House prices and interest rates: Bayesian evidence from Germany

This study uses a Bayesian VAR to demonstrate that the recent house price boom in Germany can be explained by falling interest rates and that higher interest rates are likely suciffient to stop the increase of German house prices. The latter suggests a potential drawback of the current monetary policy of the ECB. The BVAR's prior information shrinks the model parameters towards a parsimonious benchmark. We provide a simulation study to compare the frequentist properties of two useful strategies to select the informativeness of the prior. The study reveals that prior information helps to obtain more precise estimates of impulse response functions in small samples. To choose relevant control variables, we use a new Bayesian variable selection approach by Ding and Karlsson (2014). In addition to impulse responses and variance decompositions, we use a Bayesian conditional forecast to test the hypothetical effect of an increase of interest rates on house prices. This approach has the crucial advantage that it is invariant to the ordering of the variables.