The transmission between the shekel/dollar exchange rate and the housing component of the CPI

04.10.2009

The transmission between the shekel/dollar exchange rate and the housing component of the CPI

	In the last two years rental agreements have switched from quoting dollar prices to prices in shekel. In the past contracts quoting dollar prices constituted about 90 percent of rental contracts; today the figure is 15 percent.
	As a result of the above, the transmission from the shekel/dollar exchange rate to the housing component of the CPI has weakened: in the short term (up to one month) it declined from about 0.9 to 0.48, and in the long term (a year and above)––whereas in the past there was full transmission–– it has now disappeared.
	Despite the decline in the transmission and the switch to shekel contracts, the dollar is still the dominant factor in the explanation of the short-term fluctuations in housing prices.
The housing index is one of the major consumption items in the Consumer Price Index, with a weight of about 21 percent of the total index. The housing component consists of three elements: housing services for owner-occupied housing (77 percent), rent (19.5 percent), and other housing expenditure (3.5 percent). In the past, apartment prices were used as a proxy for the first element. In light of the recommendations of a committee of experts and of the IMF, the method of measurement was changed so that it reflects the price of housing services rather than the price of capital. Since 1999 this element has been measured by means of the rents quoted in new and renewed rental contracts. Thus, for the last decade the major part of the housing component has in effect been measured by changes in rents.
In reaction to the high inflation in the 1980s, sellers starting quoting prices of various items on the domestic market in dollars. In the housing market this practice continued for years also after inflation had fallen. As a result, changes in the exchange rate were mirrored by similar changes in the shekel prices of housing, at least to the extent that the price in dollars was inelastic.
In the last few years, with the weakening of the dollar, the practice of quoting a dollar price has stopped, and most new contracts quote the price in shekel. Until 2007, about 90 percent of contracts gave the rental price in dollars; today the figure is down to less than 15 percent. Figure 1 shows the housing price in the CPI, the change in the dollar exchange rate, and the proportion of new contracts quoting dollar prices. The figure clearly shows the close link between the exchange rate and the housing price and the extent of the weakening of the relation between them with the switch to shekel contracts.
The data show that the effect of the dollar exchange rate on the housing index has indeed been reduced, and this is reflected by the continuous decline in the transmission coefficient. A simple way of measuring this is via a rolling regression, in which the rate of monthly dollar/shekel depreciation explains the fluctuations in the housing component. Figure 2 shows the transmission coefficient derived from this estimate; it shows clearly that the effect of the dollar on the housing component has declined steadily over time, and most markedly with the move to shekel contracts. This result is consistent with a more stringent econometric analysis that relates to the method of measuring the elements of the housing component and to the possibility that the effect of the dollar is not only an immediate one but that it also continues for some time. Estimates performed by the Bank of Israel Research Department show that until the end of 2006, prior to the switch to shekel contracts, the transmission from the dollar to the housing component was rapid and full, whereas since 2007 it has declined, and in the long term has effectively disappeared.
Nonetheless, despite the move to shekel contracts, the data show that the dollar was and remains the dominant factor in explaining the fluctuations in the housing component in the short term. This can be seen from the correlation between the housing component and the shekel/dollar exchange rate. Figure 2 shows the correlation between the monthly fluctuations in the housing component and the exchange rate over time. The figure shows that the correlation was, and still is, high. Although it declined somewhat in 2005 and 2006, that was before the move from dollar to shekel contracts. Since 2007 it has risen again, and it is currently at a similar level to that at the beginning of the sample, in 2001.