House prices and interest rates: Bayesian evidence from Germany

This study uses a Bayesian VAR (BVAR) to demonstrate that the recent boom in German house prices can be explained by falling interest rates and that higher interest rates are likely sufficient to stop the price increase. 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 in order to avoid overfitting the data. We use an empirical Bayes approach to select the informativeness of the prior. To choose relevant control variables, we use a Bayesian variable selection approach. In addition to impulse responses and variance decompositions, we use a Bayesian conditional forecast to test the hypothetical effect of an interest rate increase on house prices.