House prices and the dollar

The Beeb reports that UK house prices are rising sharply and that the pound has hit a 14-year high against the dollar. What it doesn't say is that these two facts are related. Our chart shows that there's a strong correlation (0.53, R-squared = 28% since 1995) between annual changes in the $/£ rate and relative house price inflation in the two countries.
When UK house prices rise relative to the US's, sterling tends to strengthen against the dollar. There's probably a simple reason for this. When house prices rise, so does wealth (house prices are a measure of permanent income) and hence the demand for money. And rising demand for money should strengthen a currency.
Most pundits reckon UK house prices will continue to rise relative to US ones for a while; this is the message of strong UK mortgage approvals and the high inventory of unsold US houses.  This suggests the dollar could continue to weaken.
Personally, I'm surprised by this, and a little sceptical. Exchange rates can't be this predictable, can they?

Comments

[Alex]

I'm a little sceptical of yer microfoundations here. House prices rise, i.e. greater perceived wealth. Wealth effect>demand for money - well, the obvious mechanism here is the wealth effect on consumption. We know UK marginal propensity to consume and marginal propensity to import are high. Hence, we'd expect a deterioration in BOT, and also broader BoP due to invisible imports (think - second homes and trips to Dubai) - which certainly doesn't predict a rise in sterling, unless/until the interest rate goes up enough to attract hot money into sterling - which should press down property prices, or at least restrict their growth.

Are you sure it's not a lagging indicator of BoE rates?

[chris]

You're right that rising house prices lead to a bigger trade deficit; in the UK, monetary growth is a good predictor of the deficit. But the thing is that neither in the UK or US is there an obvious relationship between the trade gap and exchange rate. It looks like the positive wealth effect upon the exchange rate swamps the negative effect on it of higher imports.

[Alex]

I find it hard to grasp why there should be a positive wealth effect, though, seeing as essentially all the components of the liquidity preference schedule bend backwards with regard to income after a fairly low maximum. The only driver I see there is consumption - the GBMC isn't known for ploughing house price windfalls into capital formation, after all - which, ceteris paribus, shouldn't make the nut.

Perhaps mortgage approvals are a leading indicator of capital inflows?

[a different alex]

Have you seen, this is listed in the "best of the web" section of comment is free?

[james C]

Oh dear. Since relative house prices in the UK have risen over the period and the dollar has fallen, it isn't much of a surprise that you get some sort of correlation when you look at 11 years; of annual data.

[drbrightside]

I'm skeptical too. It appears there is more of a correlation between California and UK home prices in appreciation(99% since 1980 per a study by Credit Suisse). This would seem to be more of a product of supply/demand and interest rates than any particular currency phenomenon. U.S home prices have appreciated significanly even with a weaker dollar over the past three years. As UK homes get relatively more expensive appreciation will level, especially with the central bank raising rates.