Economic forecasters are always on the lookout for variables that can help predict upcoming recessions. One such variable that has gotten some recent attention is the housing price-rent ratio. As this ratio becomes higher, the rental option becomes more attractive. If it rises high enough, some households might switch from owning their homes to renting them; then the demand for owner-occupied housing would fall. The result is a contraction in the housing market that can have adverse effects on the entire economy. This narrative seems to match well with the behavior of the housing price-rent ratio leading up to the Great Recession. So if the housing price-rent ratio is on the rise again, does that mean it’s cause for concern? Let’s try to evaluate whether the housing price-rent ratio is a reliable leading indicator by graphing it, with data going back to 1975.
To be considered a leading indicator, a variable must change in sign prior to the beginning of each recession. (Recessions, as defined by NBER, are shown by gray shading.) The Great Recession started in December 2007. As we can see, the housing price-rent ratio reached its peak in April 2006, approximately two quarters prior to the start of the recession. In other words, the housing price-rent ratio seems in this case to have been a leading indicator. But for a complete evaluation, all the recession episodes must be examined. In January 1980, the U.S. economy suffered from double-digit inflation. To solve that problem, Paul Volker essentially created a recession. This recession began in January 1980. The housing price-rent ratio peaked in the second quarter of 1979 and then declined. It could again be argued that the price-rent ratio predicted this recession. In July 1981, another recession started. For this recession, whether the housing price-rent ratio correctly indicated a coming recession is less clear. The housing price-rent ratio didn’t suggest an upcoming recession in March 2001, as the ratio steadily increased.
A second condition for a variable to be a leading indicator is that it doesn’t suffer from the false-positive problem. This problem would occur when the house price-rent ratio decreases but no recession occurs. There are a number of instances when the housing price-rent ratio does suffer from this problem.
So it’s not clear whether the housing price-rent ratio qualifies as a leading indicator: It fails to identify some recessions and gives false-positive readings at other times. But in the two major recessions since 1975 (the 1980 and 2007 recessions), the housing market played a leading role; so, these recessions were predicted correctly by the housing price-rent ratio.
How this graph was created: Search for and select the series called “All-Transactions House Price Index for the United States.” Then, in the customize data option of the “Edit Graph” menu, search for and select the series called “Consumer Price Index for All Urban Consumers: Rent of primary residence.” Finally, in the formula tab, enter a/b to divide the home price index by the rent price index.
Suggested by Ryan Mather and Don Schlagenhauf.
