Interest Rates, Inflation and Home Prices

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Submitted by XBoxBoy on May 28, 2021 - 9:57am

I've been thinking about the question of how much recent price rises are due to work from home narratives, people moving from other areas, and how much is due to record low interest rates. To answer this, I decided to make some charts that would show what I could reasonably expect to happen when interest rates change.

This first graph shows the relationship between interest rates and the size of a loan with a set monthly payment. To create this graph I used $2,500 a month payment. (Which might seem low for San Diego, but the amount of the monthly payment isn't important, a larger payment simply moves the graph up.) I did not include taxes or mortgage insurance, or consider down payment. All examples I'm using are for 30 yr. fixed. The goal here is to just show how much more you can afford as rates change.


Two simple take-aways from this chart: 1) The obvious, that as interest rates go down you can afford a lot higher purchase price and 2) as interest rates go down the curve gets steeper and so prices increase more due to a .5 percent drop from 3 to 2.5 than from a .5 percent drop from 8 to 7.5.

Next, I wanted to add some historical perspective to this. Interest rates have changed a lot over the years, so how much of the change in home prices is due to change in interest rates? Here's a graph that shows, given a monthly payment combined with the 30 yr. rate at a given time, what would be the purchase price you could afford. (Again, ignoring taxes, insurance, & down payment)

For this chart, I'm using a monthly payment of $2500, a starting date of January 1987 and mortgage rate data from FRED. I am not taking into account points paid. I'm not sure how important that is or isn't.


Now, the problem with the previous chart is that it assumes that over time the monthly payment people could afford wouldn't change. But over time inflation should cause wages to increase, thus increasing what people feel they can pay monthly. So, I've added a bit of code that increases the monthly payment by the inflation rate. Here's the chart with a starting monthly payment of $2500 and every month I adjust that amount for inflation.


Note the above does not deal with the issue of location at all. The above merely looks at the impacts of interest rate changes and inflation on expected home price. These charts are not unique to San Diego, or any sub-area.(Which brings up a bunch of interesting questions about what has happened in areas where home prices haven't risen over the years!)

But now, let's introduce some data to see how the expected home price compares to actual home prices. To do this, we can use the Case Shiller Index. I'll calculate the initial price based on what could be afforded on January 1, 1987 and then using San Diego Case Shiller Index, plot the Case Shiller price over the years.


In the above chart you can clearly see the housing bubble of the early 2000's! (And note, the above chart uses San Diego Case Shiller, not national Case Shiller)

One last point, the above charts are all linear in both the x and y. But arguably the y (price) should be shown as a log scale. So here's the final chart showing my interest rate and inflation adjusted expected price and the Case Shiller price with a log scale for the y.


So what to make of the above charts? First I think it'll be really interesting to see how different people will interpret the charts differently and to see how people use the charts to argue differing points.

But for me, the biggest observation is that most if not all of the home price increases we've seen in San Diego are the result of interest rate changes and inflation. This isn't a commonly held view, and one I would have doubted before doing these charts. The narrative that the home prices increases over the years are because so many people want to move here and that demand has grown while supply of houses hasn't, just doesn't hold up when I look at these charts.

The other thing is, if home prices increases are so strongly correlated to interest rates and inflation, what would happen if interest rates were to start rising? I'm not saying that's going to happen but it's worth keeping an eye on.

Sources of data:

Interest rate:

Inflation data:

Case Shiller San Diego:,

Submitted by gzz on May 31, 2021 - 4:12pm.

The deviation I believe is explained mostly by the expectation that high rates will go down, and the very powerful behavioral economic concept of sticky downward prices.

The weakness of my first point is that the high long rates in the late 70s and early 80s reflected market expectations. The counter to this is that expectations of homebuyers and investors are not the same as major bond buyers, and also that the homebuyer only needs to hope rates dip once so they can refi. Further, lower liquidity in RE means marginal buyers expecting rates to dip have more power than in liquid bond markets.

Another thing keeping RE high when high rates make it unaffordable was the concern about runaway inflation. Those long bonds with 13% coupons were great in retrospect, but had a much worse downside than RE if inflation had moved into the 20%+ range.

Submitted by Rich Toscano on June 3, 2021 - 9:14am.

Good stuff xbox, thanks for putting in all this effort. I think the experience of the early 80s can also be interpreted that the inverse relationship between interest rates and asset prices is not written in stone.

GZZ alluded to one possible reason why, which I've always been partial to. Buying a house is prepaying your rent for life, and thus, eliminating the risk of rental inflation. So the value of home ownership should (all other things equal) be higher if people are expecting high rental inflation, and lower if they are expecting low inflation. This factor would INCREASE values (again, all things equal) during periods of high inflation*, and decrease them during low inflation. This could partially offset the intuitive relationship between rates/monthly payments and prices.

* (what matters here is future inflation expectations, not trailing inflation... but people being natural extrapolators, the former usually just follows the latter).

Submitted by sdrealtor on June 3, 2021 - 10:05am.

Intersting point on expectations of future rent inflation. I never gave any thought to that beyond locking in one's housing costs at an affordable rate for life.

Submitted by Reality on June 3, 2021 - 11:17pm.

Rich Toscano wrote:
Good stuff xbox, thanks for putting in all this effort. I think the experience of the early 80s can also be interpreted that the inverse relationship between interest rates and asset prices is not written in stone.

Nobody knows how much higher asset prices might have gone without the interest rate policies of the time. Both going up at the same time is evidence of nothing.

Submitted by sdrealtor on June 5, 2021 - 10:57am.

Home Buying Opportunities over our lifetimesHome Buying Opportunities over our lifetimes

From time to time I kid our resident permabears that they missed the opportunity of a lifetime. Yesterday I was on my weekly call with a SoCal housing economist who posted this. It actually covers homebuying over our lifetimes. Hard to argue that buying a home around 2009 to 2012 was not the opportunity of lifetime looking at this.

Submitted by XBoxBoy on June 5, 2021 - 12:01pm.

sdrealtor wrote:
Hard to argue that buying a home around 2009 to 2012 was not the opportunity of lifetime looking at this.

Yup, absolutely agree. If you look at the chart above showing deviation you find it agrees with your housing economist. 1997 to 2000 was a good time, and then again 2010 to 2013 was an even slightly better time.

Submitted by scaredyclassic on June 5, 2021 - 12:18pm.

XBoxBoy wrote:
sdrealtor wrote:
Hard to argue that buying a home around 2009 to 2012 was not the opportunity of lifetime looking at this.

Yup, absolutely agree. If you look at the chart above showing deviation you find it agrees with your housing economist. 1997 to 2000 was a good time, and then again 2010 to 2013 was an even slightly better time.

I've missed so many opportunities, they barely register. But even a dope does something right occasionally

Submitted by XBoxBoy on July 17, 2022 - 2:20pm.

Here's an updated version of the chart comparing the Case Shiller to what we would expect the price of a house to be based on historical inflation and mortgage rates. Just to remind you the red is Case Shiller and the blue is the expected price.


I'm guessing that most of you will find that to be a pretty big eye opener, like I did. It shows that things are way more out of balance than I expected. Of course we all know things are out of balance, prices shot up the last two years and now that mortgage rates are rising, this has really opened the gap between where prices are and where they should be based on inflation and mortgage rates.

For those of you who prefer a log scale here's the same data but with log scale for price:

When viewed with a log scale (which arguably is the correct way to view this data) things look less dramatic, but still a sizeable imbalance.

After looking at this, two questions come to mind for me.
1) What will be the path that brings these two back in balance?
2) How long will that take?

(On a side note, I also wonder if it is reasonable to expect that these two do come back in balance. Most the time I think about this, I come back to thinking they should, but I'm open to anyone who's got a good argument why this isn't so.)

Anyway, I'll post the above now, and potentially later I'll share some charts about where these graphs go with various assumptions (guesses!) as to where inflation, mortgage rates and prices go. If anyone has a scenario they think is particularly likely feel free to post and if there aren't too many I'll try to create the charts that show how that plays out.

Submitted by XBoxBoy on July 17, 2022 - 2:24pm.

Here's the deviation chart btw:

Submitted by sdrealtor on July 17, 2022 - 2:44pm.

Really is a dramatic shift and in an incredibly short time. One has been on a path essentially moving straight up and the other suddenly went straight down. Absent what makes real estate unique this situation would most assuredly precede a dramatic drop. What we don’t know is what happens with supply with so many locked into such long term low rates? It’s gonna make moving tough to impossible for many even if they could sell their home. Nothing would surprise me going forward

Submitted by flyer on July 18, 2022 - 12:18am.

Things really are starting to get interesting. Not really looking for more rentals, but always open to new opportunities. Otoh, really don't want to see the country continue to go through even more economic pain. Guess we'll have to wait and see how it all goes.

Submitted by The-Shoveler on July 18, 2022 - 11:25am.

LOL interesting times for sure.

IMO true RE is a local thing mostly but it is also a national thing if the whole country goes recession.

IMO if housing (nationally) goes into recession the whole thing goes into recession, then the fed will need to start worrying about deflation.

The issue is IMO, the fed wants a housing reset, the problem is there is no such thing as a housing reset that does not take the whole economy with it.

Submitted by flyer on July 18, 2022 - 9:21pm.

Could be, TS. So much of what we are experiencing is uncharted territory due to the pandemic, and for some other reasons, so, imo, anything is possible.

Sadly, all of the volatility in many sectors, is most affecting those who can least afford it, which is a substantial portion of those in our country. We can only hope there will be some meaningful resolutions sooner rather than later.

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