The effect of monetary policy on house price inflation : A factor augmented vector autoregression (FAVAR) approach

Purpose – This paper seeks to assess the impact of monetary policy on house price inflation for the nine census divisions of the US economy. Design/methodology/approach – A factor‐augmented VAR (FAVAR) model is estimated using a large data set comprising of 126 quarterly series over the period 1976:01 to 2005:02. Findings – Overall, the results of this investigation show that house price inflation responds negatively to a positive monetary policy shock, suggesting that the framework does not experience the widely observed price puzzle encountered while analyzing monetary policy shocks with standard sized VARs. Research limitations/implications – The paper only considers house price inflation and ignores other housing market variables. Moreover, given the recent economy‐wide decline in the house price growth rates, it would be worthwhile to update the data set to a more recent period, to capture the possible breakdown in the relationship of house prices with fundamentals driving the market. Practical implications – The results based on the impulse response functions indicate that, in general, house price inflation responds negatively to monetary policy shock, but the responses are heterogeneous across the census divisions. In addition, the findings suggest, in particular, the importance of South Atlantic, East South Central, West South Central, Mountain and the Pacific divisions in shaping the dynamics of US house price inflation. Originality/value – To the best of one's knowledge, this is the first paper to analyze the effect of monetary policy on house price inflation in the nine census divisions of the US economy using a FAVAR model.