House prices and business cycles: The case of the UK

This paper investigates the role of house prices in UK business cycles since the mid-1950s. First a Markov-switching common factor model is constructed to capture business cycle co-movements and the inherently different regimes across expansion and recession phases. Then house-price variables are incorporated into the baseline model to evaluate their importance in fluctuations of real economic activity. When house prices are introduced into the model as direct determinants of the evolution of individual macroeconomic indicators, only their declines have nontrivial effects on the movements of the macro variables and consequently on business cycles. Alternatively, when house prices are incorporated as factors affecting transition probabilities, strong evidence is found that house prices significantly affect the transitions of the UK economy between periods of expansion and recession. It is confirmed again that declines in house prices are more significant than their increases in house-price growth rates as factors affecting the business cycles. Finally, the importance of house price decreases is found robust to the inclusion of financial variables in the model and to the use of a different house price index.