A reduction in inflation can fuel run-ups in housing prices if people suffer from money illusion. For example, investors who decide whether to rent or buy a house by simply comparing monthly rent and mortgage payments do not take into account the fact that inflation lowers future real mortgage costs. We decompose the price-rent ratio into a rational component-meant to capture the "proxy effect" and risk premia–and an implied mispricing. We find that inflation and nominal interest rates explain a large share of the time series variation of the mispricing, and that the tilt effect is very unlikely to rationalize this finding.
The confusion between changes in nominal and real interest rates boosts real house prices when inflation declines.