Soaring house prices, but low inflation: how come?

New method lays the ground for giving central banks an additional tool to fight the risk of housing bubbles.

Central banks almost exclusively look at inflation rates when setting interest rates. Real estate prices, however, are not well reflected in the inflation rate, which is why rates do not react to housing booms. Central banks are thus missing a preventive tool to “lean against the wind” given that their role is currently limited to “cleaning up the mess” after a bubble bursts.

New research at LISER contributes to the “leaning versus cleaning debate”.

Dr. Sofie R. Waltl (LISER), Prof. Dr. Robert J. Hill and Dr. Miriam Steurer (both University of Graz) developed a novel method that takes into account real estate prices in the inflation rate so that central banks automatically react to soaring real estate prices. This in turn may help to prevent the uncontrolled bursting of a housing bubble such as the one in the US roughly ten years ago that triggered the Global Financial Crisis.

This general problem is particularly relevant in the European Union, where real estate prices are currently completely excluded from the inflation rate. This is also the reason why there were very low inflation rates in recent years although real estate prices were soaring in many member states. These countries, including Luxembourg, can thus not expect the ECB’s help.

In the recently published LISER working paper “Owner Occupied Housing in the CPI and Its Impact On Monetary Policy During Housing Booms and Busts”, Hill, Steurer and Waltl further discuss the consequences of omitting real estate prices in the inflation rate and provide solutions.