In the midst of a pronounced domestic recession, it can often be difficult to see the wood from the trees. So, in the spirit of parsimonious economic models, I thought I’d post a quick graph today which would be my one graph if I had to predict when house prices will level off.
The graph below shows the change in the unemployment rate (inverted, so a rising blue line means falling unemployment) and the change in real house prices (i.e. house prices less general inflation). I’ve trimmed the axes at +/-40%, but for those curious about just how bad 2009 will be, if unemployment were to average 11%, that would be an 80% increase in the unemployment rate. To go out to 2011, as the graph does, I’ve assumed that unemployment averages 15% in 2010 and also 2011. I’ve taken 20% as the fall in house prices in 2009.
While it’s not a perfect relationship (for example, this measure breaks down when unemployment can go no lower, as in the 2003-2006 period, when house prices rose), and of course correlation is not causation, there is certainly a strong relationship between the change in unemployment and the change in house prices. The correlation from 1984 to 2009 was above 80%.
This suggests demand, rather than supply, has driven real house prices over the past generation. It will be interesting to see, if unemployment does level off in the second half of 2010 or in 2011, whether (over)supply kicks in or whether the correction between 2007 and 2011 will have factored in supply factors already.