as well as for policy makers interested in estimating the impact of their interest rate intervention on the rest of the economy including the real estate market. We picked 1998 as the starting date of our work, which is one year preceding the long real estate boom of 1999 -2006.
In the following sections, we present our methodology, empirical analysis and results, and conclusion.

Method
We estimate housing prices (dependent variable) using two panel regression models with mortgage rate as the independent variable together with other control variables.
The local unemployment rate, the traditionally important housing-value determinant (Kim, Lee and Tran, 2014, Kau, Keenan and Kim 1993& 1994 is an independent variable common to both models. We also employ lagged housing price variables since housing price changes have a strong serial correlation as noted by, among others, Titman, Wang and Yang (2013). Capozza, Hendershott and Mack (2004) present similar serial correlation in housing price changes for metropolitan areas, as do Case and Shiller (1989). In order to isolate this persistent serial correlation problem, we include lagged housing prices up to four months. Note that Miller, Sklarz and Thibodeau (2005) employ the lagged values up to five months in their study of the impact of mortgage rates and employment rates on metropolitan housing prices. Likewise, we include monthly lagged mortgage rates and lagged unemployment rates, again in order to correct for serial correlation.
The first model regresses the natural logarithm of housing prices on the natural logarithm of mortgage rates: Where, LHP it = the natural logarithm of housing price for the i th city at time t, LMR t = the natural logarithm of mortgage rate at time t. This data is not available for individual cities over time, dependent variable. The term ε it is the random disturbance for the i th city at t th period with E [ε it ] = 0. It is assumed that ε it is uncorrelated with other independent variables and u i such that COV (ε it , ε is ) = 0 for t ≠ s.
ERecess, the general economic recession period dummy variable, and HRecess, the housing recession period dummy variable help isolate the impact of mortgage rate from the impact of economic and housing cycle variables on housing values. Note that during the period covered in this paper, the real estate downturns in California occurred at different times from the two general economic recessions as determined by National Bureau of Economic Research (the period when the GDP growth was negative).
To summarize, in model 1, the independent variables are the mortgage rate and its monthly lags, the unemployment rate and its lags, and the recession dummy variables, ERecess and HRecess.
Model 2 is similar to model 1. We apply first differences of the natural logs of hosing price, mortgage rate, and unemployment variables. The rest of the independent variables are identical in both models, so as to isolate the impact of the mortgage rates on housing values, without any other changes.

Empirical Analysis and Results
The results of the research are summarized in Table 1 for Model 1 and in Table 2 for Model 2 below. We employed staggered data sets starting with 1998-2014, followed by 1999-2014, 2000-2014 and so on, with 2007-2014 being the last set. As the results show below, there is no negative relationship one might expect to see between mortgage rates and the housing price.
This seemingly counter intuitive result is, in fact, quite well documented in the literature. Gelain, Lansing and Natvik (2015), in their study of the U.S. housing boom and bust cycles between 1995 and 2012, find that relaxing loan to equity ratios on the part of the mortgage lenders and the ensuing credit boom were more important in explaining housing booms than lower mortgage interest rates. In his study of the monetary policy and housing, Taylor (2007) presents that low money market rates led to housing booms both before and after the 1980s; and that the housing booms continued even when low money market rates were returned to the normal higher levels, as long as the long-term rates remained relatively low providing and ensuring abundant credit. In fact, both of these papers indicate that the biggest factor running up to housing booms was the belief on the part of the homebuyers that the housing price will keep appreciating; this in turn brought in many new, first time homebuyers as well as investors-speculators alike.
Our research confirms this existing literature. Table 1 and Figure 3 show no negative relationship between the log of mortgage rates LMR and the log of housing price LHP. The LMR coefficients clearly indicate that even as mortgage rates went up, housing prices went up, though at a decreasing rate, until we reach the period 2000-2014, where, as the mortgage rates went up, the housing price went up at a faster rate reflecting the housing market bubble. That trend continues without interruption until 2007-2014. In other words, throughout our research period, through the housing booms, the economic recession and housing recession, higher mortgage rates did not negatively impact housing prices. However, the negative correlation coefficients apply to the economic and the housing recession dummy variables Erecess and Hrecess and are both statistically significant throughout.  1998-2014.2 1999-2014.2 2000-2014.2 2001-2014.2 2002-2014.2 2003-2014.2 2004-2014.2 2005-2014.2 2006-2014.2 2007-2014 Values in parentheses are t-statistic. Significance at 10%, 5%, and 1% levels are reported by *, **, and *** respectively.   1998-2014.2 1999-2014.2 2000-2014.2 2001-2014.2 2002-2014.2 2003-2014.2 2004-2014.2 2005-2014.2 2006-2014.2 2007-2014 Values in parentheses are t-statistic. Significance at 10%, 5%, and 1% levels are reported by *, **, and *** respectively.

Conclusion
In this paper, we show that during our research period of 1998-2014, lower mortgage rates did not result in higher housing prices, and that higher mortgage rates did not result in a slowdown of housing price appreciation. Instead, and possibly contrary to the conventional wisdom, the rate of housing appreciation went up further in the run-up to the crash of 2006, even as mortgage rates went up. Our empirical analysis differs from existing research in that we study the role of mortgage rates during QE period using data of housing prices in sixty cities in California not the aggregate national housing prices.
The result confirms existing literature: in the boom-bust housing market cycles, interest rates do not play a major role in determining demand for housing and hence the price appreciation. Rather, it seems to be an abundance of supply of credit, coupled with an expectation of a future appreciation of housing prices that matters more. Even in the face of higher mortgage rates, as long as there was an expectation of future price appreciation backed by an abundance of credit (Quigley 1999, Gelain, Lansing andNatvik 2015), housing appreciation continued.
The results also have important policy implications. Through unconventional monetary policies such as QE the Federal Reserve did succeed in keeping interest rates low. Yet, as our research confirms, such low rates are neither necessary nor sufficient guarantees for reviving a slumping housing market. Likewise, higher rates do not necessarily dampen housing prices. The policy makers need to keep in mind that, while low rates may not hurt the housing market, it is the expectation of a future appreciation that entices people to buy housing, above all else.
Future research could employ other interest rates to explore their effect on housing prices. For example, Kim, Lee and Tran (2014) employ bond yields as a proxy for mortgage rates in their study of the impact of education industry on housing prices. Comparing the effects of different interest rates on housing prices may yield implications for economic policies.