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# Factors Determining Prices Of Houses In Uk

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FACTORS DETERMINING PRICES OF HOUSES IN UK

Factors Determining Prices of Houses in UK

Factors Determining Prices of Houses in UK

Introduction

Inflation in UK House prices has been particularly high in recent years. This has led to much discussion concerning future path of house price growth. Whether future scenario involves the moderation or instead the sharp correction in house prices has important implications for short to medium path of household consumption expenditure.1

Chart 1 plots year-on-year growth of real house prices from fourth quarter of 1964 to first quarter of 2004. The series plotted is the seasonally adjusted version of Office of Deputy Prime Minister (ODPM) mix-adjusted house price index. This house price index is deflated using National Accounts consumption expenditure deflator before calculating growth rates to show real house price growth. The peaks in rate of real house price inflation are all followed by periods of decline in real house prices. There has been acceleration in rate of house price inflation in recent years, most notably during 2002. The debate centers on scenario that will follow this recent period of above average real house price growth. However, this discussion of future path of real house price growth depends on whether and how far real house prices have deviated from their equilibrium. We estimate the simple house price equation to determine equilibrium of real house prices and, consequently, extent to which house prices have deviated from this equilibrium.

In a review of the UK literature, Meen and Andrew (1998b) note that most modern house price models use the life-cycle model of consumption as their starting point. They note that it is empirically difficult to distinguish between reduced form equations and lifecycle models. The starting point for this estimation exercise is a reduced form equation estimated as an error correction model, in the form derived by Meen (2002).2 However, in the process of estimation we could find no significant effect of the supply side factor that we included, ie the housing stock. Thus our model of house prices is a simple inverted housing demand function.

We estimate an error-correction relationship for the change in the log of real house prices (DLRHP), driven by the one-period lag of the log of real house prices, the one-period lag of real short-term interest rates (UKRR) and the one-period lag of the log of real personal disposable income (LRPDI).3 Higher real interest rates should depress house prices, while rising real disposable income should have the opposite effect. The error correction relationship also includes dynamic terms. We include one and two-period lagged changes in the log of real house price variables. These should capture the persistent overshooting of the equilibrium of real house prices, commonly discussed in the literature. We also include a lagged change in the nominal short-term interest rate (DR3M). As noted in IMF (2003), high nominal interest rates shift the burden of a household's mortgage debt onto the earlier years of its mortgage period. With low nominal interest rates over the last few years this may have ...
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