Most Overvalued Housing Market

This may surprise many people, but the US doesn't have the most overvalued housing market. The US markets rank 13th most overvalued, with the top 11 markets in Europe and the 12th in Japan.

The chart, from an article in the latest World Economic Outlook, to the left shows the "price gap" between market values (unexplained price increases) and the intrinsic value of the housing market. The intrinsic value of the housing market is define as a function of an affordability ratio (the lagged ratio of house prices to disposable incomes), growth in disposable income per capita, short-term interest rates, long-term interest rates, credit growth, and changes in equity prices and working-age population.

The article goes on to explain that the likelihood of a country to experience a slowdown in the housing market is dependant on two factors. First is the price increase which cannot be supported by the market fundamentals. The second factor is the increase in size of the residential investment to GDP ratio. At the end of 2007, Spain, Denmark, France, Italy, Finland and Belgium have the largest increase in the residential investment to GDP ratio.

One of the conclusions of the article suggest that 'in economies with more developed mortgage markets, economic stabilization could be improved by a monetary policy approach that responds to house price developments in addition to consumer price inflation and output developments. In a risk-management framework, such an approach would need to accommodate the uncertainty about what factors drive house price dynamics—in particular, whether house prices reflect changes in fundamentals or speculative forces—and their impact on the economy. House prices would seem relevant for calculating the risks to the outlook for overall economic activity and prices, particularly during periods of rapid change in house prices and when house prices seem to be moving out of line with historical norms.'

'Such attention to house price developments need not require a change in the formal mandates of major central banks, but could be achieved by interpreting existing mandates more flexibly, for instance, by extending the horizon for inflation and output targets. Moreover, it is important that such an approach be applied symmetrically: while an aggressive easing may be justified in response to a rapid slowdown of the housing sector, some “leaning against the wind” may also prove useful to limit the risk of a buildup of housing market and financial imbalances.'

Source:
'High-rise living' , The Economist
'The Changing Housing Cycle and the Implications for Monetary Policy', IMF